Speech by SEC Commissioner:
Remarks Before the NABE 2006 Washington Economic Policy Conference
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
March 13, 2006
I wish to thank the National Association for Business Economics for inviting me to be here today. Many of you attending today's conference are focused on developing policies to promote economic growth and security. It will come as no surprise to you that supervisory authorities such as the Securities and Exchange Commission focus a great deal of their attention on these very same policy issues. Economic growth is fostered through the continuous development of financial products and services, and security, both to the financial institutions as well as the system as a whole, is promoted through a keen focus on risk management. As the business and the products of financial instruments have become more complex, the task of compliance professionals, risk managers, and indeed supervisory authorities has become commensurately more complex.
Today I would like to spend some time discussing some of the higher level challenges we see financial institutions facing in managing their risk exposure, underscore some key principles that have been highlighted by industry groups and regulators relative to complex structured products, and discuss the SEC's prudential supervision of financial institutions under our Consolidated Supervised Entity program. Before I begin, however, I must remind you that my remarks represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or the staff.1
Financial markets have grown rapidly over this past decade. One of the most significant developments during this period has been the growth of derivatives, particularly credit derivatives, and the increasing use of many other complex structured financial products to accomplish a wide array of hedging and financial objectives. There has been a virtual explosion of product innovation that permits the parties to allocate risk between parties in new and efficient ways. For instance, certain structured products permit the credit risk of a portfolio of underlying exposures to be divided into tranches, each with different risk and return. This unbundling of financial risks has changed the way managers must evaluate risk and has spawned the development of more sophisticated approaches to risk measurement and management. In particular, pricing these products presents challenges since valuation depends on unobservable parameters, such as correlations among defaults.
However great the benefits of derivatives and other complex structured financial products, systemic instability could nonetheless result if the risks are not well managed by market participants. In the case of derivatives, the risk transfer effected by derivatives only works if the parties to whom the risk is transferred actually perform under the contract, that is, each party gets the benefit of its bargain. Prudently managed counterparty credit risk is as important for intermediaries, such as derivatives dealers, as it is for hedge funds and institutions that purchase these products and bear the ultimate risk. For complex structured financial transactions, the more sophisticated versions of these products may challenge current interpretations of accounting and tax rules and pose heightened legal and reputational risks to the participating financial institutions that must be identified and managed. You may recall the very problematic transactions that certain financial institutions entered into with Enron.
As financial institutions engage in complex risk businesses across legal entities and jurisdictional borders, the challenge for supervisory authorities is to oversee these activities on a consolidated, world-wide basis. The Commission historically has had limited means to examine and consider the financial activities and internal controls of entities at the holding company level. This limitation was of concern given that the activities of any material subsidiary may impact the financial health of the regulated U.S. broker-dealer or may raise systemic risk concerns to the financial system as a whole.
The Commission over the last several years gained significant experience in assessing the risk management capabilities of our largest broker-dealer holding companies through our work with the risk assessment rules, the Derivatives Policy Group members, as well as our oversight of the Derivatives Broker-Dealers, also known as BD Lite registrants. Our capacity to look globally at broker-dealer holding companies has been dramatically expanded through our development of a consolidated supervised entity program. A number of our largest, most complex broker-dealer holding companies have elected this voluntary oversight regime. They have consented to examination at the holding company level for all unregulated affiliates, in addition to the registered broker-dealer. They must also provide additional financial and risk information at the group level on a regular basis. As you may know, firm risk managers measure and manage risk at the consolidated level. Now we, as supervisory authorities, are looking at risk exposure and management at the consolidated level as well. In recognition of this enhanced oversight, these consolidated supervised entity firms are permitted to compute regulatory capital using the statistical models, such as value-at-risk and scenario analysis, developed for internal risk management purposes. Not only does this regime allow the firms to leverage their appreciable investment in internal risk management infrastructure for regulatory purposes and better align economic with regulatory capital computations, but the approach is also similar to that applied by the banking regulators to their most complex holding companies. This convergence of approaches, spanning multiple regulatory jurisdictions and national boundaries, has been well received by the regulated entities and bodes well for greater convergence of approaches in the future.
