Ratings

Securities firms need the fertile ground of a well-maintained economy to prosper. In evaluating these firms Standard & Poor's considers:

• Growth potential and capital-raising needs; openness of the economy; sensitivity to external economic factors, such as the terms of trade in single commodities; normal business cycle volatility as measured by GDP, unemployment, and bankruptcies;
• The credit cycle;
• Political stability; level of commitment to allowing private markets to allocate resources;
• Government intervention to maintain an overvalued or undervalued currency and the impact on capital markets by following a policy of incorrect valuation; institutional rigidities;
• Wealth accumulation processes, such as voluntary or mandatory pension plans, and investment constraints imposed on them; and
• Size and liquidity of capital markets; market structure (OTC or exchange-traded) stock market capitalization; transparency of markets; wide dissemination of information; ability to borrow securities to sell them short; settlement cycles and processes.

Volume of new issuance and secondary trading is generally cyclical, but inflationary fiscal or monetary policies exacerbate the severity of cycles. Standard & Poor's does not make market projections that would feed into ratings, but tries to judge the kinds of cycles the industry in a given country will face and assess the capacity of a given firm to handle that kind of cycle. Standard & Poor's will focus on the following:

• Factors that affect the severity of cycles, including stop-and-go monetary policies and the regulatory regime;
• Private and government sector debt levels;
• A country's reliance on foreign investment and the character of that investment; and
• Historical cycles in issuance and trading volumes.

Depending on inventory and investment policies (see Financial Policies and Profile section), market-price volatility may have important consequences. Standard & Poor's reviews the history of volatility in stocks, bonds, and other traded assets.

Generally, securities firms serve the basic function of distributing and trading financial instruments for customers, financing customer positions, and intermediating collateral. The importance of these functions to a given economy, the consequent size of the customer base, and the availability of substitute products or alternative suppliers will affect the approach to a rating.

The maturity of industry structure will depend in part on whether boundaries remain between various financial sectors. However, in many instances, countries have taken a "big bang" approach to liberalization of ownership or financial institution functionality, leading rapid-fire to new entrants and subsequent consolidation. Standard & Poor's reviews the following factors, as appropriate:

• Stability of the industry structure; number of players and relative size; barriers to entry and potential for new entrants; ability to exit without great cost; cost structures;
• Competition; prospect for alternative delivery mechanisms or substitute products (such as bank loans); fee structures;
• Importance of securities firms to the economy and the size of the customer base;
• Current methods of intermediating between capital raisers and capital suppliers; whether securities firms offer bank-like products, like foreign exchange trading or commercial or consumer finance;
• Relative participation of retail or institutional investors;
• Ownership; involvement of governmental or quasi-governmental bodies; cross shareholdings and its potential consequences; and
• Institutional or governmental constraints on money markets and capital markets.

The often-changing legislative and regulatory framework must be understood, as well as who the primary regulators are and what precedents exist in the regulation of securities firms. Standard & Poor's reviews:

• Regulation that prevents development of liquid money or capital markets; application of reserve requirements and their impact; existence of offshore markets and their implication on regulatory or institutional rigidities;
• Regulation of stock-trading commissions or other transaction costs;
• Regulations affecting the structure and functioning of securities exchanges;
• Regulatory examination policies and procedures;
• Presence of capital requirements that operate to prevent dividends of capital to holding companies; consequences of failure to meet regulatory capital requirements; and
• Regulations affecting interactions and relationships with customers and securities issuers, including mutual funds.

This is a very important risk. Even where litigation risk may be low, reputational risk is becoming more important as standards of behavior become stricter. Standard & Poor's reviews, as appropriate:

• Litigation by retail or institutional investors;
• Extent of regulation of sales abuses; changes in regulatory or ethical standards;
• Extent of regulation to protect transparency of markets through rules against insider trading; and
• Severity of regulatory sanctions against a given firm.

Technology is one of the forces that has driven change in the capital markets. All-encompassing communication networks foster cross-border trading and investment, expanding the number of players in many markets, while greater computing power permits the development of more complex products. Standard & Poor's reviews, as appropriate:

• The pace of adoption of technology at securities firms and the degree of competitive advantage it may create;
• The prospect for new entrants resulting from technological change, such as Internet brokers; and
• The need for technological capital spending as a barrier to entry.

Determining and executing successful strategies, given the complex and ever-changing nature of the securities business, requires strong management. Both strategy and the management team charged with carrying out the strategy are reviewed. The components of the ongoing review of these two critical dimensions of success include the following, as applicable:

• The firm's ability to develop and attract top human resources;
• The firm's track record in integrating acquisitions;
• Management continuity and succession plans;
• Product and business line strategies;
• Strengths and weaknesses relative to those of competitors;
• Employee ownership and deferred compensation plans;
• Commitment to compliance systems to avoid potentially large legal claims; success in defending against litigation;
• Management level of knowledge and involvement in risk control; and
• Presence of governmental influence over decision-making.

