A broker-dealer's net capital is computed by starting with net worth, then removing certain items and reducing others. In general terms, what are those two adjustments?
- A.Net worth is reduced only by customer credit balances, since those are the only liabilities relevant to net capital.Wrong. Net capital adjustments are not limited to customer credit balances; they apply broadly to non-allowable assets and haircuts on remaining assets.
- B.Non-allowable assets -- those not readily convertible to cash -- are subtracted out entirely, and haircuts, which discount the value of remaining securities positions for market risk, are applied to what is left.Correct. Non-allowable assets are removed entirely, and haircuts then discount the remaining allowable securities positions.
- C.Net worth is increased by adding back all liabilities, then reduced by a single haircut applied to total assets.Wrong. Liabilities are not added back in this way, and haircuts are not applied as one single blanket discount on total assets.
- D.Non-allowable assets are discounted by a haircut, while allowable assets are removed from the calculation entirely.Wrong. This reverses the treatment; non-allowable assets are removed entirely, and haircuts apply to allowable assets.
Why: Net capital starts from net worth -- assets minus liabilities on the firm's own books -- and then makes two distinct kinds of adjustments. Non-allowable assets, meaning assets that cannot be readily converted to cash, are removed from the computation entirely rather than merely discounted. The assets that remain and are allowable, mostly securities positions, are then reduced by haircuts, percentage deductions sized to the risk that the position's value could decline or be hard to sell before it converts to cash. The two adjustments answer different questions -- can this become cash at all, and how much might it lose before it does.
A broker-dealer records a substantial receivable from its well-capitalized parent company on its books. For net capital purposes, is this receivable treated as an allowable asset because the parent is financially strong?
- A.Yes, since the parent's financial strength is exactly what determines whether a receivable from it is allowable.Wrong. The debtor's financial strength is not the test; the test is whether the asset is readily convertible to cash for the firm's own creditors.
- B.Yes, but only up to the amount of the parent's own net capital, if the parent is also a registered broker-dealer.Wrong. There is no such proportional allowance tied to the parent's own net capital; affiliate receivables are generally non-allowable regardless.
- C.No -- a receivable from an affiliate is generally treated as non-allowable regardless of the affiliate's financial strength, because the test is whether the asset is readily convertible to cash for the firm's own creditors, not whether the debtor is creditworthy.Correct. Affiliate receivables are non-allowable regardless of the affiliate's strength, because the test concerns the firm's own liquidity, not the debtor's creditworthiness.
- D.No, but only if the affiliate is located in a different regulatory jurisdiction than the broker-dealer itself.Wrong. Jurisdiction is not the determining factor; affiliate receivables are non-allowable generally, regardless of location.
Why: The non-allowable asset test asks whether the firm itself could convert the asset to cash promptly if it needed to, not whether the debtor is good for the money in some general sense. A receivable from an affiliate is treated as non-allowable because affiliate transactions are not arm's-length in the same way a receivable from an unrelated party is, and because collecting from an affiliate in a stress scenario is exactly the kind of related-party risk the rule is designed to exclude from the firm's own liquid cushion, regardless of how well capitalized that affiliate happens to be.