“SEC Reform After Dodd-Frank and the Financial Crisis”
Commissioner Daniel M. Gallagher
U.S. Securities and Exchange Commission
U.S. Chamber of Commerce
December 14, 2011
Thank you, David (Hirschmann), for your very kind introduction.
I am honored to be here today with Congresswoman Emerson and Congressman Garrett. And it is a unique pleasure to share airtime with my dear friend and former boss, Commissioner Paul Atkins, my friend Brian Cartwright, who was formerly the General Counsel of the SEC, and my friend, former Commissioner Roel Campos. Roel, I am taking care of your old office – Paul’s furniture looks great in it!
Before I begin my substantive remarks, I have to provide the boilerplate disclaimer that my comments today are my own, and do not necessarily represent the positions of the Commission or my fellow Commissioners.
I also want to take a moment at the outset to explain why I believe initiatives like this – that Jack Katz and the Chamber have undertaken – are so important. I have known Jack for a long time, and I know that he, like myself, has a deep and long-held respect and affinity for the SEC and its staff. And both of us have been deeply saddened to watch the torrent of criticism befall the agency over the last few years. Like Jack, though, I believe that this criticism provides the Commission with a unique opportunity to re-think and critically analyze the way we fulfill our mission.
Those who hold the agency dear are right to rush to its defense – in particular the defense of a loyal and hard-working staff that has been subjected to frequent, unfair criticism. But we should not reflexively protect past practices or shun appropriate criticism. Smart regulation, smart enforcement, and smart management require that we constantly evaluate and evolve as regulators. And so we are here today, in all of our various capacities, to help ensure that the Commission meets this obligation of serious introspection, and for that I am very appreciative. I can tell you that I did not come back to the agency to protect the status quo at the expense of meaningful change that investors, taxpayers, and the SEC staff should expect and demand.
The topic of this event – fundamental reform of the SEC -- could not be more timely. Although this is only my sixth week as a Commissioner, I previously spent four years at the Commission as a member of the staff, and because of that I believe I have a healthy perspective on the potential reforms being discussed today and the effectiveness, or ineffectiveness, of the myriad changes that have taken place over the last few years.
An examination of the SEC should be through the prism of the Financial Crisis and the Dodd-Frank Act,1 which together have had a greater impact on how the Commission undertakes its mission than any set of events at least since Enron, WorldCom and Sarbanes-Oxley at the onset of the millennium, and probably since the Great Depression and the initial formation of the Commission in 1934.
The Dodd-Frank Act presented an opportunity to make changes that could have served the U.S. capital markets very well. Indeed, the 2,319 pages of legislation were meant to address the problems associated with the Financial Crisis. It was both expected and necessary that Congress respond to those events. Although the full impact of the legislation will not be known for years as regulators toil on the implementation of the Act, it is becoming clear that the SEC will need to focus on a number of issues within the Commission’s core competencies that were not addressed in the legislation.
I believe that the Commission’s model of regulation could have served as the basis for many of the reforms in the Dodd-Frank Act. The virtues of the SEC model are many. First and foremost, its structure – a bipartisan Commission of five commissioners, no more than three of whom may represent one political party – ensures that the Commission considers a diversity of views, provides some level of insulation from political pressures, and allows the Commission to benefit from the varying experiences of the Commissioners and their staffs. In addition, the Commission is accountable to Congress: not only do Congressional oversight committees review carefully the actions of the Commission, but the Commission is also dependent on Congress for its funding and answerable to Congress for its spending. This accountability translates into greater accountability to the American electorate. And of course, the Commission is required to engage in an open and transparent process in exercising its regulatory function.
Another key aspect of the Commission’s regulatory mission is the core mandate to require clear and timely disclosure by the market participants it oversees. When these disclosure obligations are not met, there is the very real threat of swift and stern enforcement. Thus, issuers can offer securities to investors so long as proper and timely disclosure is made, and investors may take whatever risks they choose. There is no guarantee of investment performance and there is no government-backed principal protection. In the absence of fraud or other abuse, investors’ decisions to take risks enable them to reap the rewards – but they can also lose.
In the context of regulated entities, broker-dealers in particular, the SEC regulatory and oversight construct focuses on the protection of investor assets, and the winding down of firms that take unnecessary risks or simply fail to achieve success. Once again, there are no bailouts or expectations of a taxpayer backstop in this model – the SEC has no balance sheet. Entities can live or die. When they die, our rules should ensure that investor assets are safe and that there is sufficient capital in place to wind them down.