In addition to the SEC's prudential supervision of certain financial institutions, two other initiatives, the recently published report of the Counterparty Risk Management Policy Group II and the forthcoming Interagency Statement on Sound Practices Concerning Complex Structured Financial Activities, provide the industry with important guidance on best practices for managing the risks related to complex financial transactions.
There is much to commend to you from the recently issued Counterparty Risk Management Policy Group II Report. The Report, which was about six months in the making, reflects the considered opinions of many of the leaders of risk management in the financial system today. I would like to focus on a few broad areas where I found the CRMPG II Report to be very useful in highlighting and reinforcing the critical risk management issues that we focus on at the Commission. One is the interplay of liquidity, capital, and margin. I will highlight some of the challenges we see based on our experience overseeing regulated entities.
So called "tail events," or the rare but extreme financial shocks, as well as the lesser, more likely financial disturbance, is what supervisory authorities and risk managers concern themselves with when crafting regulatory policy and industry best practices. But what triggers a systemic event, or a lesser disturbance, is not easy to predict. We do, however, have the benefit of experience and can look to recent past events to glean the triggers and subsequent market dynamics that commingled into what the CRMPG II Report refers to as a "perfect storm."
Common to many shocks is a triggering event that causes sharp and sudden declines in the price of one or several asset classes, which, in turn, raises questions about or, in fact, impairs the credit worthiness of major counterparties or institutions. In response to falling asset prices, market participants attempt to mitigate and sell off positions, which collectively increases downward pressure on asset prices and decreases liquidity. The evaporation of liquidity further causes market and credit risk to spike and may impair balance sheet liquidity for institutions as well. Concurrent with this, once seemingly ample margin and collateral become insufficient, which dramatically exacerbates credit concerns. This increases market participants' need to behave defensively, which reinforces the market's downward spiral with potentially systemic effects.
At the SEC, we have long believed that the primary determinant of whether an investment bank holding company can survive various stress events is liquidity at the holding company level. When liquidity is available at the holding company level to "plug a hole" in any entity within the group immediately, business can proceed without regard to regulatory restrictions. Given the dynamic of a market shock I just described, liquidity must sometimes be accessed before the extent of the underlying problem is even fully understood. An event may begin with a negative newspaper article or even a rumor, about losses in a business or some other troublesome occurrence. Days may pass until the true facts become clear. But during that time, counterparts will want to know, even without regard to the actual details, whether the firm can continue to fund its balance sheet and meet its obligations, assuming these stories or rumors are true. If the firm's answer is "no" or even "maybe," the counterparts may ask to be paid immediately and there may be a real liquidity crisis, no matter what the underlying facts.
Large liquidity pools at the parent company level are therefore a critical component of our supervisory approach. Significant cash, freely available for use anywhere in the group, sends a strong signal that makes actual need for use of that liquidity relatively unlikely.
We believe that this approach addresses the same concerns that underlie much of the CRMPG II Report, which talks about a wide variety of potential triggering events having potentially systemic consequences. In addition to describing a dynamic where a decline in asset prices compels a sell-off, which, in turn, puts further downward pressure on asset prices, the Report also underscores the importance of major institutions preserving their creditworthiness in such an environment, which we view as equivalent to preserving their liquidity. Closely related to financial institution liquidity is the need to focus on market liquidity, and its implications for market risk and counterparty credit risk management at financial institutions. The two liquidity concepts are clearly related, that is, when market liquidity vanishes, financial institutions may need to support positions with their own capital, which then taxes their own balance sheet liquidity.
For some time now, risk managers at the largest financial firms have developed an entire suite of measures to capture the exposures to their portfolios from market movements.
