-------------------- BEGINNING OF PAGE #1 ------------------- REGULATING IN A WORLD OF TECHNOLOGICAL AND GLOBAL CHANGE REMARKS OF COMMISSIONER STEVEN M.H. WALLMAN BEFORE THE INSTITUTE OF INTERNATIONAL BANKERS Four Seasons Hotel, Washington, D.C. March 4, 1996 * The views expressed herein are those of Commissioner Wallman and do not necessarily represent those of the Commission, other Commissioners or the staff. Introduction Good afternoon. Thank you for the privilege of speaking at the Institute s Annual Washington Conference. I am pleased to be part of such an important event, and I appreciate the opportunity to share a few thoughts with you. This is a particularly interesting moment to be involved in the financial markets, whether as a direct participant or regulator. It is hard to recall a time when the pace of change in the markets has been so accelerated. Today s cutting edge in sophistication is quickly made obsolete by tomorrow s innovation. Such rapid change clearly presents substantial opportunities for industry, for investors and for consumers of financial services -- a net positive result. At the same time, it poses unique challenges, both for industry and regulators. From an industry perspective, the challenges are primarily competitive. From a regulator s perspective, we face a daunting task. We must adopt, remove or modify regulations to adjust to a future marketplace that we can barely envision, with market participants we can barely identify. Critical to serving the public interest is maintaining flexible but effective regulation that allows the market for services and the market for providers of services to continue to evolve. Such rapid change, created by technological innovation and globalization, leads to a few conclusions that I would like to develop: First, there will have to be greater regulatory cooperation and coordination, both domestically and internationally. Second, changes in technology and the financial markets clearly make it more difficult for us to regulate as we have in the past. We must consider adopting a new regulatory philosophy, one that is more goal oriented and less command-and-control oriented. I am not suggesting that the concerns that serve as the underlying rationale for regulation -- be they directed at maintaining investor or consumer protection, preserving the safety and soundness of a financial system, or minimizing systemic risk more generally -- no longer exist. To the contrary, these broad concerns may even be greater in a world of globally intertwined market participants and markets, even as our global markets exhibit great resilience post-Barings, Daiwa and others. I do mean to say though that technology and globalization have greatly accelerated the pace of change in our financial markets and those who participate in them, and we need, therefore, to change the way we regulate. -------------------- BEGINNING OF PAGE #2 ------------------- Third, and more importantly, in addition to affecting the process and philosophy we use to regulate, technology and globalization have made obsolete many of the underlying premises on which effective regulation has been based. Consequently, we must consider new ways to ensure satisfaction of regulatory ends. As a final matter, I would also note that regulators will have to work harder to ensure that they and their respective constituencies understand the different financial products and services being offered in the new financial environment. To paraphrase from Sy Symm s, an educated consumer is a regulators best friend . The Financial Marketplace of 1996 and Beyond You might think that an SEC Commissioner would start by noting the distinctions between the market for securities and the demand for other financial services. But, in fact, there is little distinction between these markets; and in the minds of financial service consumers, many of whom want one stop shopping for their financial needs, any distinction is increasingly being viewed as negative. In this connection, I recognize the significance -- and necessity -- for Glass Steagall reform, and others here have spoken more specifically to that issue. But although modernization and change in this area is critical, we need to start focussing on tomorrow s issues as well. To a great extent, we already have one financial services market characterized by competition among various securities firms, banks both commercial and investment, and, increasingly, other business entities.-[1]- --------- FOOTNOTES --------- -[1]- For example, consider the following: Merrill Lynch, a traditional securities firm, owns Merrill Lynch Bank and Trust Company, and Merrill Lynch Financial, both FDIC insured banks that offer certificates of deposit, money market deposit accounts, and also make and purchasesecured loans. For the first time in history, mutual fund assets ($2.7 trillion) have surpassed commercial bank deposits ($2.4 trillion). The continued growth in fund assets reflects many changes in the market including, among others, the fact that many consumers today use money market funds for checking account purposes in lieu of traditional demand deposit accounts; Traditionally non-financial-services entities are expanding their activities into financial services. For example, in addition to its traditional telephone calling cards, AT&T now issues general purpose consumer credit cards. Similarly, through GMAC, General