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Speech by SEC Commissioner:
"Plans and Prospects for Financial Regulatory Reform"
by
Commissioner Elisse B. Walter
U.S. Securities and Exchange Commission
UC San Diego Economics Roundtable
San Diego, California
April 23, 2010
Thank you, Jim, for that kind introduction. I would also like to thank the UCSD Extended Studies and Public Programs and the Department of Economics for inviting me to speak today about the plans and prospects for financial regulatory reform. I am delighted to be here with you in lovely San Diego.
Financial regulatory reform is a subject of great interest to me, and I hope that I do not overwhelm you with too much information. I find that the media reports on this subject frequently do not really give a reader a good sense of many of the important issues involved, particularly those focusing on investor protection, which is the SEC's central mandate. I do hope, however, that the American public understands the critical nature of financial regulatory reform. Although the U.S. economy may be emerging from the recent financial crisis, regulatory reform is still absolutely critical if we are going to prevent another financial crisis from happening in the future.
Before I go any further, I need to remind you that my remarks today represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or members of the staff.1
Introduction
Over the last several years, there have been an increasing number of calls for varying types of comprehensive reform of our financial regulatory system. Legislation has finally started to move forward in Congress. As you are probably aware, last December, the U.S. House of Representatives passed the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173), although without any Republican support. The House bill was spearheaded by Chairman Barney Frank of the House Financial Services Committee.
We are still waiting to see how events will unfold in the Senate. In March, the Senate Banking Committee, under the leadership of Senator Christopher Dodd (D-CT), reported out of Committee its own comprehensive reform bill, the Restoring American Financial Stability Act of 2009 (S.3217), also without any bipartisan support. Yet, the Senate legislation is still developing. To cite just a single example, it was widely believed that the part of the Senate Banking Committee Bill, or Dodd bill as I will refer to it, dealing with the regulation of the over-the-counter derivatives market was intended to be only a placeholder until Senators Jack Reed (D-RI) and Judd Gregg (R-NH) could reach a compromise agreement. Further complicating matters, the Senate Agriculture Committee, under the leadership of Senator Blanche Lincoln (D-AR), just reported out of Committee its own bill addressing derivatives regulation, the Wall Street Transparency and Accountability Act.
Even as I speak to you this morning, there are breaking developments. Therefore, let me apologize in advance if my comments are already outdated. The Senate floor debate may begin soon, and the only thing I can say definitively is that it appears that something in fact may, or may not, happen.
In this brief talk, I cannot hope to cover all the important changes to our regulatory system contained in the bills. I also cannot cover the numerous international initiatives to reform the structure of financial regulation. Given my position at the SEC, what I would like to do instead is focus on certain issues in the bills that relate directly to our agency's mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Unfortunately, time does not permit me to delve into the merits of creating an independent Consumer Financial Protection Agency or opine on the controversial Volker rule (which would preclude banks from engaging in proprietary trading), although these and other topics certainly deserve close attention.
My remarks this morning will be organized around five principles that I believe should guide any regulatory reform effort. These are principles that I first articulated in a speech early last year,2 and I believe they provide a helpful framework to discuss the ongoing legislative efforts.
Principle 1: The objectives of managing systemic risk and protecting investors should both be maintained and pursued in a balanced manner.
The financial crisis has taught us that there is a constant need to watch for, warn about, and eliminate conditions that could cause a sudden shock that could lead to a market seizure or a cascade of failures that could put the entire financial system at risk.3 While traditional financial oversight and regulation are part of what is needed to prevent systemic risks from developing, it is clear that our current regulatory structure failed to identify and address systemic risks that developed over recent years. I believe that one of the weaknesses of our current regulatory system is its siloed framework, which fails to provide regulators with the authority and real-time information needed to monitor effectively and reduce risks flowing across regulated entities and markets.4 One of the central goals of the financial reform bills is to address systemic risk by identifying and regulating financial firms that are so large, interconnected, or risky that their collapse would threaten the entire financial system.
The House bill would address systemic risk and the silo problem, in part, by creating a new Financial Services Oversight Council, consisting of the heads of federal financial regulatory bodies, including the SEC, and chaired by the Secretary of the Treasury. The Council would have the authority to designate certain financial firms—including broker-dealers, investment advisers, and investment companies—as so large that their failure could cause a threat to financial stability or the economy. Such firms would be subject to increased oversight and regulation, including stricter capital and other prudential standards. In certain circumstances, the Council could even force a systemically significant firm to discontinue or place limits on certain of its activities or force it to divest business units or other assets. While there are certain differences from the House bill, the Dodd bill would also establish a Council of Regulators to identify certain large interconnected firms that require additional regulatory oversight.
