Methodology. Rating Securities Firms Operating in the United States

Transcription

1 Methodology Rating Securities Firms Operating in the United States may 2008

2 CONTACT INFORMATION Alan G. Reid Managing Director U.S. Financial Institutions Tel Roger Lister Chief Credit Officer U.S. Financial Institutions Tel Peter Bethlenfalvy Group Managing Director Global Corporate Finance Tel DBRS is a full-service credit rating agency established in Privately owned and operated without affiliation to any financial institution, DBRS is respected for its independent, third-party evaluations of corporate and government issues, spanning North America, Europe and Asia. DBRS s extensive coverage of securitizations and structured finance transactions solidifies our standing as a leading provider of comprehensive, in-depth credit analysis. All DBRS ratings and research are available in hard-copy format and electronically on Bloomberg and at DBRS.com, our lead delivery tool for organized, Web-based, up-to-the-minute information. We remain committed to continuously refining our expertise in the analysis of credit quality and are dedicated to maintaining objective and credible opinions within the global financial marketplace.

3 Rating Securities Firms Operating in the United States TABLE OF CONTENTS The U.S. Securities Industry 4 Rating Methodology Overview 5 Monitoring 5 DBRS Approach to Rating Securities Companies 6 Interconnected Analytical Elements 7 Determining the Rating from the Building Blocks 7 (1) Franchise Strength 8 (2) Liquidity and Funding 9 (3) Earnings Power 10 (4) Capital Structure and Adequacy 11 (5) Risk Profile and Risk Management Processes 12 Rating Considerations Beyond the Five Building Blocks 14 Holding Company Fundamentals 14 Support from Parent or Other Owners 14 Consideration for Regulatory Environment and Systemic Support 14 Notching and Seniority of Rated Debt Classes and Preferred Shares 15 Related Research and Methodology Links 15 3

4 The U.S. Securities Industry The U.S. securities industry encompasses a wide range of activities, including financial advisory, underwriting of equity and debt instruments, trading of a broad range of assets, structuring/securitization, leveraged lending, merchant banking, retail brokerage, asset management, prime brokerage, clearing and other securities services, and much more. The mix of participants competing in the U.S. securities industry is diverse, ranging from large universal banks that have retail as well as wholesale banking businesses, to large broker dealers with global trading and investment banking franchises, to more focused players such as advisory boutiques, regional brokers, asset managers and direct brokers that serve retail investors through low-cost distribution channels. There is also a wide range of specialized firms, such as futures brokers and specialists that focus on particular products or segments of the securities markets. DBRS has assigned ratings for a number of participants in the U.S. securities industry, ranging from broker dealers to large banks with securities operations to smaller players with more focused franchises. In its analysis, DBRS focuses on five interconnected building blocks franchise strength, liquidity and funding, earnings power, capital resources, and risk profile / risk management. DBRS views these building blocks as interrelated. Each element is essential to the overall credit assessment. In the short run, liquidity and funding are critical for securities companies, most of which are primarily wholesale-funded. As wholesale-funded institutions, securities companies generally depend on the confidence of lenders and counterparties to successfully manage their operations in times of stress. Historically, failures of securities companies have often been precipitated by a liquidity crunch due to a lack of confidence. In the long run, franchise strength and earnings power drive a securities company s financial profile. Both help determine the extent to which the company can generate consistent earnings that can be used to invest in strengthening its franchise and internally generate capital to support expansion. This rating methodology focuses on the large U.S. broker dealers, but it is also applicable to other companies active in the securities industry. The term securities industry is used in a broad sense and includes diverse activities ranging from trading to origination to wealth and asset management. The term securities company refers to companies that typically generate most of their earnings in the securities industry. The term broker dealer refers to companies that focus on investment banking and/or trading activities and whose primary operating entities are legally incorporated as broker dealers. DBRS characterizes as direct brokers companies that focus on the delivery of retail brokerage services through low-cost distribution channels, primarily the Internet. 4

