Speech by SEC Chairman:
Address to the Security Traders 12th Annual Washington Conference
Chairman Christopher Cox
U.S. Securities and Exchange Commission
The Willard Inter-Continental Hotel
May 7, 2008
Thank you, John [Giesea, President & CEO] for that kind introduction. It’s a pleasure to join you once again for this outstanding Annual Conference here in Washington.
I know that Erik Sirri, our Director of Trading and Markets, and Buddy Donohue, our Director of Investment Management, joined in your program yesterday, as did former Commissioner Annette Nazareth last night. Last night and today you’ve hosted several of my colleagues from the Congress as well. And of course you’ve just heard from my current colleague on the Commission, Paul Atkins. Your last two days have given you a good idea of what a typical day at the office is like for me.
Once again, you’ve shown impeccable timing in scheduling this Washington conference for the very best days of the year in the nation’s capital. Of course, most of the year the D.C. weather is not so beautiful. I’m sure you know that this city has four seasons: Fall; Sleet; Hay Fever; and Humid. It was during a Washington August that “humidity” was first described as “the experience of looking for air and finding water.”
But today, on this springtime afternoon, it’s every bit as nice as my home state of California. Or, as one New Yorker said to me recently, it’s even better here on the East Coast. He told me that every day of the year the sun shines on New York three hours before it shines on California, so all we ever get in California is secondhand sunshine. Think that one over.
Let me begin by acknowledging the work of the Security Traders Association over many years to uphold high ethical and business standards among your membership and throughout the markets. You have indeed been the leaders in insisting that honesty and integrity be the watchwords of professional equity trading in the United States.
You have also been exceptionally able and active advocates for improvements in the trading markets, and for setting higher standards for market quality and bolstering U.S. competitiveness.
In that connection, I want to commend your recently-issued report on the U.S. market structure, which will serve as a solid foundation for dialogue between market participants and regulators. By focusing on the intersection between regulation and technology, and such important current issues as the sources of market volatility, you have once again contributed in a very constructive way to our ongoing mutual work of constantly improving what are already the world’s most efficient and robust trading markets.
Maintaining the vibrancy of our markets in the 21st century requires both a high degree of adaptability and redoubled vigilance on the part of regulators. It is vital that our regulatory system be adaptable in order to ensure that regulation “keeps it real,” and focuses on what truly matters to investor protection and market integrity — while permitting and indeed encouraging innovation and competitiveness. And it’s more important than ever for regulators to be vigilant, because in the midst of such fast-paced, technologically- and competitively-driven change, the fundamental principles of investor protection could easily become lost without a relentlessly skeptical inquiry on the part of the SEC and every market participant.
As recent events have shown, nowhere is this more true than with the significant changes that have taken place in recent years in the investment banking industry. The stress in the credit markets that began with subprime-related assets and recently led to the financial crisis at Bear Stearns has underscored that while financial institutions have become adept at dispersing risk through a variety of structured products and OTC derivatives, in the process they have also so expanded the number and kinds of direct and indirect counterparty relationships that today they comprise a nearly impenetrable web of connections and interdependencies among market participants. This complexity is impressive when it works, but as we have seen, these increasingly intricate relationships can prove very fragile. In such a world, the demands we place on risk management, on the supervision of systemically important financial institutions, and on the protective mechanisms of the trading markets themselves are greater than ever.
And yet here, the framework of federal financial services regulation as it was developed throughout the 20th and 21st centuries is dangerously behind the times.
Today, no regulator in the federal government is given explicit authority and responsibility for the supervision of investment bank holding companies with bank affiliates. Under the statutory scheme that the Congress devised, most recently in the Gramm-Leach-Bliley Act, there is mandatory consolidated supervision by the Federal Reserve for commercial bank holding companies, including financial holding companies. For investment banks that do not have U.S. banks within the consolidated group, the law provides for a holding company supervision structure that is purely voluntary — and only one investment bank, Lazard Ltd., has volunteered for this supervision. The four largest investment bank holding companies in the U.S. are ineligible for it because they have specialized bank affiliates, such as industrial banks or certain savings banks.
There is simply no provision in the law that requires investment bank holding companies to compute capital measures or to maintain liquidity on a consolidated basis. Nor does the law provide for a consolidated supervisor that is knowledgeable in their core securities business, and that would be recognized for this purpose by international regulators.