I fully support efforts to remove the silos that exist today and address systemic risk in a manner that looks across the markets. But, I also strongly believe that such efforts should not be allowed to override or erode the central role that the SEC plays in protecting investors or to confine the SEC's role to a retail sales perspective. More generally, we should ensure that new systemic risk rules add to, rather than undercut, needed consumer and investor protections. In other words, while new rules relating to systemic risk should be able to supersede existing regulatory requirements that conflict and are less stringent, important investor and consumer protections should remain fully in place.
Let me explain. Investor protection is the core of the SEC's mission. In that respect, the SEC differs from other financial regulators. Banking regulators, for example, are primarily concerned about the safety and soundness of financial institutions and the financial system. As SEC Chairman Schapiro has stated, "The vision of the Congress when it created an independent SEC was to make sure that there was one agency of government focused single-mindedly and without dilution on the well-being of America's investors."5 She went on to say: "Congress made [the SEC] independent precisely so we can champion those who otherwise would not have a champion, and, when necessary, take on the most powerful interests in the land. Regulatory reform must guarantee that independence in the future."6
The best approach to the application of new systemic risk powers, I believe, is to ensure that any new systemic risk framework breaks down silos, is appropriately tailored to system risk, is additive to existing and future rules and protections, and is implemented through an open and transparent process to avoid unintended consequences. This can be accomplished under the legislation now before Congress; however, depending on how that legislation is implemented, there is a risk that it could erode the strength of the investor protection voice that is critical to strong financial services regulation.
A good example of how a concern for systemic risk could undercut the protection of investors is enforcement. Bringing an enforcement action against a financial institution for violations of the federal securities laws undoubtedly causes reputational harm, and yet vigorous enforcement is essential to protecting investors. Investors will be better able to make sound investment decisions if they understand the failings of a company that is subject to an enforcement action; yet, in some cases, publicizing that action could undercut the continuing viability of that entity or at least make it more difficult for it to conduct its business. A regulator that is focused almost exclusively on safety and soundness of the financial system and of the institutions that it regulates may well favor prudential measures over enforcement actions, and be less inclined to support making enforcement actions and their underlying facts public, even if that is in the interest of investors.
There is, of course, much more to be said on this topic but, in the interest of time, let me proceed to the next principle.
Principle 2: The current regulatory framework should be restructured to eliminate gaps and weaknesses, and to increase market transparency, so that important products and market actors are not beyond the oversight of regulators.
I'd like to illustrate this concept by mentioning one area where the Commission has recently taken action without additional legislation, using its existing authority, to address transparency problems exposed during the recent financial crisis. During the crisis, asset-backed securities ("ABS") holders suffered significant losses, and the securitization market has been relatively dormant ever since. Early this month, we proposed rules to enhance investor protection in the context of asset-backed securities. The proposed rules include a requirement to file tagged, computer-readable, standardized loan level information; a requirement to file a computer program that gives the effect of the "waterfall" that dictates how payments flow to investors; additional time for investors to consider transaction-specific information; and repeal of the investment grade ratings criterion for expedited access to the capital markets (through what we call shelf registration) in favor of a "skin in the game requirement."
The "shadow banking system" provides a clear example of serious gaps and weaknesses in the existing regulatory structure that must be remedied through legislation. By "shadow banking system," I mean the non-bank financial institutions that carry out banking-type functions but are subject to little or no regulation or supervision. This morning I am going to focus on hedge funds and over-the-counter ("OTC") derivatives.
Regulation of Hedge Funds and Hedge Fund Advisers
The SEC currently lacks basic data about hedge funds and hedge fund advisers. As you may know, in 2004, the SEC sought to remedy this problem by requiring hedge fund advisers to register with us, only to have that action overturned by the courts.7 As a result, these entities remain virtually unregulated. Yet, they are important and influential participants in the financial markets. In fact, according to a recent report, the global hedge fund industry has about $1.4 trillion in assets under management.8
Although the House bill and the Dodd bill have their differences, they take the same basic approach to hedge fund advisers by narrowing the exemptions from registration that are currently available. Today we only have authority to sue hedge fund advisers for fraud. The legislation would have the effect of requiring many hedge fund advisers to register with the SEC, and thus be subject to the full investment adviser regulatory regime. The bills also contain recordkeeping, reporting, and information-sharing provisions that are important to effective examination of these entities.