5 Rating Methodology Overview Ratings assigned to a U.S. securities company reflect the opinion of DBRS on that company s credit quality. Reflecting a detailed analysis of a securities company s strengths and the challenges it faces, these ratings are provided as a forward-looking measure of a securities company s ability to meet its financial obligations in a timely manner. Long-term ratings express DBRS s view on a securities company s remoteness from defaulting or otherwise being unable to pay as agreed on its obligations. Short-term ratings give an indication of the risk that a borrower will not fulfill its near-term debt obligations in a timely manner, with a one-year horizon. Differences in the strengths of securities companies relative to each other are also reflected in their ratings. DBRS does not employ a formulaic approach in determining ratings, but rather seeks to combine the inextricably-linked elements that characterize each company into an overall assessment of a securities company s credit strength. Ratings for U.S. securities companies at the parent holding company level reflect the consolidated strength of their underlying operating companies, as well as the holding company s strength as a parent. For securities companies owned by non-u.s. parents, the ratings take into account the likelihood that such parents would provide support, if the need arose. Senior ratings cover senior unsecured debt and other similar senior obligations, as well as a securities company s ability to meet its full payment obligations on financial contracts on a senior basis. DBRS rates various debt securities issued by a securities company individually and these ratings are adjusted for the seniority of the securities versus the senior unsecured debt rating. MONITORING Ratings are an intermediate-term assessment of strength across economic and credit cycles. Once issued, the ratings are regularly monitored by DBRS for appropriateness and changes are made when deemed necessary. DBRS follows a wide range of indicators of a securities company s financial position. Earnings are evaluated and events are assessed to determine any impact on a securities company s fundamentals. Lower earnings that are driven by a deteriorating economy, market fluctuations or weakness in specific sectors are not a cause to downgrade, unless the deterioration reveals inherent weaknesses in a securities company s franchise, its earnings power, risk management processes, liquidity, capital or risk exposure. For U.S. securities companies, ratings are based primarily on the intrinsic strength of a securities company and its subsidiaries. Each rating is the product of a detailed analysis that leverages qualitative and quantitative analysis. The analysis utilizes publicly available information, as well as non-public information that the rated company may share with DBRS as an insider as defined by the Securities and Exchange Commission s (SEC s) Regulation Fair Disclosure. Securities company ratings by DBRS based solely on public information are rare. Public information utilized by DBRS includes financial reports, regulatory disclosures and public presentations. Non-public financial information shared with DBRS could include budgeted revenue and capital targets, as well as information about internal liquidity and risk management systems. Face-to-face meetings provide further input and an opportunity to assess the quality of the securities company s executives in managing the franchise and adjusting to a changing environment. 5

6 DBRS APPROACH TO RATING SECURITIES COMPANIES The analysis takes advantage of the analytical framework that DBRS s financial institutions group has developed to quantify or evaluate various elements underpinning a securities company s intrinsic strength. This evolving framework includes various ratios and other metrics, as well as qualitative characteristics. By combining the interconnected elements of a securities company s strength, the framework facilitates the evaluation of a securities company s overall financial profile. Metrics and stress tests help identify strengths and weaknesses. The analysis looks at trends in these metrics to gain a perspective on whether a securities company is gaining or losing strength. Peer group comparisons are a particularly valuable tool for identifying relative strength and understanding changes in a securities company s competitive position over time. In determining the appropriate peers, DBRS considers not only securities companies of similar size and business mix. Given that there are only five large, independent U.S. broker dealers of which one is in the process of being acquired DBRS also includes business segments of universal banks and other participants in the securities industry into its comparisons. Smaller participants with particular strength in certain businesses, such as the direct brokers or regional brokerages serving retail investors, are also included in certain peer comparisons. This framework continues to evolve as the financial institutions group of DBRS continues to enhance its analytical tools. Generally, DBRS s ratings primarily reflect a securities company s intrinsic strength. For some securities companies, external factors and parent support can play a role in determining ratings. When a U.S. securities company is the subsidiary of a foreign entity or has significant foreign ownership, potential support from the parent, if deemed likely to be forthcoming in times of need, can lift the rating. However, except for some form of parent support, DBRS does not see any lift for U.S. securities company ratings from external support, based on the U.S. regulatory environment. The question of external support is discussed in more detail below. 6