It was precisely because the existing statutory scheme addresses neither how nor by whom investment bank holding companies with specialized bank affiliates should be supervised that the SEC in 2004, under the direction of my predecessor Bill Donaldson, adopted our Consolidated Supervised Entities (“CSE”) program for U.S. investment banks. This, too, is a purely voluntary program, but in 2004 and 2005, the five largest investment banks volunteered to participate — in part because of the implications of the European Union’s Financial Conglomerates Directive, which had recently required consolidated supervision either internationally or at a European level.
Because the CSE program is not authorized in statute, it relies on the SEC’s authority under the Securities Exchange Act of 1934 to determine net capital rules for the regulated broker-dealer subsidiaries of investment banks. In essence, the entire CSE program was constructed as an alternative means of complying with the SEC’s net capital rule for broker-dealers. Using this alternative required as a condition that the investment bank’s holding company’s consent to group-wide supervision by the Commission. This was a creative, unprecedented, and significant regulatory extrapolation. And it filled in part, but only in part, what the Commission believed was a significant statutory gap.
Since the CSE program was put into place, it has been recognized as “equivalent” to other internationally recognized programs for purposes of the European Union’s Financial Conglomerates Directive. It provides consolidated supervision to investment bank holding companies that is designed to be broadly consistent with Federal Reserve oversight of bank holding companies. It’s overarching purpose has been not to protect the entire investment bank holding company, but rather to monitor for financial or operational weakness in the holding company or its unregulated affiliates that might place the U.S.-regulated broker-dealers and other regulated entities at risk.
It is within this context that the SEC confronted the rapid deterioration of liquidity at Bear Stearns during the week of March 10th. This was the first time, not only during the relatively brief existence of the voluntary CSE program, but at any time, that a major investment bank that was well-capitalized and amply liquid using capital and liquidity measures largely developed for commercial banks experienced a crisis of confidence that resulted in a loss not only of unsecured financing, but also short-term secured financing. This occurred even though the collateral it was able to provide was high quality, such as agency securities, and had a market value that exceeded the amount to be borrowed.
The notion embedded in the Gramm-Leach-Bliley Act that investment banks should be able to operate outside of a statutory consolidated supervision regime is no longer tenable in the wake of Bear Stearns. It is impossible for anyone to say that in this case, “the system worked.” It is true that the statutory scheme produced all that it ever demanded — no customer cash or securities were ever at risk of loss because of the elaborate protections they enjoy under the SEC’s existing regulation, including the segregation of customer funds and securities. But that limited purpose, which views the SEC’s role and that of other financial regulators vis-a-vis the nation’s largest investment banks as limited to protecting customer funds and securities in the regulated broker-dealer subsidiaries of firms such as Bear Stearns — is no longer enough.
In the immediate aftermath of the Bear Stearns meltdown — and by immediate, I mean within days — the SEC has focused on the need to change the standards for measuring the adequacy of liquidity in light of the “run on the bank” that Bear experienced. Three days after the Bear transaction, I wrote to the Basel Committee to offer strong support for extending the existing capital adequacy standards to deal explicitly with liquidity risk. And in the ensuing weeks, the SEC has arranged to join with the Basel Committee in this important work. At the same time, without waiting for new internationally accepted standards, the Division of Trading and Markets has strengthened the liquidity requirements for CSE firms relative to their unsecured funding needs. They are closely scrutinizing the secured funding activities of each CSE firm, with a view to lengthening the average term of secured and unsecured funding arrangements. And they are currently obtaining funding and liquidity information for all CSEs on a daily basis, and discussing with CSEs the amount of excess secured funding capacity for less-liquid positions. There will also be more disclosure of actual capital and liquidity positions of the CSE firms in terms that the market can readily understand and digest. The CSEs will institute public disclosure of their capital ratios computed under the Basel Standard later this year, and then phase in additional disclosure related to concentration of exposures.
Beyond all of this, the SEC is establishing additional scenarios for risk management purposes, focused on market shocks that are of shorter duration and more extreme in their impact, including inflicting on a CSE firm a substantial loss of secured funding. These new scenarios will be layered on top of the existing scenarios as a basis for sizing liquidity pool requirements. As a result of this additional analysis, firms will be required to take steps such as increasing the term of secured funding and diversifying their funding sources. The Division is currently discussing with CSE senior management their longer-term funding plans, including plans for raising new capital by accessing the equity and long-term debt markets.