I generally support these efforts to shine a spotlight on private fund activity. There are two ways, however, in which I think the bills could be improved.9 First, the Dodd bill would provide exemptions from registration for venture capital and private equity fund advisers, while the House bill would do the same for venture capital funds. Since most rules under the Advisers Act apply only to advisers that are registered, this could result in new regulatory gaps. I am not convinced that the different goals and strategies employed by venture capital and private equity fund advisers are so different from the goals and strategies of hedge fund managers to justify "partial regulation," although I recognize that there are important benefits these funds provide, notably seed capital for start-up businesses.
Second, the House bill and the Dodd bill would increase the assets-under-management dollar threshold for investment advisers to register with the Commission. Advisers below the threshold would be prohibited from registering with the Commission, and would instead be regulated by state authorities. Even though, as a result of other changes under the bills, new private fund advisers would have to register with us, the net effect of increasing the threshold would actually mean that more advisers would leave our oversight than come under it. And, this would all happen at a time when we need more oversight of these private fund advisers, not less.
If the decision to raise the threshold is motivated by legitimate concern for the SEC's limited resources, Congress should consider the fact that the states may well not have the resources to handle this substantial increase in workload. State regulation would just be moving a problem from one place to another. Rather than changing jurisdictional lines to address a resource question, we should instead tackle funding head-on.
Congress should allow the SEC to be self-funded. Unlike most other financial regulators, the SEC remains without a stable funding stream because it depends on yearly appropriations from Congress. The SEC's 3,800 employees oversee approximately 35,000 entities—including 11,500 investment advisers, 7,800 mutual funds, 5,400 broker-dealers, and more than 10,000 public companies—a nearly 10 to 1 ratio that is only growing larger.10 And, these numbers do not include the many unregulated entities that our enforcement staff pursues. Independent funding would allow the SEC to better protect millions of investors. It could also enable the SEC to maintain appropriate staffing in light of any increased workload as a result of the new legislation, and would have other important advantages, including improving the SEC's ability to plan for and fund critical technology initiatives.
In addition, or as an alternative, I believe that Congress should create a self-regulatory organization, or SRO, for investment advisers—in other words a non-governmental body that is overseen by the government—to enhance investment adviser oversight. That suggestion is quite unpopular in some circles, I realize, but is an effective way to increase regulatory resources in this area without imposing an additional burden on taxpayers.
Regulation of OTC Derivatives
Financial derivatives played an important role in the recent market crisis. As you may know, the Commodity Futures Modernization Act of 2000 ("CFMA") explicitly prohibited the SEC from regulating much of the OTC derivatives market, including credit default swaps. As a result, the SEC cannot adopt reporting and other prophylactic measures to prevent fraud, manipulation, and insider trading with respect to any security-based swap agreement. Nor can the SEC require the disclosures, such as position and trade reporting, as well as information regarding counterparties, needed to surveil the market. The CFMA similarly precluded the Commodity Futures Trading Commission ("CFTC") from regulating the swap markets.
Overall, in my view, the House bill and the Dodd bill represent an important step forward in bringing transparency to this largely opaque market. The bills would bring currently unregulated swaps, swap dealers, major swap participants, and swap markets under a fairly comprehensive regulatory framework. They would improve transparency and regulatory oversight. They would facilitate the standardization and central clearing of swaps, which is an important step in addressing systemic risk in the financial system because it reduces counterparty risk, a significant source of instability in our financial system—consider the runs on Bear Stearns and Lehman Brothers.
Nonetheless, I believe that the bills could be strengthened in several ways to further avoid regulatory gaps and eliminate regulatory arbitrage opportunities.
The regulation of the securities markets and the futures markets currently is split between the SEC and CFTC. As financial products have become increasingly indistinguishable in economic function and purpose, however, it often is quite difficult to determine their correct regulatory treatment. For example, is a new product a futures contract, subject to CFTC jurisdiction, or a security, subject to SEC jurisdiction? This ambiguity can lead to protracted interagency disputes over products that straddle regulatory boundaries. These disputes serve neither the interests of investors nor the efficiency and competitiveness of our financial markets. In my view, they instead waste valuable regulatory resources. Moreover, trading conduct and positions taken in these markets are often part of the same overall strategy.
For these reasons, I—and others—have expressed the view that Congress should seek to merge the regulatory oversight responsibilities of the SEC and CFTC to provide more comprehensive oversight of the increasingly interrelated futures and securities markets.11 I formed this opinion from experience working at both agencies. But neither the House bill nor the Dodd bill would merge the two agencies. Indeed, the bills add unnecessary complications to the regulation of the swap markets by dividing jurisdictional responsibility for swaps in a way that can only be described as "jurisdictional gerrymandering." Consider that, under both bills, as well as the Lincoln bill just reported out of the Senate Agriculture Committee, jurisdiction over securities-related swaps would be divided between the SEC and CFTC.