7 Interconnected Analytical Elements DBRS s analysis focuses on five interconnected aspects of a securities company s financial fundamentals (Exhibit 2). These elements are discussed in more detail in this section. Exhibit 2 Interconnected Building Blocks Franchise Strength Liquidity Earnings Power Capital Structure and Adequacy Risk Profile and Risk Management Processes Illustrative Elements Business mix, scale, scope, client base, market positions, competitive advantages, track record, culture, management quality, nimbleness Funding profile, liquidity management processes, alignment of longterm funding with illiquid assets, contingency funding plans, liquidity management across subsidiaries Diversification of earnings, resiliency of earnings, efficiency, pre-tax margin, return on equity, capacity to absorb adverse events Capital levels, quality and composition, capital position relative to regulatory requirements Market, credit, interest rate, operational, legal, and regulatory risk, risk measurement processes and tools, performance/track record DBRS considers these building blocks to be significantly interrelated and considers each building block an essential element in the overall assessment. Accordingly, ratings reflect this interdependence, rather than following a simple additive weighting scheme. Nevertheless, there is a sequence in the assessment that provides a perspective on the relative importance of the interconnected building blocks. DETERMINING THE RATING FROM THE BUILDING BLOCKS Franchise strength is the key driver of the rating. The stronger a securities company s franchise is, the higher its rating is likely to be. It is unusual for a securities company to be well rated if it has a weak franchise, absent some form of parent or structural support mechanism. Liquidity is another critical, interrelated building block that is not assessed in isolation, but rather in the context of the entire institution. Liquidity is particularly important for the large U.S. broker dealers and many other securities companies that depend on wholesale markets for funding. A highly rated securities company is less likely to have weak liquidity than a lower-rated securities company. However, strong liquidity by itself does not necessarily result in a high rating, if it is combined with a weak franchise and modest earnings power. Conversely, highly specialized niche players in the securities industry with strong liquidity could be rated highly, even though their franchises and earnings power may be less strong relative to larger, more diversified players. Also important is the earnings power a securities company generates from its franchise. Strong, resilient earnings provide the best protection for creditors. Earnings provide the ability to generate capital and sustain the expansion of a securities company s franchise. Weak earnings are likely to lead to underinvestment and a weakening competitive position. Additionally, earnings provide the capacity to withstand adverse events without invading capital and to rebuild capital, if necessary. Given the inherent volatility of the securities industry, which can result in large variation in earnings over time, earnings resiliency becomes an important component of a securities company s ratings. A strong franchise does not guarantee strong earnings power, although usually one is derived from the other. Securities companies can have franchises with a number of strengths, such as leading market positions in a range of businesses, but fail to translate these strengths into strong earnings power. Profit margins and expense ratios are used to gauge earnings power, with peer comparisons and trends over 7

8 time providing perspective on a securities company s performance. Better-rated securities companies tend to have stronger, more diversified franchises that generate more resilient earnings. In assessing earnings power, DBRS also takes into account a securities company s risk profile, which reflects, among other things, its business mix, concentrations and exposure to stress scenarios. Similarly with capital, high capital ratios alone are unlikely to drive a high rating if a securities company has a weak franchise, poor earnings power and an elevated risk profile. In evaluating capital adequacy, DBRS seeks to identify how well a securities company is capitalized relative to its risk profile, earnings power and regulatory requirements. Strong risk management processes are critical to ensure that a capital cushion is not rapidly dissipated by trading losses and asset write-downs. It is important for well-rated securities companies to have a sound capital position that allows them to sustain their franchise under adverse market conditions. (1) Franchise Strength In assessing a securities company s franchise strength, DBRS considers a broad range of factors that parallel the business mix of the particular company being analyzed. The focus of the analysis follows the particular business profile of the company being rated. Generally, DBRS strives to evaluate franchise strength by comparing a securities company s business to the peers within its relevant market segments. Historical data analysis is used to gain a perspective on whether a company s franchise strength is increasing or declining over time. Naturally, the types of markets and metrics that DBRS utilizes differ according to which company is being analyzed. Evaluating the franchise strength of a large independent U.S. broker dealer requires a different approach than a direct broker, a regional brokerage firm or a custody, clearing and asset management specialist. Peer Comparisons by Business Segment The large independent U.S. broker dealers are active across a broad range of trading, origination and wealth and asset management businesses. Hence, DBRS analyses their franchises based on global peer comparisons within the respective business areas. These include fixed income capital markets (with credit and interest rate products, currencies and commodities), equity capital markets, investment banking (which includes financial advisory, equity underwriting and debt underwriting), as well as wealth and asset management (which can be further subdivided into retail brokerage, high-net-worth private banking and institutional asset management). DBRS also evaluates the market position of the large U.S. broker dealers in other important businesses such as securities services, particularly prime brokerage, merchant banking and other principal investment strategies. For other securities companies, DBRS utilizes metrics appropriate to evaluate their franchise strength within their respective markets. For direct brokers, DBRS looks at client assets and trading volumes, as well as retail deposits. For specialized securities services companies, DBRS takes into consideration assets under custody and assets under management, as well as business volumes in relevant markets. In evaluating a securities company s franchise strength, its market position within each relevant business segment is taken into consideration. To gain insight into the level of geographic diversification of a securities company s franchise, market share can be reviewed on a global basis and a U.S.-domestic basis. Size in each business segment can be an important factor to determine franchise strength, particularly for large securities companies that compete on a global basis across a range of activities. On the other hand, some businesses, such as retail brokerage, do not necessarily require global scope. For example, a direct broker with a sound, U.S.-focused client base can have a strong, defendable franchise. DBRS generally views a diverse franchise with a broad range of earnings sources positively. However, franchise strength is based less on total revenues or other aggregated metrics, and more on a securities 8