Some, like value-at-risk, are statistical and provide insight into the likelihood of losses exceeding certain thresholds. Others, like stress and scenario analysis, speak only to the size of a theoretical loss and not to its probability of occurrence. The art, rather than the science, of risk measurement comes into play in deciding how to combine all the various signals to form a single picture of risk that can be the basis for prudent management action. Intermediaries and investors must continually review their risk management measures to develop a full picture of the firm's risk exposure and revise internal controls to manage their risks across affiliates and product groups as their business grows and changes.
The Basel Standard, by aligning capital requirements with internal risk measurement techniques, has clearly focused attention on risk measurement and, at the same time, moved many institutions to increase the resources devoted to risk modeling and related areas. I think that this more risk-sensitive capital standard is unambiguously a very good thing. But the Basel Standard does tend to focus most of our attention on the particular models that generate the inputs to the capital adequacy calculations. And at the end of the day, these are single numbers, which cannot capture the entire range of risks that are material at a large firm.
The single number of particular interest in computing capital adequacy to our consolidated supervised entity firms, which generally mark positions to market daily and hold positions in the so-called Basel trading book, is the value-at-risk measure.
Value-at-risk is clearly an excellent indicator of the market risk associated with highly liquid positions, for example, in interest rate and foreign exchange products. And it is probably a good indicator of the general level of risk taking at large firms. When VaR rises, risk generally rises. But VaR is not particularly well suited to measuring the risks of complex products and less liquid products, such as highly structured credit derivatives. Nor is VaR, which is a probabilistic measure, particularly useful in understanding the impact of very low probability "tail" events about which historical data may provide little insight. As the industry is heavily focused on implementing the Basel Standard, regulators must not lose sight of the need for complementary risk measures to VaR, and the importance of looking at risk in many ways using many different measures.
We have worked hard to incorporate multiple approaches to risk measurement into our own supervisory approach at the SEC. And we have engaged with our supervisory colleagues to develop an approach to the Basel trading book that looks beyond just the VaR number. The CRMPG II report is therefore extremely helpful in highlighting the importance of alternative techniques, notably scenario and stress analysis, to deal with products that must be marked to model and with products that, during a stress event, may become illiquid.
Closely related to capital adequacy is the role that adequate margin plays in promoting financial stability. The Report takes a view that is very consistent with my own when it emphasizes that credit terms, including margin arrangements, should be established at levels that are likely to be sustainable over time and should be established at levels sufficient to withstand periods of systemic stress. You recall that Long Term Capital Management had obtained very aggressive margin terms from the dealer community with only a small amount of excess collateral. If initial and maintenance margins are set for normal conditions, it results, during stress periods, in market participants facing insufficient margin to support their positions. They are thus forced to liquidate into a falling market that furthers the downward spiral I described earlier. It is critical to strike the right balance in setting margin standards that preserves enough cushion for extreme events.
Presently, several self-regulatory organizations are developing new rules that would create a portfolio margin system for customers of broker-dealers. Portfolio margining will recognize most types of offsetting positions in correlated products and permit calculating margin based on the sensitivity to price movements of an entire portfolio of securities held in a margin account. A portfolio margin system is attractive to brokerage firms as well as customers because it would recognize a greater number of offsets than permitted under the current strategy-based margin rules. However, in determining the amount of margin required in a portfolio margin system, it is critical that the risk of a portfolio be measured for stress scenarios where correlations among different underlying positions may change. Further, broker-dealers would be required to actively manage the risk in portfolio margin accounts, especially concentration and liquidity risk, to ensure that firms have adequate resources for difficult market conditions.
At the Commission we are continually learning through our oversight of prime brokers about the complex nature of new products, the evolving nature of markets, and the particular risk management challenges prime brokers face in light of their relationships with hedge funds. Prime brokerage is a highly lucrative and highly competitive business for broker-dealers. And hedge funds could not successfully execute their investment strategies without prime brokers lending them securities and capital. Relationships with hedge funds pose special risks and risk management challenges for prime brokers. Indeed, it has been our observation that certain trading strategies utilized by hedge funds are very difficult to measure in terms of risk exposure. Take, for example, capital structure arbitrage. For prime brokerage counterparties, strategies that span multiple asset classes pose significant systems challenges for measuring and offsetting risks.