While the existing assumptions for both commercial and investment banks that the CSE program relied upon have been found faulty, at least as applied to a firm such as Bear Stearns without access to backup liquidity through the Fed’s discount window, it is important also to understand what they are good at.
When the Commission adopted the CSE program in 2004, it was already evident that protecting investors by monitoring the financial integrity of large broker-dealers was becoming more difficult, since so much of the firms’ risk-taking business was being conducted in unregulated affiliates within a securities firm holding company structure. In particular, the Commission had the experience of Drexel Burnham’s collapse relatively fresh in mind. And in that paradigm, the problem was not a crisis of confidence or a run on the bank, which were thought to be more of a problem for deposit-taking institutions, but rather the need to protect against financial weakness in an unregulated affiliate or the parent company, which could undermine an otherwise well-capitalized broker-dealer, and even disrupt the trading markets in the unwinding process.
The most significant change brought about by the CSE program was that the SEC could, for the first time, monitor positions that could affect the financial health of a broker-dealer, but which were booked in unregulated affiliates. Just as importantly, the Commission could monitor these positions and assess their risks in a comprehensive manner. For the first time, large investment banks were required to compute a capital adequacy measure that reflected all of those exposures. This was a significant improvement, even if it did not completely make up for the lack of statutory consolidated supervision. It addressed head-on the opacity of investment bank affiliate risk-taking that had been highlighted in the report of the President’s Working Group on Financial Markets following the near-collapse of Long-Term Capital Management in 1998. Commentators at that time commonly referred to the affiliates of the U.S. broker-dealers as “black holes.” With the regulatory invention of the CSE program, we made tremendous strides in bringing these affiliates’ activities into the light.
And the CSE program did more. Because the CSE models applied on a consolidated basis, there were added requirements that CSEs maintain capital and liquidity in the broker-dealer itself. For the five largest firms, this meant a liquid capital cushion of no less than $5 billion. As a result, the capital of the major broker-dealers was maintained when they joined the CSE program, and in addition, new capital and liquidity requirements were added at the holding company level.
Beyond the stronger capital requirements, the CSE program added regulatory monitoring of risk controls. And like the computation of capital and the measurement of liquidity, this was implemented across the entire consolidated entity.
Even prior to the experience with Bear Stearns, the SEC’s supervision of investment bank holding companies recognized that capital is not synonymous with liquidity — and that more than capital is required to determine a firm’s financial health. A firm can be highly capitalized — that is, it can have far more assets than liabilities — and still face liquidity problems. So while the ability of a securities firm to withstand stress events is linked to the amount of its capital, it also needs sufficient liquid assets in the way of cash, Treasuries, and agency securities that can be used as collateral in lending arrangements, so that it can be sure of meeting all its financial obligations as they arise.
For these reasons, the CSE program before Bear Stearns required substantial liquidity pools, intended to ensure that firms could operate normally in all market environments — even where normal funding arrangements weren’t available. Specifically, the liquidity measures were designed to ensure that the holding company could meet its expected cash outflows in a stressed environment without any access to unsecured funding whatsoever for a period of at least one full year.
You will perhaps be surprised, but surely not comforted, to know that at the beginning of the week of March 10 and throughout the year before that time, Bear Stearns comfortably maintained an overall Basel capital ratio at the consolidated holding company level of not less than the Federal Reserve’s 10% “well-capitalized” standard for bank holding companies. And its liquidity at the outset of that week was also ample, and indeed significantly higher than it had been earlier in the year.
The Bear Stearns experience demonstrated, however, that the prevailing measurements of capital and liquidity that were then being used by the SEC and by every bank and securities regulator, not only here in the United States but around the world, were inadequate to prevent or predict the “run on the bank” that Bear endured. In just two days between Thursday, March 13, and the close of business on Friday, March 14, Bear’s liquidity pool fell by over 83% — from $12 billion to $2 billion.
This was a development that neither the Consolidated Supervised Entities program nor any bank regulatory model had anticipated. Short-term secured financing was unavailable even when Bear offered high-quality collateral such as agency securities. What neither the CSE regulatory approach nor any existing regulatory model had taken into account is the possibility that secured funding, even if it were over-collateralized with U.S. Treasury or agency securities, might disappear in a crisis of confidence.
The course of events that week was a cascade of panic against which even a larger and less leveraged firm might have been defenseless. At first, some counterparties began pulling back from providing unsecured lending. Then the same reluctance to deal with Bear was extended to secured lending on less liquid and lower-quality securities. Some skittish prime brokerage clients began moving their cash balances elsewhere. As rumors swirled about Bear’s financial position, these actions in turn influenced other counterparties. Clients and lenders began also to reduce their exposure to Bear Stearns. This, in turn, created large volumes of novations of derivative contracts.