9 company s position within each market in which it competes. A highly diverse franchise that consists of businesses with weak market positions relative to peers would not be viewed positively. Management s Contribution to the Franchise DBRS takes into consideration management s acumen in creating and maintaining a favorable business mix, together with the viability and achievability of initiatives to enter new markets and broaden the product mix. DBRS also evaluates experience and depth of management, gauging the ability to run the respective securities company effectively, manage business volumes and control risk. The capacity of operating systems and the robustness of administrative policies and practices are also considered in this context. DBRS also considers management s ability to direct the institution as it grows. The effectiveness and efficiency of management s use of a securities company s resources is evidenced by the securities company s profitability relative to the level of risk taken. While success in delivering strong earnings and franchise growth is viewed positively, the risk profile that is generating this growth and the ability of management to cope with an adverse environment are also analyzed. (2) Liquidity and Funding DBRS views the liquidity and funding profile as a key rating factor for securities companies that act as market makers and therefore hold large amounts of trading assets on their balance sheets. The liquidity analysis for a securities company focuses predominantly on the soundness and stability of its funding. DBRS views positively a diverse range of secured and unsecured funding instruments, issued across multiple maturities and currencies, with a broadly diversified investor base. DBRS recognizes that most securities companies are wholesale-funded institutions that depend on the confidence of lenders and counterparties to continue their operations in a stressed environment. Historically, failures of securities companies have often been precipitated by a liquidity crisis due to a lack of confidence. DBRS takes into consideration the role of the Federal Reserve Board (the Fed) as a liquidity provider to financial institutions. DBRS recognizes that the Fed has recently introduced new lending facilities and made changes to existing ones on a temporary basis, expanding its role as a liquidity provider to depositary institutions and primary dealers that interact with the Federal Reserve Bank of New York on a regular basis. Since the large U.S. broker dealers all have operating subsidiaries that are primary dealers, they benefit from some of these facilities, namely the Primary Dealer Credit Facility and the Term Securities Lending Facility. Both facilities are open to primary dealers and they were established on a temporary basis to improve market liquidity and overall market functioning. The Fed has announced that it will keep this new array of liquidity facilities in place for as long as necessary. DBRS views positively that with these steps, the Fed has begun playing a more extensive role as liquidity provider for primary dealers during difficult market conditions. DBRS reviews a securities company s overall liquidity policies and framework. Contingency liquidity plans are considered, including the assumptions that underlie a securities company s liquidity stress scenarios. Liquidity ratios, relating a securities company s excess liquidity to its funding needs over a set period of time, are taken into consideration. DBRS pays attention to a securities company s exposure to temporary restrictions in its access to unsecured and secured funding. The level of unencumbered assets that could be sold or pledged as collateral to generate liquidity is considered, relative to funding needs. The maturity profile of long-term debt is also reviewed to gauge the risk of large amounts of funding coming due within short time periods. 9