Motors engages in financing activities as diverse as mortgage banking; Some retail banking customers may now purchase mutual funds, securities and annuities, insurance and other financial products from their banks, either directly or through third party service providers on bank premises; and Discount brokers such as Charles Schwab now offer software to retail account holders designed to allow them easier access to their portfolios from home. These are just samples of commonplace occurrences and services being offered by the rapidly changing segments of the financial services industry. The list of services offered by market participants would obviously expand immediately if we were to achieve de jure, as opposed to de facto, Glass Steagall reform. -------------------- BEGINNING OF PAGE #3 ------------------- Most of us would agree that this is as it should be. By allowing competitive forces to operate, we encourage financial innovation and the continuing evolution of structures for our financial markets that are optimal, both from the perspective of satisfying the needs of consumers and of maintaining the long- term viability of our financial markets. I. The Growing Impact of Technology and Globalization on the Financial Markets Beyond traditional industry competition, however, advances in communications, technology and increasing globalization have fostered a huge variety of products and services. We have shrunk our markets in terms of accessibility, while simultaneously expanding their depth in terms of available offerings. In the securities industry, one of the best illustrations of this has been the growth of electronic trading systems as an alternative to traditional exchange/auction or dealer-based trading systems. Many of these systems permit investors to deal directly with each other at lower costs than previously-existing systems. The challenge is to maintain a regulatory regime flexible enough to allow for the continued development of such systems, consistent with allowing us to meet our regulatory objectives, without imposing unnecessary or constraining costs. Without delving into the details, I believe we can all agree that the continued growth of the Internet presents even more of an opportunity for expansion in financial services through the use of technology.-[2]- Once more consumers become comfortable with electronic communication technology generally, and when certain security and confidentiality issues related to the transfer of sensitive information are more satisfactorily resolved and universally accepted, I think we will really see innovation in this area, over the Internet and through proprietary systems, including: real-time individual consumer securities trading; and the providing of more real-time disaggregated financial information through access to select portions of a company s management information system. Technology has also allowed for the development of sophisticated new products and services that demand analytics that were previously unavailable. It has thereby furthered the development of modern portfolio theory, facilitated the investment decision making process and aided the proliferation of derivatives and other risk management tools. Technology also has had a profound effect on the globalization of the financial markets. Simply put, the walls between competitors built by geographic boundaries and time zones which once dictated and furthered nationalistic views toward commerce are now generally non-existent due to better communications and analytics. Access to foreign capital markets and foreign users of capital through today s technology is --------- FOOTNOTES --------- -[2]- Businesses utilizing the Internet now have access to over 25 million potential consumers, making the Net a marketingtool of vast potential. Similarly, consumers having a personal computer -- quickly becoming a household staple as common as a television -- now have access to approximately 37,000 Web sites and services a number of which include, for example, informationon stock market activity, brokerage firm and mutual fund products and services, prospectuses and other SEC filings (as well as documents filed with other federal agencies), and products and services offered by traditional and increasingly virtual banks. And this just scratches the surface. -------------------- BEGINNING OF PAGE #4 ------------------- relatively simple. Implications for Regulators These changes in the markets over the past few years clearly have been both pervasive and a net positive for consumers of U.S. financial services. The implications for regulation are far more dramatic, however. 