Without a doubt, the most notable feature of the Financial Crisis was the taxpayer-funded rescue of certain firms. And so the most pressing policy concern following the crisis has been how to address the problem of “too big to fail.” Unfortunately, nearly a year and a half after the enactment of Dodd-Frank, some commentators believe that we have not addressed that problem. As you know, the Financial Stability Oversight Council, or FSOC, has been tasked with crafting criteria for the designation of firms as “systemically important financial institutions,” or SIFIs, and to designate SIFIs under those criteria. The FSOC recently proposed a new three-step designation process that begins with a firm’s size and certain other quantitative criteria, then moves on to consider other quantitative and qualitative data. Ultimately the FSOC, after providing firms an opportunity to dispute the contemplated SIFI designation, may vote to designate a firm as SIFI. SIFIs will be subject to stringent regulation by the Fed, including increased capital requirements, supervision and other requirements.
Although I expect that SIFI regulation will be very burdensome, FSOC’s designation of SIFIs may have unintended, positive consequences for SIFIs. Notwithstanding the prohibition in Dodd-Frank against taxpayer funded bail-outs, there is a danger that credit providers may be pricing in a presumption that the government would once again rescue SIFIs in a financial crisis. Similarly, SIFIs may have other competitive advantages that spring from their special status as federally protected firms. For example, as we have seen several times in the last three years, counterparties can swiftly leave non-taxpayer-backstopped firms, such as stand-alone broker-dealers, for SIFI firms when there is instability in the markets. And this has happened even in fully-collateralized transactions involving highly liquid assets. It is simply impossible to compete with the promise of government protection. It would be premature to judge, at this point, the extent to which these potential competitive advantages may offset or exceed the burdens of more stringent regulation, but these are serious concerns.
In my view, the framework for regulating SIFIs should allow for these firms to fail. In 2009,2 FDIC Vice Chairman Nominee Thomas Hoenig, then the President of the Federal Reserve Bank of Kansas City, convincingly argued that permitting large institutions to fail, allowing for losses to be identified and taken, replacing management, and re-privatizing these institutions has resulted historically in a quicker economic recovery and lower costs to taxpayers than attempting to save these institutions and taking an incremental and delayed approach to addressing problems.
Although the SEC no longer acts as a holding company supervisor, its regulatory paradigm should provide guidance for regulators in this space. MF Global provides an informative case study. With assets listed in its bankruptcy filing of approximately $41 billion, MF Global fell below the $50 billion threshold at which firms will be considered for SIFI status and consolidated Fed regulation. While there are still significant questions as to whether MF Global complied with its obligations under existing regulations to segregate client assets, it is clearly a positive outcome that the firm’s failure was permitted to proceed without governmental intervention and the financial system did not melt down.
A very high profile event in the crisis separate from the bailout of Bear Stearns and AIG, but intimately tied up with the problem of too-big-to-fail, was the breaking of the buck by the Reserve Primary Fund, representing only the second time in history that investors have lost money in a money market mutual fund.
Despite the fact that the Dodd-Frank Act did not address money market funds, these funds have emerged as an issue in the past month or so. Indeed, in an early November speech, the Chairman explicitly stated her intent to “issue a proposal in very short order.”3 Since then, I have spent a considerable amount of time during my first 26 business days as a Commissioner focused on this important issue. And, based on what I have learned to date, I have questions about many of the currently discussed reform options.
Before I comment on some of the specific proposals currently on the table, I want to step back for a moment and express my more general concerns with the push towards rulemaking in this area. In particular, I want to make sure that we keep in mind two important and related questions as we proceed. First, for what specific problems or risks are we trying to solve? And second, do we have the necessary data that will allow us to regulate in a meaningful and effective way?
Let me address the first question. As I said earlier, I do not believe that it should be – nor can it be – the goal of the Commission to ensure that securities products are risk-free. Of course we must strive to prevent fraudulent and manipulative practices. But when the risks of an entirely legal investment are adequately disclosed, it is not the Commission’s job to forestall the possibility of loss. To put a finer point on it, in light of the extensive disclosures regarding the possibility of loss, money market funds should not be treated by investors or by regulators as providing the surety of federally insured demand deposits.