10 DBRS looks at a securities company s access to a variety of liquidity sources. Many securities companies have gained direct access to the Federal Reserve through different recently created programs, including the Primary Dealer Credit Facility and the Term Securities Lending Facility. Another aspect of a securities company s liquidity is the relation between a company s sources of longterm funding, including equity and long-term debt, and the amount of less liquid assets that should be funded on a longer-term basis. Some securities companies use various net cash capital measures to manage and monitor this relation. DBRS also takes into consideration the asset-liability management framework and practices of a securities company. Contingent liquidity needs in the form of commitments and off-balance sheet structures are also reviewed. Holding company liquidity is considered, with a focus on the holding company s ability to meet its obligations in a stress scenario, when access to liquidity from regulated subsidiaries may be temporarily restricted. DBRS pays close attention to a securities company s policy regarding relatively stable funding sources, such as deposits. DBRS views positively the fact that in recent years, all large U.S. broker dealers have, to varying degrees, set up and expanded banking subsidiaries that are attracting deposits. Moreover, relatively low-cost, sticky retail deposits are stabilizing the liquidity profile of U.S. direct brokers. Deposits are also providing a relatively stable funding source to the leading securities services specialists. However, due to the wholesale nature of most securities industry businesses, retail deposits play a much lesser role for most securities companies than for typical U.S. banks with significant retail operations. (3) Earnings Power In assessing a securities company s earnings power, the analysis looks at the components underlying a securities company s earnings and its ability to withstand stress. Profitability and efficiency metrics are used to evaluate a securities company s earnings power. Ultimate profitability reflects the combination of earnings and capital strength relative to the securities company s risk profile. Trends over time and peer comparisons provide opportunities to gauge the strength and trajectory of earnings power. Besides the level of profitability, resiliency of earnings is an important consideration. Revenue Diversification Earnings diversification typically results in more stable earnings power, which is viewed positively by DBRS. The analysis of revenue diversification starts by examining the contribution of various components that contribute to earnings. The analysis takes into account the breadth of different businesses that generate revenues/earnings for the securities company in question. Moreover, diversification across geographies is considered. DBRS also gauges the relative resiliency and correlation between different business areas in which a securities company is involved. For example, both equity trading and investment banking activities tend to be correlated with stock market trends. Conversely, some fixed income capital markets businesses such as commodities, foreign exchange and interest rate products tend to be less correlated or even negatively correlated with stock market trends. Earnings from these less correlated businesses add more to a securities company s earnings resiliency than earnings from highly correlated businesses. Some securities industry businesses such as custody and clearing generate much more stable earnings than others, such as investment banking. Such higher stability can to some extent make up for lower margins that are associated with some of these businesses. DBRS reviews a securities company s pre-tax margins as well as other metrics such as return on common shareholders equity to gauge profitability. Such metrics are considered in connection with the respective company s capital levels, its earnings volatility and its risk profile. Relative to large U.S. banks, the large U.S. broker dealers have historically demonstrated bigger variation in profitability across market cycles. 10

11 As a result of this higher volatility, DBRS generally expects broker dealers to achieve somewhat higher margins through the cycle relative to banks. Efficiency An important consideration for earnings power is the efficiency of a securities company s operations and how well management controls expenses. One useful measure is the ratio of operating expenses to operating revenues (expense ratio), which can be used to show trends over time and to compare the performance of a securities company with its peers. DBRS views positively an expense ratio that is low relative to peers and flexible. Since many businesses within the securities industry generate volatile revenues, it is important for the large U.S. broker dealers to aggressively manage their costs to protect their margins in a down market cycle. While expense ratios can indicate differences in efficiency, especially over time, they are also impacted by a securities company s mix of businesses. In evaluating how well a securities company manages its expenses, account is taken of its business mix. Besides total expenses to net revenues, DBRS also reviews the ratio of compensation expenses to total net revenues (compensation or comp ratio) and the ratio of non-compensation expenses to total net revenues (non-comp ratio). The large U.S. broker dealers have historically been successful in maintaining their comp ratio close to 50% by managing bonus payments and other compensation expenses closely in line with revenue trends. When reviewing efficiency, DBRS also pays attention to a securities company s investment into building out its franchise. It is viewed as important that a company invests sufficiently to maintain or expand its operations over time. (4) Capital Structure and Adequacy The composition and adequacy of capital receives careful analytical attention as a measure of a securities company s solvency and its capacity to absorb losses from operations, including mark-to-market writedowns, in excess of its earnings. Factored into the analysis are the strength and diversity of the securities company s franchise, the resiliency of its earnings power, the reliability of its operating processes and the soundness of the securities company s risk management processes. The risk inherent in a securities company s assets and the liquidity of its assets are also taken into account. If assets are predominantly highly liquid and low-risk, then less capital is needed to support them. Another important consideration is the extent of losses that a securities company could absorb out of its current earnings before the need arose to invade capital. DBRS also addresses the ability of the securities company to generate capital through earnings retention to support balance sheet growth, make strategic acquisitions and accommodate required capital investments, as well as management s practice in prioritizing capital adequacy relative to meeting shareholder expectations regarding return on equity. Management targets for various capital ratios are important considerations. Also important is management s practice of paying dividends and buying back shares. Generally, the large U.S. broker dealers maintain low dividend payout ratios, with larger amounts of capital regularly returned via share buy-backs. Capital Ratio Analysis DBRS reviews a securities company s mix of capital resources that often includes common equity, preferred shares and hybrid instruments. DBRS uses various capital ratios to illuminate different perspectives on a securities company s capital resources. No single measure, however, encapsulates all the factors determining capital adequacy. 11