One of the key distinctions between larger and smaller firms is the degree to which smaller, less-diversified firms are exposed to great risk of business cyclicality, or changes in competitive framework, regulation, taxation, or technology. It is also the case that certain downturns can result in more correlated business line performance than what may be anticipated by diversification strategies (e.g. the 2000-2002 downturn in securities markets). In trying to assess a firm's exposure to this panoply of external risks, Standard & Poor's reviews, as appropriate:

• The proportion of revenue contributed by commissions, trading, net interest income, asset management, or other;
• Review of internally reported business line segment revenues and pretax profitability; correlations between segments;
• Concentration of revenues in product lines, for example, high-yield bonds in the institutional setting or mutual funds in retail financial services;
• Concentration/dispersion of trading strategies or products;
• Geographic contribution of revenue and pretax profitability;
• Diversification between sets of customers, such as institutional, retail, discount, and high-net-worth individuals; and
• Periods during which anticipated diversification benefits evaporate (for example, Mexican devaluation in late 1994, LTCM crisis in 1998, and the bursting of the equity bubble in 2000).

This separates the firms with a sustainable business tied to growing capital markets or demographic opportunities from those that will only do well when volumes are cyclically strong. The sum of these parts should translate directly into better pricing power and higher margins compared to other firms. Depending on the firm's business, Standard & Poor's would examine, as appropriate:

• Size of distribution force;
• Any available measures of depth of customer relationships (for example, number of different products used by a client);
• Character of customer base; customer demographic and financial profile; customer turnover; number, growth, and average activity of accounts; net transfers of client assets to or from a firm;
• Available external rankings of firms' underwriting, trading, advisory, or research services;
• Market shares of relevant secondary markets (for example, stock exchange or government security primary dealer);
• Advantages derived from market position, such as informational economies of scale; and
• Published rate schedules and the extent of discounting from rate schedules.

A great deal of emphasis is placed on understanding how a particular management has, or has not, succeeded in navigating industry cycles, particularly compared with its peers' performance. Standard & Poor's reviews the following, as appropriate:

• Annual volatility of revenues, pretax profit margins, and returns on equity;
• Quarterly performance compared with firms with a similar business during a cyclical downturn; and
• Sources of volatility in performance (trading volatility or broad-based cyclicality); sensitivity of pretax income to changes in revenue (operating leverage).

The cost function depends on the services provided and the types and numbers of customers served. For example, discount firms do not need sales assistants to help prospect for clients or research analysts to provide stock reports. Standard & Poor's would review the following issues, as appropriate:

• Proportions and trends in fixed costs;
• Noncompensation cost per employee as a measure of overhead costs;
• Makeup of noninterest expenses and proportion to net revenue;
• Size of support staff compared with producers; costs per transaction;
• If a branch sales network is used, sales (usually commissions) per branch, profitability, and branch break-even points;
• Sensitivity analysis of costs under low-trading-volume scenarios

The variability of compensation and headcount during cyclical downturns;

• Stability or cyclicality of expense control "culture" and the ability of management to maintain some discipline even in euphoric market environments; and
• Internally or externally sourced overhead functions, such as clearing services or research.

The ability of firms to sustain meaningful fee-based businesses varies widely across industry segments and geographic markets. Standard & Poor's would examine, as appropriate:

• The proportion of net revenue and pretax profit derived from less-cyclical activities, such as asset management, custody, and other fee-based revenue sources;
• In asset management, the breakdown of assets that are institutional and retail;
• Level of less-cyclical fee income in relation to fixed or total costs; and
• Impact of accounting methods.

Standard & Poor's tries to assess the relative potential for unacceptable trading losses. We believe sound risk management goes well beyond having the latest risk evaluation technology in place. Risk appetite, risk management and control structure as well as the strengths of risk compliance personnel are all important. Standard & Poor's would review, as appropriate:

• The importance of trading to a given firm and the instruments traded (with special emphasis on less-liquid instruments); importance of proprietary trading;
• How independence of control functions is maintained;
• How accountability is imposed on trading and control functions;
• Daily volatility of trading results;
• Control lapses and fraud;
• Risk measurement framework;
• Use of P&L reporting as a reality check to position or risk reporting;
• Limit-setting and monitoring; handling of limit, valuation, or other control violations;
• Discipline in not trading a new product until control infrastructure is in place;
• Controls over overseas branch offices;
• Staffing, reporting lines and role of internal audit; control issues raised by internal audit and their resolution;
• Aging of securities inventory and turnover; backup facilities for trading, processing and settling transactions;
• Asset-liability management; interest rate risk; and
• Underwriting commitment process; limits on size of sole-managed underwritings.

