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Federal Register / Vol. 86, No. 149 / Friday, August 6, 2021 / Notices
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lender.255 As discussed above, one critical difference between Exchange Act rule 18a1 and the Basel capital standard is that an SBS Entity cannot count as capital the amount of initial margin posted to a counterparty or third-party custodian unless it enters into a special loan agreement with an affiliate.256 Under the Basel capital standard, a Covered Entity can count initial margin posted away as capital without the need to enter into a special loan arrangement with an affiliate.
Consequently, to count initial margin posted away as a liquid asset for purposes of the second additional capital condition, the Covered Entity must enter into the same type of special agreement that an SBS Entity must execute to count initial margin as an allowable asset for purposes of Exchange Act rule 18a1.257
If an asset does not fall within one of the five categories of liquid assets as defined in the Order,258 it will be considered non-liquid, and could not be treated as a liquid asset for purposes of the second additional capital condition in the Order. For example, one commenter listed the following categories of non-liquid assets on the Balance Sheet Table: 1 Investments;
2 Loans; and 3 Other Assets. 259
These categories of assets generally could not be treated as liquid asset. The non-liquid investment category would include the Covered Entitys ownership interests in subsidiaries or other affiliates. The non-liquid loans category would include unsecured loans and advances. The non-liquid other assets category refers to assets that do not fall into any of the other categories of liquid or non-liquid assets. These non-liquid other assets would include furniture, fixtures, equipment, real estate, property, leasehold improvements, deferred tax assets, prepayments, and intangible assets.
As discussed above, the first prong of the second additional capital condition will require the Covered Entity to subtract total liabilities from total liquid assets and then apply a deduction haircut to the difference.260 The amount remaining after the deduction will need to equal or exceed $20
million. The method of calculating the amount of the deduction relies on the calculations Covered Entities must make 255 See
para. c1iiiB5 of the Order.
Capital and Margin Adopting Release, 84
FR at 4388788.
257 See Capital and Margin Adopting Release, 84
FR at 4388788.
258 See para. c1iiiB of the Order.
259 See SIFMA 5/3/2021 Letter Appendix C.
260 See para. c1iiA1 of the Order.
256 See
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under the Basel capital standard.261 In particular, under the Basel capital standard, Covered Entities must riskweight their assets. This involves adjusting the nominal value of each asset based on the inherent risk of the asset. Less risky assets are adjusted to lower values i.e., have less weight than more risky assets. As a result, Covered Entities must hold lower levels of regulatory capital for less risky assets and higher levels of capital for riskier assets. Similarly, under Exchange Act rule 18a1, less risky assets incur lower haircuts than riskier assets and, therefore, require less net capital to be held in relation to them. Consequently, the process of risk-weighting assets under the Basel capital standard provides a method to account for the inherent risk in an asset held by a Covered Entity similar to how the haircuts under the Exchange Act rule 18a1 account for the risk of assets held by SBS Entities. For these reasons, it is appropriate to use the process of riskweighting assets under the Basel capital standard to determine the amount of the deduction haircuts under the first prong of the second additional capital condition.
Under the Basel capital standard, Covered Entities must hold regulatory capital equal to at least 8% of the amount of their risk-weighted assets.262
Therefore, the deduction haircut required for purposes of the first prong of the second additional capital condition is determined by dividing the amount of the Covered Entitys riskweighted assets by 12.5 i.e., the reciprocal of 8%.263 In sum, the Covered Entity must maintain an excess of liquid assets over total liabilities that equals or exceeds $100 million before the deduction derived from the firms 261 See BCBS, Risk-based capital requirements RBC20, available at: https www.bis.org/basel_
framework/chapter/RBC/
20.htm?inforce=20191215&published=20191215.
262 See BCBS, Risk-based capital requirements RBC20.
263 See para. c1iiiC of the Order. The Commission acknowledges that a Covered Entitys risk-weighted assets will include components in addition to market and credit risk charges e.g., operational risk charges. However, the Commission expects the combined market and credit risk charges will make up the substantial majority of the risk-weighted assets. In addition, the Commission believes that this method of calculating the deduction in the first prong of the second additional capital condition is a reasonable approach in that it addresses market and credit risk similar to the process used by security-based swap dealers authorized to use internal models to compute market and credit risk deductions under Exchange Act rule 18a1. See, e.g., Exchange Act rule 18a1e prescribing requirements to calculate market and credit risk charges, including use of an 8% multiplication factor for calculating the credit risk charges.

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risk-weighted assets and $20 million after the deduction.264
The second prong of the second additional capital condition requires the Covered Entity to make and preserve for three years a quarterly record that: 1
Identifies and values the liquid assets maintained pursuant to the first prong;
2 compares the amount of the aggregate value the liquid assets maintained pursuant to the first prong to the amount of the Covered Entitys total liabilities and shows the amount of the difference between the two amounts the excess liquid assets amount; and 3 shows the amount of the deduction required under the first prong and the amount that deduction reduces the excess liquid assets amount.265 This prong has been modified from the proposed Order to conform to the modifications to the first and third prongs of the proposed capital condition discussed above i.e., combining them into a single prong that imposes a simplified net liquid assets test. Under the Order, the quarterly record will include details showing whether the Covered Entity is meeting the $100
million and $20 million requirements of the first prong.
The third prong of the second additional capital condition requires the Covered Entity to notify the Commission in writing within 24 hours in the manner specified on the Commissions website if the Covered Entity fails to meet the requirements of the first prong and include in the notice the contact information of an individual who can provide further information about the failure to meet the requirements.266 As discussed above, the first additional capital condition requires the Covered Entity to apply substituted compliance with respect to notification requirements of Exchange Act rule 18a8 relating to capital.267 A
Covered Entity applying substituted compliance with respect to Exchange 264 For example, assume a Covered Entity has total assets of $600 million of which $595 million are liquid and $5 million are illiquid and total liabilities of $450 million. In this case, the Covered Entitys liquid assets would exceed total liabilities by $145 million $590 million minus $450 million and, therefore, the Covered Entity would have excess liquid assets greater than $100 million as required by the first prong of the second additional capital condition. Assume further that the Covered Entitys risk-weighted assets under the Basel capital standard equal $400 million. In this case, the Covered Entitys deduction would equal $32
million $400 million divided by 12.5. Subtracting $32 million from $145 million leaves $113 million, which exceeds $20 million. Therefore, the Covered Entity would meet the second requirement of the first prong of the second additional capital condition.
265 See para. c1iiiA2 of the Order.
266 See para. c1iiiA3 of the Order.
267 See para. c1ii of the Order.

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