12 When evaluating large U.S. broker dealers, DBRS considers gross leverage (total assets over book equity), as well as net or adjusted leverage (adjusted assets over tangible equity). There are different definitions of adjusted assets, but they all aim to eliminate assets with low price and funding risk. For example, high-quality bonds like U.S. Treasuries that are funded on a secured basis would be eliminated. DBRS calculates adjusted assets as total assets minus intangible assets, minus segregated cash, minus securities received as collateral, less securities purchased to resell and minus securities borrowed. Adjusting total assets for generally low-risk, liquid trading assets is viewed as useful to provide a different view on a broker dealer s capital position. Other capital measures are also used, including ratios based on tangible equity and assets to abstract from goodwill. In evaluating tangible capital ratios, DBRS considers the extent to which a securities company is generating earnings from the acquired assets and the extent to which the assets underpinning the goodwill still have value. The large U.S. broker dealers are now regulated at the holding level as Consolidated Supervised Entities (CSEs) by the SEC. As CSEs, they are subject to group-wide supervision and examination by the SEC and to minimum capital requirements consistent with regulatory rules under Basel II. The Basel II rules have been developed by the Bank of International Settlements Basel Committee on Banking Supervision. Relative to GAAP-based capital measures, regulatory capital measures incorporate certain adjustments that DBRS finds useful. First, equity is adjusted to more closely reflect bank regulators view of capital. While excluding most intangibles and other comprehensive income, Tier 1 regulatory capital includes trust preferred securities and other qualifying hybrids in Tier 1 capital. Importantly, the regulatory ratios adjust assets and other exposures for their perceived risk content. Risk-weighted assets (RWA) are calculated that incorporate credit risk, market risk, operational risk and other risk types (such as liquidity risk and legal risk) under Basel II. Relative to regulatory capital measures under the pre-existing Basel I agreement, Basel II rules provide a refined framework for measuring RWA, particularly the advanced internal rating-based approach under Basel II which is expected to be utilized by the large U.S. broker dealers. The resulting Tier 1 ratio (Tier 1 capital to RWA) provides a risk-adjusted measure of a securities company s capital adequacy. At this time, all large U.S. broker dealers are in compliance with the regulatory requirements under the CSE/Basel II framework. However, the SEC has not yet released details on the broker dealers compliance, for example, their regulatory capital ratios. DBRS expects to take more regulatory information into consideration in its analyses as it becomes available. For some securities companies, DBRS can also utilize their own estimates of economic capital. The extent to which the evaluation of capital adequacy can rely on these estimates depends upon the quality of the underlying analysis. In summary, as said above, DBRS utilizes a broad range of capital ratios, with no single ratio encapsulating all the factors that determine capital adequacy. (5) Risk Profile and Risk Management Processes Taking risk is an inherent function of securities companies as financial intermediaries. A critical element of the rating process is evaluating the nature and extent of the risks that a securities company faces and how well these risks are managed. The analysis of a securities company s risk profile and risk management processes differs according to the company s particular business mix and risk profile. For the large U.S. broker dealers, market risk resulting from trading positions and write-down risk resulting from non-trading positions are two key elements of the risk analysis. 12