In addition to credit risks inherent in bond, derivative, and loan trading positions, securities firms are exposed to credit risk from derivatives counterparties, customer loans secured by collateral, and, increasingly, unsecured credit exposures to corporate underwriting clients. Standard & Poor's reviews the management of credit risks as well as the firm's appetite for taking on risks. Specifically, the following are reviewed, as appropriate:

• Method for setting counterparty credit limits;
• Front-office systems that permit calculation and aggregation of exposure as new transactions;
• Systems that monitory adequacy of collateral;
• Top actual and potential exposures;
• Concentrations of credit risk by borrower, geography, and industry;
• Problem credits and loss history;
• Credit loss reserve adequacy; and
• Credit underwriting process; size authorization and signing requirements.

The balance sheet needs and capital intensity of securities activities vary widely among companies and even within a given firm. Capital strength or weakness is assessed in the context of these needs, as well as the diversity of the rated firm and the capital size of key competitors.

Standard & Poor's emphasizes the quality of capital. Capital with fixed maturities and charges are weaker forms of capital. Standard & Poor's would not include subordinated debt in capital. Our primary capital measure is "adjusted total equity," which incorporates common and preferred equity, within limits, and excludes goodwill and other intangibles.

In making capital calculations, perpetual preferred equity exceeding 25% of total adjusted equity is excluded. Trust preferreds that have certain dividend deferral features are included in total equity for calculation purposes up to a limit of 10% of adjusted total equity.

Conceptually, capital is needed to cover all forms of risk, including market, credit, liquidity, operational, and litigation risks. Externally published balance sheet data are inadequate to properly assess all of these risks; not only do assets—or, more accurately, positions—change daily, but also major risk categories like operational and litigation risk are not reflected. While Standard & Poor's uses balance sheet data and risk-adjusted asset categories, the exercise is inexact and requires a great deal of judgment. Standard & Poor's reviews the following, as appropriate:

• Management's policies regarding balance sheet usage for major activities, especially over capital needs of particular businesses;
• Size and trend of the balance sheet;
• Makeup of the balance sheet;
• Internal capital generation (growth of capital from income);
• Share repurchase programs;
• Presence in capital-intensive businesses, such as institutional trading; need for future capital growth to meet continually expanding trading opportunities and expanding derivatives positions;
• Presence in businesses that have large litigation risks, such as retail brokerage or equity underwriting;
• Reserves for liquidity and litigation;
• Equity double leverage (effectively holding company debt whose proceeds are invested as equity in subsidiaries);
• The liquidity characteristics of the assets funded by equity double leverage;
• Capital that is not available to the parent company, such as that invested in derivative product companies;
• Excess of regulatory capital over minimum requirements; and
• Capital needs of off-balance-sheet transactions, such as securitized assets.

In different systems, the availability and use of market-sourced, credit-sensitive funding varies. Within a given country, the kinds of funding different securities firms use depends in part on the types of activities in which they engage, as well as their creditworthiness and access to money and capital markets. Those without such access tend to rely on secured funding or bank loans. Standard & Poor's reviews, as appropriate:

• The attributes of funding; overall composition of funding sources; maturity structure of both short- and long-term funding; diversity of short-term funding sources; concentrations of funding from individual entities;
• Extent of funding from insured or uninsured customer sources; existence, maturity and legal underpinning of markets for secured sources of funding, such as repurchase agreements or buy-sell agreements;
• Relationships with banks or other sources of funds; and
• Numbers and names of primary bank relationships; access to central bank or governmental sources of emergency liquidity;
• Financial policies and contingency planning;
• Character of the assets funded;
• Ability to quickly liquidate short-funded assets;
• Ability to borrow against short-funded assets as collateral;
• Ability to transfer liquid assets between various legal entities of the organization;
• Maintenance of a comfortable cushion of asset liquidity in excess of the potential short-term repayment needs; and
• Short-term obligations that are not on the balance sheet that may arise because of a credit crisis, such as the need to provide collateral for previously uncollateralized transactions, such as swaps.

Accounting regimes can vary widely between systems and affect the quality of information available to management. While fair value accounting imposes discipline on management, the absence of liquid trading markets for certain instruments presents meaningful valuation challenges. New accounting pronouncements, such as accounting for securitizations, and the variety of accounting choice, such as accounting for stock options, can create large changes in earnings results and in the size and composition of balance sheets. Standard & Poor's will review, as appropriate:

• Transparency of accounting used by the firm;
• Fair value or historical cost;
• The appropriateness of market measures in determining the fair value of specific positions;
• Conservatism of management's internal accounting model;
• Quality of external auditing; and
• Existence of an internal audit department and its role and reporting lines.