In the face of what was essentially the wholesale transfer by counterparties of their open contracts with Bear Stearns to other dealers, the industry faced a number of significant logistical challenges. Not surprisingly, there was a sharp increase in the number of collateral disputes involving Bear Stearns. These disputes reinforced the market’s impression that Bear Stearns was distressed. And that, in turn, induced more novations by other counterparties.
By week’s end, Bear Stearns could no longer fund certain high-quality debt instruments on a secured basis. They faced a choice between filing for bankruptcy on Monday morning, or concluding an acquisition agreement with a larger partner.
These unprecedented events have highlighted the fact that for all of the good the CSE program has accomplished, it did not serve to prevent the loss of a major investment bank. Nonetheless it is extremely fortunate that the program existed, so that when the Federal Reserve Bank of New York came into Bear Stearns on short notice in March, they could see Basel ratio calculations they were familiar with, and they could immediately review both capital and liquidity assessments on a consolidated basis. Just as importantly, the Federal Reserve could leverage off of the work and experience of the SEC staff who well understood not just the regulated broker-dealer but the consolidated institutions, their business activities, and their risk management processes.
Yet the fact remains that even today, the SEC has no explicit statutory mandate to supervise the nation’s investment banks on a consolidated basis. The statutory no-man’s land that continues nine years after the Gramm-Leach-Bliley Act should not be tolerated indefinitely. As I have outlined, since the Bear Stearns collapse, the SEC has made significant changes that reflect the new reality. But more needs to be done. Very soon, the SEC — or if not the SEC then another regulator — must be given the express authority and a regime appropriately tailored to securities firms to supervise the nation’s investment banks on a consolidated basis. We have all the empirical evidence we need of that.
We also have a useful set of experiences in administering the voluntary CSE program over the last few years that can help inform any new legislative approach. We have learned that what is required is a program broadly consistent with existing Federal Reserve holding company oversight, but tailored to reflect two fundamental differences between investment bank and commercial bank holding companies.
The first of those differences is that the CSE program reflects the reliance of securities firms on mark-to-market accounting as a critical risk and governance control. Any future statutory regime will have to take this highly salient feature of investment banking into account.
Second, the CSE program reflects the critical importance of maintaining adequate liquidity for holding companies that, until most recently, did not have access to an external liquidity provider. How the Federal Reserve and Congress choose to deal with the for now temporary extension of the Primary Dealer Credit Facility to investment banks will play a large part in determining the best way to measure and regulate liquidity.
The Bear Stearns experience, like much of the fallout from the subprime crisis, has made your world exceptionally challenging over the last year. With your help, regulators and policy makers in Washington are working hard to ensure that the proper lessons are derived from these experiences, and that rapid and significant changes are made in the regulatory process to put that learning quickly into effect. That important work is going on not only at the SEC, but also within IOSCO, the Basel Committee on Banking Supervision, and the Financial Stability Forum.
It has been a pleasure to be your luncheon speaker, and to bat cleanup as we now bring to a close this very impressive two-day event.
The Washington Conference — this is the 12th Annual event — is an excellent opportunity for you to explore the public policy issues facing our equity markets, and to get an up-close view of the broader context in which so many decisions affecting the markets are being made in the Congress and the Executive Branch. It is also a wonderful opportunity for me to express my profound thanks to all of the professionals here who have worked so energetically with the Commission to make our securities markets better and stronger. The constructive dialogue that the Security Traders Association maintains with the SEC is the kind of work that rarely attracts headlines. And yet it’s a vitally important contributor to making the U.S. securities markets the most trusted, admired, and effective in the world.
The capital markets in which each of you is such a vital participant represent a cornerstone of America’s economic strength — but their continued success can never be taken for granted. Their smooth functioning, their depth, and their liquidity comprise a national asset that we hold in trust. And no one knows better than the people in this room how to preserve assets and make them grow — you’re proving it once again with your Special Report on U.S. Market Structure, which is aimed at keeping America’s standards high and affirming the primacy of the investor. So thank you for the work that you do each day to strengthen our markets, and for the vocation that you have chosen. On behalf of the 3,600 men and women of the Securities and Exchange Commission, we are proud to be your partners.