(Editor's notes: These criteria have been superseded by the article titled "Criteria | Financial Institutions | Broker-Dealers: Rating Securities Companies," published on June 9, 2004)

Ratings Analysis Methodology Profile Securities Companies

In many markets and countries around the world, including Taiwan, securities firms as a group are essential to the functioning of capital markets, allowing buyers and sellers to find common prices either through exchanges or over-the-counter transactions and bringing new issuers into those capital markets. They aid the liquidity of markets by providing financing for securities positions and facilitate transfers of collateral needed to allow for the short-sale of securities. Their operational capabilities also help the smooth clearance of securities transactions. Expertise in valuing businesses leads to advisory assignments.

Rated securities firms operate with leveraged balance sheets and Taiwan Ratings does not expect debt to be paid down through operating cash flow but through their continued access to financing and liquidation of inventory. The creditworthiness of securities firms is not easily measured using balance sheet ratios or examining asset categories. Securities inventory turns over every few days. The size of the balance sheet is elastic, growing and shrinking as underwriting or trading opportunity wax and wane. Likewise, care and judgment are needed in analyzing the income statement. The firms are often a mix of low-and high-margin businesses not clearly delineated in published financials, making comparisons difficult and the selection of peers a sensitive exercise. Assessing the staying power of a securities firm also entails analysis of a great deal of privately and publicly sourced data.

Taiwan Ratings considers the following issues when rating securities firms:

External Factors

Economy

Securities firms need the fertile ground of a well-maintained economy to prosper. Taiwan Ratings considers:

• Growth potential and capital raising needs; assessment of the openness of the Taiwanese 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 (where securities firms are involved in lending for purposes other than financing securities);
• political stability; level of commitment to allowing private markets to allocate resources;
• governmental intervention to maintain an overvalued or undervalued currency and the impact on capital markets by following a policy of misvaluation; institutional rigidities;
• Wealth accumulation processes, such as voluntary or mandatory pension plans, and investment constraints imposed on them;
• Size and liquidity of capital markets; market structure (over-the-counter or exchange traded) stock market capitalization; transparency of markets; wide dissemination of information; ability to borrow securities in order to sell them short; settlement cycles and processes.

CYCLICALITY
Volume of new issuance and secondary trading is generally cyclical, but the severity of cycles is exacerbated by inflationary fiscal or monetary policies. It should be noted that Taiwan Ratings does not make market projections that would feed into ratings. But Taiwan Ratings does try to judge the kinds of cycles the securities industry will face and assess the capacity of a given firm to handle that kind of cycle. Taiwan Ratings focuses on:

• Factors that affect the severity of cycles, including stop-and-go monetary policies and the regulatory regime,
• the levels of leverage that investors can achieve,
• Taiwan's reliance on foreign investment and the character of that investment;
• historical cycles in issuance and trading volumes.

Volatility
Depending on inventory and investment policies (covered in Financial Policies and Profile), market-price volatility may have important consequences. Taiwan Ratings reviews:

• The history of volatility in stock, bond and other traded assets.

Industry Structure
Generally, securities firms serve the basic function of distributing and trading financial instruments for customers, financing customer positions and intermediating collateral. Depending on the system, two basic distribution channels exist based on customer type: institutional or retail. The importance of these functions to the 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, other countries have taken a "big bang" approach to liberalization of ownership or financial institution functionality, leading rapid-fire to new entrants and subsequent consolidation. As such, Taiwan Ratings reviews:

• 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 the securities firms to the Taiwanese 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;
• institutional or governmental constraints on money markets and capital markets.

Regulation
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. Taiwan Ratings reviews:

• regulation that prevents development of liquid money or capital markets; application of reserve requirements and their impact; existence of off-shore markets and their implication of regulatory or institutional rigidities;
• regulation of stock trading commissions or other transaction costs;
• securities transaction taxes and "stamp" taxes;
• 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;
• functioning and effectiveness of self-regulatory organizations;
• orientation of regulation, that is whether it aims at avoiding firm failures or protecting customers;
• history of securities firm failures.

Litigation/Reputational Risk
This has become a very important risk in many countries around the world. Even in countries where litigation risk may be low (such as Taiwan), reputational risk is becoming more important as standards of behavior become stricter. Taiwan Ratings reviews:

• 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;
• severity of regulatory sanctions against a given firm.

Technology
Technology is one of the forces that has driven change in the capital markets. All-encompassing communication networks fostered cross-border trading and investment, expanding the number of players in many markets while greater computing power permitted the development of more complex products. Taiwan Ratings reviews:

• 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;
• the need for technological capital spending as a barrier to entry.

Franchise Value And Business Risk
Because securities industries are often characterized by different segments serving different types of customers with products whose growth potential, profitability and cost functions vary markedly, comparisons need to be made between similarly situated firms.

Management And Strategy.
This caption deals with what the firm does for a living and how they do it. Included would be a review of:

• whether the firm is innovator or imitator;
• whether poacher or trainer;
• whether acquirer or builder;
• integration track record;
• responses to changes in the industry, including new entrants;
• focus of management on core competencies;
• management flexibility to respond to competitors that try to change the basis of competition;
• continuity of management;
• ability to attract and retain talent without paying greater commission or running a higher level of bonuses to pretax income; broker turnover;
• employee ownership and deferred compensation plans;
• commitment to compliance systems in order to avoid potentially large legal claims; success in defending against litigation;
• management level of knowledge and involvement in risk control; management support of the control functions in disputes with traders;
• presence of governmental influence over decision-making.