So what is prompting this urgency to reform money market funds? What are the particular risks that money market funds, as currently constituted, pose to investors and to the capital markets? What problem are we solving here?
I’ll admit that I just posed a bit of a trick question. We cannot know what risks money market funds pose unless – and this brings me to my second point – we have a clearer understanding of the effects of the Commission’s 2010 money market reforms.4 For some reason, much of the discussion surrounding the current need for money market reform sweeps aside the fact that the Commission has already responded to the 2008 crisis by making significant changes to Rule 2a-7. Notably, those amendments only became effective in May 2010. Without an adequate understanding of the current state of play, we are handicapped in our effort to define existing risks and measure their magnitude. Nor can we simply hand-wave and speak vaguely of addressing “systemic risk” or some other kind of protean problem. The risks and issues justifying a rulemaking must be specifically and thoughtfully defined in relation to the Commission’s mission. As a reminder, the Commission’s mandate is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. We are not expected to regulate with other goals in mind.
Given my belief that any rulemaking in this space could be premature, and possibly unnecessary, I thought I’d spend just a few minutes on the current proposals being bandied about. Although I am keeping an open mind about all options in this space, and am fully aware that the devil is in the details of many of these proposals, I do have some initial reactions.
First, I am hesitant about any form of so-called “capital” requirement, whether it takes the form of a “buffer” or of an actual capital requirement similar to those imposed on banks. Although I am not opposed to a bank-like capital requirement in principle, it is my understanding that the level of capital that would be required to legitimately backstop the funds would effectively end the industry. And I have doubts that a smaller capital buffer that accrues over time would be sufficient to protect investors and funds in an actual crisis. I am concerned that it could simply create the illusion of protection, and further obscure the well-disclosed risk of investing in money market funds.
I will note, however, that at least one industry participant has suggested the possibility of a stand-alone redemption fee. Although the details of the imposition of such a fee would need to be carefully considered, this suggestion avoids my worries about capital requirements. This minimal approach does not set up false expectations of capital protection, externalizes the costs of redemptions, and could be part of an orderly process to wind down funds when necessary. And, a meaningful redemption fee may cause a healthy process of self-selection among investors that could cull out those more likely to “run” in a time of stress. But despite my initial positive reaction to the notion of a redemption fee standing alone, grafting the fee onto a capital buffer regime will not assuage my concerns with such a capital requirement. Indeed, a combined approach retains all the problems of any capital solution, unless something significant is done to manage investor expectations regarding the level of protection provided.
Second, I acknowledge that a move to a floating NAV would work a profound change to the money market fund industry as we recognize it today. This proposal has its ardent supporters and its impassioned critics. I believe that it is an important option to keep on the table and to subject to further study and consideration. For example, it would be important to understand the effect of such a change on the commercial paper market and bank deposits.
Finally, I should make explicit what I hope you have already gleaned from my statements thus far. If the Commission moves forward with a proposal, the option of doing nothing until we have seriously analyzed the impact of last year’s reforms must be given serious consideration. By pre-judging the outcome of this rulemaking – that something, anything must be done as soon as possible, never mind the consequences – the Commission runs the danger of skewing its analysis of any proposed regulatory changes. Any analysis we undertake will necessarily be flawed if we lack a rigorous sense of the current baseline against which to measure the effects of any proposed changes. Moreover, we have a legal obligation to thoroughly consider all reasonable alternatives, and that includes the alternative of doing nothing beyond those significant changes the Commission has undertaken just last year.
Another area within the SEC’s regulatory sphere which could have benefitted from additional legislative authority – and which is near and dear to me – is the supervision of broker-dealers. In particular, the Commission could have benefitted from enhanced authority with respect to non-bank broker-dealer holding companies. These institutions would, presumably, generally not be deemed systemically important under the FSOC’s SIFI criteria, yet they are a core part of the SEC’s regulatory program. Unfortunately, rather than increasing the Commission’s oversight authority in this space, the Commission’s only statutory authority for such a program was eliminated from the Exchange Act, 5 and a new Federal Reserve Board program was established. 6 As various bills are floated in Congress, this is an area where I hope the Commission will be provided greater tools to carry out its core mission.