13 Direct brokers, in contrast, may have less market risk, particularly if they act as brokers on an agency basis rather than dealers with a large inventory. Instead, direct brokers may have exposure to credit risk through their loans and investment portfolios and to operational risk. For specialized providers of securities services, operational risk can become a key concern due to the large business and transaction volumes of these companies. The analysis of DBRS includes a review of a securities company s overall risk management framework, culture and practices. Market Risk With regard to market risk, DBRS looks at a variety of measures, including the distribution of daily trading revenue (particularly loss days), volatility of trading revenue and value at risk (VaR). DBRS views VaR as a measure of limited usefulness, due to its static character and differences in calculations and definitions that make VaR measures hard to compare across securities companies. Moreover, DBRS does not consider risk in isolation. Rather, risk is evaluated relative to the rewards (revenues, earnings) generated from risk positions taken. To this end, DBRS considers trading revenues (approximated as principal transactions revenues) generated relative to the VaR levels for the large U.S. broker dealers. The level of pre-tax earnings relative to VaR provides a measure of a securities company s ability to absorb trading losses out of current earnings. DBRS also looks at the composition of the large U.S. broker dealers market risk exposure, across equity price risk, interest rate risk, credit premium, commodity prices and currency rates. Credit risk is evaluated with regards to current exposure as well as commitments. Other non-trading risk for example, resulting from proprietary investments into less liquid assets is also taken into consideration. Credit Risk For securities companies with significant credit risk exposure, portfolio analysis is performed to evaluate asset quality, potential concentration risk and exposure to a deterioration in the economic and market environment. A securities company s track record in managing risk generally and asset quality in particular through economic cycles, and its capacity to sustain a sound credit profile in the intermediate future, are important considerations. Where possible, DBRS aims to meet with management, particularly with officers involved in risk management, to gauge a company s general risk appetite and its approach to managing those risks. Operational Risk Given the operational complexity of many securities companies, operational risk is an important consideration in evaluating a securities company s soundness and the potential for losses that could impair earnings and capital. These risks include diverse elements such as minimizing human error, failures in systems and technology and the risk of not meeting regulatory and compliance requirements. A securities company s track record in managing operational risk over time and its disaster recovery plans also receive attention. Systems in place to monitor and mitigate reputation risk are also evaluated. 13

14 Rating Considerations Beyond the Five Building Blocks In addition to the five interconnected building blocks, DBRS takes a range of other considerations into account in its analysis. Some key considerations are described below. HOLDING COMPANY FUNDAMENTALS The ratings of U.S. securities companies take into account the structural subordination of their obligations to those of their operating subsidiaries. DBRS takes into consideration the fact that typically almost all assets of a consolidated securities company are held by its subsidiaries and these subsidiaries generate most revenues, while the holding company is dependent on its own, typically limited, resources and on dividends from subsidiaries. Dividends from regulated subsidiaries could be curtailed if regulators perceive this action is needed to safeguard the viability of a subsidiary under their supervisory control. As described above in the liquidity section, assessing the adequacy of a holding company s financial fundamentals and liquidity requires taking into account the holding company s capacity to meet its financial obligations and its double leverage (the ratio of equity investments in subsidiaries to equity at the holding company level). The review focuses on the resources available to meet operating expenses and debt service obligations, including the repayment of maturing debt. Thus, only the holding company s unencumbered liquid assets and other assets readily available from non-regulated subsidiaries are considered as available funding sources to pay its debt obligations, expenses and stock dividends. SUPPORT FROM PARENT OR OTHER OWNERS If a securities company s ultimate parent company is domiciled in the United States, the ratings are typically based primarily on that securities company s intrinsic credit quality. For foreign-owned securities companies operating in the United States, varying degrees of expected parent company support are factored into the ratings. More details on how DBRS incorporates such expected support in its ratings can be found in the methodology titled Enhanced Methodology for Bank Ratings Intrinsic and Support Assessments. This methodology also applies to external support for securities companies rated by DBRS. CONSIDERATION FOR REGULATORY ENVIRONMENT AND SYSTEMIC SUPPORT DBRS views the U.S. regulatory structure as providing a strong operating environment, which generally benefits the securities companies operating in this environment. However, DBRS does not ascribe any too big to fail systemic support to elevate ratings beyond intrinsic strength. Ratings are generally not adjusted for any implicit support from the U.S. government or any of its agencies. Under DBRS s current ratings process that is consistent across countries, U.S. securities companies without foreign ownership receive a Support Assessment (SA) of SA3 (for more detail, refer to methodology titled Enhanced Methodology for Bank Ratings Intrinsic and Support Assessments). This SA3 designation means that external support for these institutions is not expected to be forthcoming under most circumstances with enough certainty to warrant raising ratings above the rating based on a U.S. securities company s intrinsic strength. For comparison, an SA2 support assessment by DBRS reflects the expectation of some sort of systemic external support, ideally with a timeliness element in it. An SA1 support assessment by DBRS reflects a very strong to good likelihood of and predictability of timely external support. This could be the case for a securities company operating in the United States that is owned by a foreign institution and viewed as likely to receive support from its parent, if needed, or vice versa. 14