Diversification.
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. In trying to assess a firm's exposure to this panoply of external risks Taiwan Ratings reviews:

• 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, correlation 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;
• periods during which anticipated diversification benefits evaporate.

Market Position.
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, Taiwan Ratings examines:

• 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;
• published rate schedules and the extent of discounting from rate schedules; a broad product line (which usually helps cement customer relationships and keep sales people interested).

Performance Track Record
A great deal of emphasis is placed on understanding how a particular management has, or has not, succeeded in navigating industry cycles, particularly in comparison to peers. Taiwan Ratings reviews:

• annual volatility of revenues, pretax profit margins and pretax returns on equity over 10-year period (if available);
• quarterly performance in comparison to firms with a similar business during a cyclical downturn;
• sources of volatility in performance (trading volatility or broad-based cyclicality); sensitivity of pretax income to changes in revenue (operating leverage).

Productivity
This is sensitive to the type of products and customers of a securities firm, so it is important to compare firms that are in similar business lines. Taiwan Ratings examines such issues as:

• commission revenue per broker; net revenue per capita.

Cost Structure
Again, the cost function depends on the services provided and the types and numbers of customers served. Discount firms do not need sales assistants to help prospect for clients or research analysts to provide stock reports. Taiwan Ratings reviews:

• proportions and trends in fixed costs;
• noncompensation cost per employee as a measure of overhead costs;
• make up of noninterest expenses (for example, proportions of compensation and noncompensation); noncompensation expense as a ratio of 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 breakeven points;
• sensitivity analysis of costs under low-trading-volume scenarios;
• levels and cyclical trends in compensation as a ratio of net revenue and as a ratio of precompensation pretax income;
• 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;
• internally or externally sourced overhead functions, such as clearing services or research.

Earnings Stabilizers
The ability of firms to sustain meaningful fee-based businesses varies widely across industry segments and across geographic markets. Taiwan Ratings examines:

• 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;
• impact of accounting methods.

Financial Policies And Profile

Market Risk Appetite And Control
Taiwan Ratings tries to assess the relative potential for unacceptable trading losses. We recognize that risk management is more of an art than a science, but view statistical modeling and measurement of risk as reinforcing the deployment of databases, models, accounting and valuation infrastructures that are needed to test whether the positions a securities firm is taking are in fact those that management thinks it is taking. Taiwan Ratings reviews:

• 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; large one-day losses;
• 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; back-up facilities for trading, processing and settling transactions;
• asset-liability management; interest rate risk;
• underwriting commitment process; limits on size of sole-managed underwritings.

Credit Risk
In the past, most credit risks securities firms have taken have been short-term in nature or secured by collateral. Increasingly, securities firms are booking long-dated credit risk in swap transactions and, more recently, credit derivatives. Taiwan Ratings reviews:

• 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 to long-dated credit risk;
• concentrations of industry exposure;
• problem credits and loss history;
• credit loss reserve adequacy;
• credit underwriting process; size authorization and signing requirements.

Capital
The balance sheet needs and capital intensity of securities activities vary widely between 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.

Taiwan Ratings emphasizes the quality of capital, particularly when comparing pure forms of equity capital versus less pure capital such as revaluations. 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, major risk categories like operational and litigation risk are not reflected. While Taiwan Ratings uses balance sheet data and "risk-adjusts" asset categories, the exercise is inexact and requires a great deal of judgment. The exercise also assumes a well-diversified business, which is often not the case. Taiwan Ratings reviews:

• management's policies regarding balance sheet usage for major activities, especially over capital needs of particular businesses;
• size and trend of the balance sheet;
• make-up of the balance sheet;
• measures of leverage (for example, total assets to equity and adjusted assets to equity); internal capital generation (growth of capital from income);
• share repurchase schemes;
• presence in capital intensive businesses, such as over-the-counter dealing; need for future capital growth to meet continually expanding OTC 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;
• narrowness of revenue base, indicating that if profitability dries up spending on up-to-date technology and investment in recruiting and training sales people would have to come from capital;
• other capital needs, such as technology spending;
• 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;
• excess of regulatory capital over minimum requirements;
• capital needs of off-balance sheet transactions (like TBAs - to be arranged - and securitized assets).

Liquidity Management
In different systems, the availability and use of market-sourced, credit-sensitive funding varies. Within Taiwan, the kinds of funding different securities firms presently use seem evenly distributed (including secured lending and bank loans), while their creditworthiness influences their funding costs to some extent. Taiwan Ratings reviews:

• the attributes of funding: overall composition of funding sources; maturity structure of both short-term and long-term funding; diversity of short-term funding sources; concentrations of funding from individual entities;
• 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 (are there any regulatory constraints on bank loans);
• numbers and names of primary bank relationships;
• access to central bank or governmental sources of emergency liquidity.

Taiwan ratings also puts great emphasis on:

• assessing 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;
• maintenance of a comfortable cushion of asset liquidity in excess of the potential short-term repayment needs;
• 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 or certain bonds borrowed.

Accounting
Accounting regimes widely between systems and affect the quality of information available to management. While Taiwan has made significant progress in adopting an approach that is close to the International Accounting Standards, some differences continue to exist. Mark-to-market imposes discipline on management, but lower-of-cost-or-market (LOCOM) used in certain businesses like merchant banking is more conservative.

Taiwan Ratings reviews:

• transparency of accounting used by the firm;
• mark-to-market or historical cost; use of LOCOM; conservatism of the management's internal accounting model;
• trade date or settlement date recognition;
• quality of external auditing;
• existence of an internal audit department and its role and reporting lines;
• procedures for monitoring error and suspense accounts.