Hedge funds are active in an increasingly wide range of products. In addition to debt and equity instruments, hedge funds have become significant players in energy markets, in the trading of leveraged or non-investment grade loans, and in purchasing certain securitization instruments. At the same time, the ways in which leverage can be applied have multiplied. Not only can positions be funded through traditional margin accounts, now over-the-counter derivatives and products involving embedded leverage, which may have a small notional value but are highly sensitive to market movements, have also become important sources of leverage to hedge funds. This phenomenon, where market participants can achieve leverage through OTC derivatives, has been called "synthetic prime brokerage." Because no single external counterparty can comprehend the aggregate position and leverage of a hedge fund or other counterparty, it can and must exercise diligence with respect to evaluating counterparty creditworthiness and in measuring as comprehensively as possible its own risk exposure. It must then make prudent choices when deciding to enter a transaction or requiring margin or other collateral. Again, the holding company's liquidity is a backstop to shortcomings in these analyses.
In light of the limitations of risk modeling, I found particularly compelling the CRMPG II Report's finding that, "The development of model-based portfolio margining programs is useful in mitigating counterparty risk by relating the amount of initial margin to the underlying risks." The Report goes on to say, "However, because the amounts of required margin may increase with changes in volatility, users should fully analyze the liquidity and risk management of potential margin requirements during times of market stress." I cannot emphasize enough that margin calls during stress events can further destabilize market liquidity and intermediaries' balance sheet liquidity.
Indeed, the Report goes on to recommend that firms be alert to the potential for overall leverage in the system to increase, particularly arising from liberalization of credit terms. In my view, supervisory authorities must be vigilant in ensuring that they do not create an environment that encourages a competitive "race to the bottom" concerning margin.
Another area of focus in the CRMPG II Report is documentation risk. The Report highlights the serious issues arising from inaccurate, incomplete, or unsigned documentation and confirmation of OTC transactions, as well as certain practices in assigning these contracts. In particular, the Report notes that incomplete or unsigned agreements permitted fundamental disputes over the terms of the transaction to occur. Uncertainty regarding the terms of the transaction enormously increases risk to the parties, since hedging and risk management is based on certain economic assumptions related to the understood terms of the transaction. The Report also identifies that within the credit default swap market, the practice of assigning transactions without notice to the counterparty is fundamentally problematic. The Report emphasizes that market participants must know their counterparty for risk management purposes and therefore must be notified in advance and give consent to an assignment. Without notice and consent, current assignment practices also present operational difficulties, since the party assigned is attempting to pay the wrong counterparty, and increase the prospect of back office chaos, in the event of a systemic shock.
The Report makes several useful recommendations, some of which have already been taken up by the industry. First, it urges the industry to immediately devote additional resources to reducing the backlog of unsigned trade confirmations. Further, the Report recommends the industry adopt practices that would minimize the uncertainty of trade terms by: using master confirmations, circulating drafts of structured confirmations on a pre-trade basis, pre-negotiating short form confirmations pre-trade, signing or initializing term sheets pre-trade, and orally verifying material trade terms promptly after trade date. The Report also advises that firms individually should monitor the backlog and consider, in extreme cases, reducing trading volume until the backlog is cleared up. It also calls for convening an industry-wide roundtable to focus aggressively on reducing confirmation backlog and work toward technological and operational enhancements, such as the automation of OTC derivative settlement, and other back office improvements.
This past September, the Federal Reserve Bank of New York, along with other supervisory authorities, such as the SEC, met with fourteen of the largest credit derivatives dealers and reached agreement on key practices and target dates for reducing the backlog in confirmations. The dealers set and achieved a 30% reduction in confirmations outstanding more than 30 days and are working toward additional reductions. To facilitate processing, the firms have committed to using DTCC (clearance and settlement) systems to conduct bilateral lock-ins of the trade terms and have committed to establishing industry standards for settlement of standard transactions and facilitating client use of DTCC systems. Finally, the dealers have developed guidance to implement a Novation Protocol to ensure evidence of consent is received by the date of novation.