15 An element in DBRS s ratings assessment is evaluation of management s relationship with its regulators. Indications of adversarial relationships would cause DBRS to be concerned about the strength of the franchise and its prospects. Close supervision is also good for senior debt holders, because it reduces the risk that sustained deterioration passes unnoticed. NOTCHING AND SENIORITY OF RATED DEBT CLASSES AND PREFERRED SHARES DBRS takes into consideration the seniority of different classes of rated debt, hybrid instruments and preferred shares. In cases where the condition of a securities company has deteriorated significantly, equity owners are highly likely to face losses, while senior creditors may well still receive payment in full. DBRS rates different financial instruments at various levels relative to senior unsecured debt (so-called notching). Reflecting the greater risk of loss for holders of subordinated debt, this debt is typically rated one notch below senior debt issued by the same entity. Similarly, ratings of trust preferred securities and preferred shares also take into account the ranking of these securities in the issuer s capital structure and the issuer s credit strength. Depending on the specific structure of trust preferred securities, they are typically rated one or two notches below senior debt. DBRS typically rates preferred shares and hybrid instruments with preferred-share-like characteristics two notches below senior debt. RELATED RESEARCH AND METHODOLOGY LINKS The DBRS reports referenced below include examples of frequently used financial ratios and comparative statistics used in U.S. securities company rating analysis, as well as additional detail on DBRS rating methodologies. Building Up the Business DBRS Outlook for the U.S. Securities Industry 2007 Enhanced Methodology for Bank Ratings Intrinsic and Support Assessments Methodology Rating Banks and Bank Holding Companies Operating in the United States 15

16 Copyright 2008, DBRS Limited and DBRS, Inc. (collectively, DBRS). All rights reserved. The information upon which DBRS ratings and reports are based is obtained by DBRS from sources believed by DBRS to be accurate and reliable. DBRS does not perform any audit and does not independently verify the accuracy of the information provided to it. DBRS ratings, reports and any other information provided by DBRS are provided as is and without representation or warranty of any kind. DBRS hereby disclaims any representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability, fitness for any particular purpose or non-infringement of any of such information. In no event shall DBRS or its directors, officers, employees, independent contractors, agents and representatives (collectively, DBRS Representatives) be liable (1) for any inaccuracy, delay, loss of data, interruption in service, error or omission or for any damages resulting therefrom, or (2) for any direct, indirect, incidental, special, compensatory or consequential damages with respect to any error (negligent or otherwise) or other circumstance or contingency within or outside the control of DBRS or any DBRS Representative, in connection with or related to obtaining, collecting, compiling, analyzing, interpreting, communicating, publishing or delivering any such information. Ratings and other opinions issued by DBRS are, and must be construed solely as, statements of opinion and not statements of fact as to credit worthiness or recommendations to purchase, sell or hold any securities. DBRS receives compensation from issuers, insurers, guarantors and/or underwriters of debt securities for assigning ratings. This publication may not be reproduced, retransmitted or distributed in any form without the prior written consent of DBRS.

17 Corporate Headquarters DBRS Tower 181 University Avenue Suite 700 Toronto, ON M5H 3M7 TEL