1. Greater Coordination of Regulatory Efforts Technology and innovation have had one obvious effect: As it becomes harder and harder to draw lines among the players and services in the financial arena, there will have to be greater coordination of regulatory efforts, and cooperation among regulators, both domestically and internationally. Information will have to flow more easily among regulators if we are to ensure that (1) each agency has access to the information necessary to fulfill its statutory mandate, and (2) market participants subject to multiple regulators are not so overburdened that they become competitively disadvantaged. If we fail to achieve either goal, consumers of financial products and services ultimately will be harmed. Of course, we also must be careful to ensure that institutions engaged in similar activities are regulated in a functionally equivalent manner. a. Enhanced Coordination Among Domestic Regulators As an example of enhanced coordination among domestic regulators, last year the Commission and the OCC entered into an agreement to conduct joint inspections of bank advised mutual funds and units of banks that provide investment advice to mutual funds. The goals of this agreement are to examine these entities in a cost-effective way to avoid major duplication or unnecessary regulatory burdens. A similar agreement has now been reached among the Commission, state securities regulators and the securities self-regulatory organizations relating to broker- dealer examinations. b. Enhanced International Regulatory Coordination Each domestic regulator still has primary and pervasive control over entities within its jurisdiction. The principal gaps lie in cross-border activities. Perhaps more importantly then, we are also beginning to see more coordination among international regulators as geographic boundaries continue to tumble, and distinctions among domestic and foreign markets and market participants disappear. For example, in addition to its work with the International Organization of Securities Commissions ( IOSCO ) and foreign securities regulators, the Commission currently is part of a joint agreement with the CFTC and the U.K. Securities and Investment Board designed to coordinate our efforts in the area of derivatives regulation. More recently, the Commission and the SIB have engaged in the joint study and inspection of the operational controls of U.S. and U.K. firms engaged in significant cross-border derivatives activities. c. The Competitive Implications of Changing Markets It would be a mistake to assume, however, that such coordination and cooperation is driven only by the needs of regulators. Changes brought about by technology and the -------------------- BEGINNING OF PAGE #5 ------------------- globalization of the financial markets have implications on the competitiveness of markets. To a large extent, those of us in the United States have been the beneficiaries of a shrinking financial world. For example, because of the vast sources of domestic capital underlying the liquidity and strength of our markets, we have been very successful in attracting to our marketsboth foreign suppliers and foreign users of capital. Lest we become too comfortable, however, those of us in the U.S. should recognize that the technology that makes our capital markets so accessible to others also represents a two way street. While historically we have had the benefit of having large capital pools and very liquid markets here at home, it does not take too much imagination to envision a scenario where -- given the current state of technology -- it is just as easy for U.S. capital providers to move to direct off-shore investments in companies listed in foreign markets. Of course, this has implications on the availability of capital for U.S. firms and the liquidity and competitiveness, including the attractiveness for foreign listings, of our domestic markets. The current debate over the development of international accounting standards serves as a case in point. Our system of accounting and financial reporting is one of the engines that drives our capital markets. The integrity of the U.S. financial markets stemming in part from our accounting and financial disclosure system has been the envy of the world. Yet, the pressure to move beyond U.S. GAAP and develop a coordinated body of international accounting principles continues. The Commission clearly has been moving in this direction -- and it must continue to move in this direction at a faster pace. Through its involvement with the International Accounting Standards Committee and the IOSCO, some progress has been made and a number of international accounting standards have been promulgated. Unfortunately, the debate on international accounting standards too often focuses on whether the U.S. should lower its accounting standards or the international community should raise its standards. I believe this is a "red herring." Accounting standards differ for a variety of reasons. Sometimes there are cultural reasons (such as the extent to which investors in a jurisdiction are primarily sophisticated institutions or relatively unsophisticated individuals) or economically-based reasons (such as whether the various players in the capital markets are primarily creditors or interrelated parts of a closely-managed economy, or independent shareholders). The relevant question though is not whether particular accounting standards differ; rather it is whether they serve their purpose of fairly presenting a company's financial condition. With this in mind, I think we could and must do more in this area to foster and support the creation of a comprehensive body of international accounting standards that satisfy that requirement. 