I'd like to speak briefly now about another concern of ours at the Commission. That is the area of Complex Structured Financial Products.
As we all know, the post Enron era has seen both public and private sector reflection on how to improve upon the policies and procedures to identify, evaluate, assess, document, and control the credit, market, operational, legal, and reputational risks associated with complex structured financial products. Much like our experience in 1998 with LTCM, the Enron experience has served as a wake up call for supervisory authorities and to the industry to develop and embrace internal controls in these areas. The CRMPG II Report recommends a number of guiding principles, including that firms have in place a systematic review and approval process by senior management for new or significantly modified products. Similarly, it recommends that they have a framework for escalating to senior management transactions entailing unique reputational risk. The Report also addresses the type of discussions that should occur at the outset of a relationship, including: disclosure of risks, the impact of the intermediary's other business activities vis-a-vis the contemplated transaction, and the manner in which the complex transaction will be recorded, valued, and margined. Many of the Report's recommendations are largely consistent with the expectations of supervisory authorities as reflected in the FSA's guidance as well as the forthcoming revised Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities. I believe this guidance will inform our reviews of the risk management practices of our regulated entities as they relate to these products.
Finally, many of the Commission's recent enforcement actions have made clear that managing conflicts must be a compliance and legal priority in every financial organization. The old adage that there is safety in numbers no longer applies. The fact that your competitors are engaging in certain practices also will not exempt you from potential liability for conflicts. The Commission has urged its regulated firms to carefully review their business practices, to assess those areas where conflicts exist, with the goal of managing or eliminating such risks. Many large firms involved in multifaceted activities heeded our call and conducted extensive analyses of their business practices. They spent considerable time assessing where changes needed to be made and they adapted their businesses accordingly.
I'd like to share with you now just a few of the broad areas of conflicts that broker-dealers and their affiliated asset managers described in their presentations to the staff.
Some securities firms identified potential conflicts related to the presence of research analysts on the trading desks, particularly in their fixed income areas, where gaining knowledge of otherwise confidential or restricted information is possible. Several firms noted that current information barriers, that restrict access to information about firm positions and that require analysts to separate when preparing reports, do not address information shared orally on a trading desk. These firms also noted that research analysts are evaluated for purposes of performance and bonuses by sales and trading personnel, which may influence the analysts' objectivity.
Securities firms also spoke of potential conflicts related to the firm's facilitation of customer orders, with the related receipt of confidential order information, while the firm engages in proprietary trading. Absent strong information barriers, information could flow to the detriment of the customer, but to the good of the firm. Another concern centered on employee investments in certain types of securities that are less transparent for the firm to surveil (e.g., hedge funds, private equity funds), which could conflict with their sales and trading activities for customers. The firms also highlighted the persistent issue of firm personnel having the ability to make allocation decisions that could prefer the employee's interests over the customer's (such as when portfolio managers allocate superior trades to personal accounts rather than the publicly held funds they manage), or that could prefer one customer over another (such as when a prime broker decides to buy in short positions of some customers and not others).
Finally, broker-dealers also have conflicts as a result of maintaining multiple relationships with companies, such as acting as an underwriter, advising on M&A transactions, making markets, and holding principal debt or equity positions. Firms also may be asked to provide advice to the company at the same time they possess knowledge about that company gained through confidential business relationships, e.g., being a creditor of the company.
How each firm specifically addressed these conflicts varied depending upon its specific internal business structure. Many put into place business review processes to continuously assess conflicts as they may arise. A number of major firms voluntarily met with Commission staff to share the results of their efforts and to seek input on certain conflicts issues. We were heartened by this process and continue to encourage firms to maintain rigorous oversight of their conflicts.
To conclude, I hope my remarks today have highlighted some of the issues that we are focused on at the Commission that foster effective risk management at our largest financial institutions and promote financial stability for the system as a whole.