As I stated at the beginning of my remarks, it is important for the Commission to be open to constructive criticism and suggestions for improvement, which events like this are intended to foster. The Commission should consider specific proposals like those included in Jack Katz’s report7 that was released in connection with this event, as well as others presented here today, and should work with Congress on appropriate legislation to enhance the Commission’s operations.
In this vein, notable legislative initiatives include the SEC Regulatory Accountability Act,8 which was voted out of the House Financial Services Committee in November, and the Regulatory Accountability Act,9 which was approved by the House earlier this month, each of which would impose enhanced cost-benefit analysis requirements on the Commission when adopting rules. Significantly, the SEC Regulatory Accountability Act, which was proposed by Congressman Garrett, would among other things require the Commission to conduct periodic retrospective evaluations of the effectiveness and impact of its regulations.
While I am still studying the detailed recommendations contained in Jack’s latest report, a couple of his proposals strike me as being particularly incisive:
his call for a second special study, in the model of that undertaken by the Commission under Chairman Cary, of American regulatory policy, including the future of the U.S. and global secondary market structure, the interaction of the equity, debt and derivatives markets nationally and internationally, and the development of a corporate disclosure system that reflects the needs of investors and the information technology of the present and future; and
his recommendations to integrate cost-benefit analysis at the earliest stages of the rule development process so that this analysis can guide the regulatory process, and to adopt a regulatory look-back requirement for major rules.
Thank you all very much for your attention today. We would not be here if the SEC were not an incredibly important institution. The fact that so many different people have expended so much effort in an attempt to reinvigorate the agency is a testament to that fact. As we consider proposals to improve the agency, we should focus on the Commission’s strengths and successes – the functions that the SEC does well and that investors and participants expect us to do well and the strengths of our regulatory design. And we should learn from, but not dwell on, its failures. With this focus in mind, and with the help of people like Jack Katz, I know we can achieve our common goal of restoring the standing, reputation, and effectiveness of the Commission.
1 Pub. L. No. 111-203, 124 Stat. 1376 (July 21, 2010).
2 Thomas M. Hoenig, Too Big Has Failed (March 6, 2009). Available at http://www.kc.frb.org/speechbio/HoenigPDF/Omaha.03.06.09.pdf.
3 Chairman Mary L. Schapiro, Remarks at SIFMA’s 2001 Annual Meeting, (Nov. 7, 2011). Available at http://www.sec.gov/news/speech/2011/spch110711mls.htm.
4 Money Market Fund Reform, Investment Company Act Release No. 29132 (Feb. 23, 2010) [75 FR 10060 (Mar. 4, 2010)].
5 See Pub. L. No. 111-203, §617, Elimination of Elective Investment Bank Holding Company Framework (eliminating Section 17(i) of the Exchange Act).
6 See Pub. L. No. 111-203, §618, Securities Holding Companies, which generally defines “securities holding company” to include “a person (other than a natural person) that owns or controls 1 or more brokers or dealers registered with the Commission” excluding certain institutions that are otherwise already regulated, and which provides:
SEC. 618. SECURITIES HOLDING COMPANIES.
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(b) SUPERVISION OF A SECURITIES HOLDING COMPANY NOT HAVING A BANK OR SAVINGS ASSOCIATION AFFILIATE.—
(1) IN GENERAL.—A securities holding company that is required by a foreign regulator or provision of foreign law to be subject to comprehensive consolidated supervision may register with the Board of Governors under paragraph (2) to become a supervised securities holding company. Any securities holding company filing such a registration shall be supervised in accordance with this section, and shall comply with the rules and orders prescribed by the Board of Governors
applicable to supervised securities holding companies.
(2) REGISTRATION AS A SUPERVISED SECURITIES HOLDING COMPANY.—
(A) REGISTRATION.—A securities holding company that elects to be subject to comprehensive consolidated supervision shall register by filing with the Board of Governors such information and documents as the Board of Governors, by regulation, may prescribe as necessary or appropriate in furtherance of the purposes of this section.
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7 Jonathan G. Katz and U.S. Chamber of Commerce Center for Capital Markets Competitiveness, U.S. Securities and Exchange Commission: A Roadmap for Transformational Reform (Dec. 2011) ; see also Jonathan G. Katz and U.S. Chamber of Commerce Center for Capital Markets Competitiveness, Examining the Efficiency and Effectiveness of the U.S. Securities and Exchange Commission (Feb. 2009).
8 H.R. 2308.
9 H.R. 3010.