Under the House and Dodd bills, a securities-related swap based on nine or fewer securities would be regulated by the SEC, while a securities-related swap based on 10 or more securities would be regulated by the CFTC. In my view, dividing jurisdictional responsibility in this manner is illogical and arbitrary and only invites abuse, regulatory arbitrage, and gaming.
It would also make it much more difficult for the SEC to oversee the whole securities-related marketplace. Market participants could choose whether to buy and sell cash securities or engage in synthetic transactions using securities-related swaps in order to fall within the jurisdictional authority of a particular regulator. Certainly, business choices should not be made on the basis of an evaluation of which agency is perceived to be weaker or more permissive. This risk of regulatory arbitrage is particularly high in customized over-the-counter transactions where individual market participants can self-select the entire portfolio of securities that would be referenced in one swap, for instance, in a "synthetic prime brokerage" arrangement (or what could be called a "managed swap account").
Even if Congress mandates that the SEC and CFTC adopt uniform rules over securities-related swaps within their respective jurisdictions, nothing guarantees that over time one agency or the other will not become less rigorous in oversight and less vigorous in enforcement.
The best way to prevent regulatory arbitrage is by creating clear lines of regulation. Swaps are just economic substitutes for the asset or event underlying a contract. For instance, securities-related swaps have a significant impact on the debt and cash equity securities markets. Thus, the most sensible approach would be for all securities-related swaps to be regulated by the SEC and all commodities-related swaps to be regulated by the CFTC. This simple regulatory approach—one in which the same regulator can impose similar requirements on similar products—would prevent regulatory arbitrage and gaming, as well as provide regulators with the best chance of detecting and deterring fraud, manipulation, or other abuses.
Finally, I would like to say just a few words about the Lincoln bill. While I believe that the Lincoln bill would bring much needed improvements to the opaque derivatives market, in certain important respects, the bill is a step backward.
Professor John Coffee has called the United States Balkanized structure of financial regulation, and I quote, a "crazy-quilt structure of fragmented authority."12 I believe that the Lincoln bill would only exacerbate that problem.
First, in comparison to the House and Dodd bills, the Lincoln bill's definition of security-based swaps, the swap agreements over which the SEC would have jurisdiction, is dramatically narrower.13 As a result, under the Lincoln bill, the bulk of the securities-related swap market could be regulated by a non-securities regulator. This makes no sense when you consider that securities-related swaps are the economic equivalents of securities!
Second, to compound the problem, the Lincoln bill would expand the definition of swap to include certain instruments that are currently regulated as securities, such as options and forward contracts on broad-based security indexes. As a result, these instruments would no longer be subject to the full protections of the federal securities laws.
What we need is reform of the OTC derivatives market that is rational and reasonable, and that does not make the U.S. regulatory system even more complicated and incoherent. Investors deserve this.
Principle 3: Consumers should receive the same level of protection when they purchase comparable products and services, regardless of the financial professional involved.
When your elderly Aunt Millie walks into the local financial professional to ask for advice, she has no idea—nor should she—which set of laws governs the conduct of the person on the other side of the table. For this reason, I believe that every financial intermediary that offers a comparable product or service should be regulated in a substantially similar way. Moreover, I support a fiduciary duty for all financial professionals offering personalized investment advice.
The House bill would make important progress in this direction by requiring the SEC to adopt rules requiring that the standard of conduct for a financial professional giving personalized investment advice about securities to retail customers would be to act in the best interest of the customer without regard to the interests of the professional. It would also prescribe that the standard shall be no less stringent than the standard applicable to investment advisers under the antifraud provisions of the Advisers Act, from which the fiduciary duty for investment advisers arise. The Dodd bill, in contrast, would require that the SEC conduct a study regarding the effectiveness of existing legal and regulatory standards of care for brokers, dealers, and investment advisers.
I believe that just mandating the SEC to conduct a study would be a mistake. For one thing, a study has already been conducted. In 2008, the SEC hired the RAND Corporation to do this, and RAND found that trends in the financial services market since the early 1990s had blurred the boundaries between investment advisers and broker-dealers, and that firms were constantly evolving and bundling diverse products and services in response to market demands and the regulatory environment.14 The RAND Report also found that retail investors were confused about the differences between investment advisers and broker-dealers, including the legal duties owed to investors with respect to the services and functions those professionals performed.
We do not need another study to tell us that investors are confused. Instead, it is time to move forward with substance. Of course, as I have said many times, what I would prefer to see is a legislative approach harmonizing the regimes governing investment advisers and broker-dealers comprehensively, taking into account the strengths and weaknesses of both regimes. Unfortunately, both bills fall short of proposing this comprehensive solution.
Principle 4: Important gatekeepers should be regulated to minimize conflicts of interests, increase transparency, and foster competition.
Gatekeepers act as "reputational intermediaries," providing important services that benefit investors. For instance, credit rating agencies—on which I will focus this morning—evaluate the creditworthiness of a company. Credit rating agencies played a key role in the recent financial crisis, and it is clear that their importance to the markets far outstripped the amount of oversight they received. And, too often investors failed to use their own judgment and simply relied on the credit rating agencies.
Before considering the current legislation, let me briefly explain the action that the Commission has already taken, using its current authority. Over the last two years, in response to the role that credit rating agencies played in the financial crisis, the SEC has taken steps to improve ratings quality. In February 2009, the SEC adopted amendments to its rules for Nationally Recognized Statistical Ratings Organizations ("NRSROs") to require them to make additional public disclosures about their methodologies for determining structured finance ratings, to disclose publicly the histories of their ratings, and to make additional internal records available to the SEC in order to assist staff examinations. The amendments also prohibited NRSROs and their analysts from engaging in certain activities that could impair their objectivity, such as recommending how to obtain a desired rating and then rating the resulting security.
Furthermore, last fall, the SEC adopted additional amendments with respect to the disclosure of ratings histories. In this most recent NRSRO rulemaking, the SEC adopted new rules that (1) require a broader disclosure of credit ratings history information; and (2) create a mechanism for NRSROs not hired to rate structured finance products to nonetheless determine and monitor credit ratings for these instruments in order to provide investors with a greater diversity of ratings and help foster new NRSRO entrants. We also proposed further amendments and new rules which would, among other things, augment the information an NRSRO is required to disclose about conflicts of interest and the magnitude of conflicts, highlight ratings shopping and other key information, and provide the SEC with reports of compliance reviews. Further, we issued a concept release soliciting comment on whether the Commission should propose to subject NRSROs to the consent and liability provisions of the Securities Act applicable to "experts" in connection with a public offering.
In the legislative arena, both the House bill and Dodd bill would provide important improvements to the SEC's regulatory oversight of credit rating agencies. Both bills seek to make it easier for investors to sue credit rating agencies, establish a new Office of Credit Rating Agencies at the SEC to strengthen regulation (with the House bill also calling for the establishment of an Advisory Board to advise the Commission and to ensure that it fully executes its oversight responsibilities over the rating agencies), and require rating agencies to have an independent board of directors. Both bills also would improve internal controls, require greater transparency of rating procedures and methodologies and management of conflicts of interest, provide the SEC with greater enforcement tools, and reduce reliance on credit ratings. The Dodd bill would enhance the Commission's enforcement authority by expanding the misconduct to which penalties apply to include individuals associated with credit rating agencies.
Principle 5: No matter what new shape is constructed for financial regulation, it must incorporate strong enforcement powers for regulators to pursue wrongdoing and deter future misconduct, but those powers must be in addition to—not in lieu of—regulatory authority.
As we continue to learn more about the causes of the financial crisis, one clear lesson is the vital importance that vigorous enforcement of existing laws and regulations plays in the fair and proper functioning of financial markets. Through vigorous and even-handed enforcement, we can hold accountable those whose violations of the law caused severe loss and hardship, recoup investor losses, and deter others from engaging in wrongdoing. Such enforcement efforts also help vindicate the principles fundamental to the fair and proper functioning of financial markets: that investors have a right to disclosure that complies with the federal securities laws and that there should be a level playing field for all investors.
Time does not permit me to address this issue in any depth. However, I would like to mention that I am pleased to see the House bill and the Dodd bill have included several legislative measures advocated by the SEC to improve its ability to protect investors and deter wrongdoing. In the interest of time, I will just mention one. New whistleblower legislation would provide substantial rewards for tips from persons with unique, high-quality information about securities law violations. This legislation, along with our own cooperation initiatives, would increase incentives for persons to share information quickly while expanding protections against retaliatory behavior. We expect this program to generate significant information that we would not otherwise receive.
Conclusion
In closing, I appreciate the opportunity to speak with you this morning and share my thoughts on important regulatory reform developments in the House and Senate. These are difficult matters, to be sure, and although we may not get it completely right, we must seek the best possible legislation.
Please feel free to call me or send me an e-mail if you have any thoughts on financial regulatory reform or other topics. My door is open to you, and I am always interested in your perspectives, thoughts, and ideas. Thank you again for asking me to be with you today.
Endnotes
http://www.sec.gov/news/speech/2010/spch042310ebw.htm
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