2. Change in Regulatory Approach I believe there must also be a dramatic change in regulatory approach. The pace of change and innovation requires an increased emphasis by regulators on macro or goal-oriented regulation -- as opposed to dictating substantive regulatory standards for specific problems. This necessitates a massive change in the way regulators think about regulating, and in the -------------------- BEGINNING OF PAGE #6 ------------------- way laws are written. Such a change is critically important, and very hard to do. Because it is so hard, there will be those who throw up their hands and suggest that there should be no regulation. I do not subscribe to that view. The question should always have been, and always be, how do we achieve better regulation, not whether we need more or less regulation. In order to realize this macro or goal-oriented approach, I suggest that those of us who are regulators will have to focus on a four part analysis in approaching regulatory issues: * First, we need to understand the root -- typically economic -- causes of a market or market participant s behavior. * We also need to understand and evaluate how that behavior affects other market participants. * We must anticipate whether a proposed course of regulation affects the underlying economics and motivations of market participants in the long-term, or simply addresses current symptoms of a problem. As regulators, we are prone to try to solve the current problem at hand, with sometimes not enough thought being given as to how our solutions affect longer-term behavior. * Finally, once the purpose of a regulation is clear, regulated persons should be permitted flexibility to allow their methods of complying with the regulation to evolve in accordance with changes in the markets -- in other words, the regulation should be as goal-oriented as possible, as opposed to dictating specific processes that must be followed. * Let me provide a simple illustration: Last October, the Commission published, for the first time, full interpretive guidance regarding the use of electronic communications to fulfill the delivery requirements of the federal securities laws -- an issue of importance to investors and other participants in the securities industry. Given the advantages afforded by electronic media, we determined that our goal should be to encourage electronic delivery of information, even to the point of preferring it over paper in the long-run. However, instead of taking a command and control approach to this issue and dictating specific formats that alone would suffice for electronic delivery of information along with a dozen conditions limiting electronic communications use, as had first been suggested, our interpretive release focuses on two goal- oriented issues: whether the electronic communication provides investors with notice of and access to information similar to that which would be received by traditional paper delivery. It is left to the market to create innovative ways to satisfy these two concepts. In this way, technological innovations in this area might best continue to flourish, instead of be constrained. The response has been overwhelmingly favorable, and the Commission will soon issue a follow-up release addressing the use of electronic delivery by broker-dealers, investment advisers and transfer agents. As mentioned, such an approach requires a wholesale change in the way regulatory agencies approach their mission, and in the way lawmakers write laws. It takes creativity, and a good deal more work then just writing command and control prescriptions. It also takes some faith. We have to be willing to believe that -------------------- BEGINNING OF PAGE #7 ------------------- the future holds worthwhile innovations as well as, yes, potential problems and issues. And we have to be willing to believe that allowing innovation without dictates from regulators as to what it must look like is ultimately better, not worse. 3. Does Sovereign-Based Regulation Work? Changes brought about by technology and increased globalization then are forcing greater international competition among markets and participants, greater international coordination and cooperation among regulators, and a reexamination of regulatory philosophy. These changes also raise -- in my mind at least -- the fascinating question as to whether traditional notions of regulation work at all. For example, the Commission has extensive and detailed regulations regarding the operation of securities exchanges. How then would the Commission regulate -- and should the Commission regulate -- the posting of quotations on the Internet by a foreign stock exchange, when those quotes inevitably become available to investors in the U.S.? And how long will it be after that before there is a simple mechanism for an Iowa resident to buy, for example, Frankfurt Stock Exchange listed stocks over the Internet? Obvious are the enforcement difficulties, and the policy issues arising from the operation of disparate regulatory regimes, if one were to determine that U.S. jurisdiction exists as a result of this conduct. Such an example clearly illustrates the need for greater coordination among international regulators. More importantly, It also underscores the need to determine how we should regulate in such a global system, because the usual method of regulation by geographic jurisdiction is about to disappear. Some have argued that, while enhanced international coordination is a step in the right direction, it is an interim step on the way to what is really needed -- a single international regulator for global financial markets. I doubt that this goal will be realized within any time frame relevant for those of us discussing it today. I would also argue that the existence of multiple regulators of international financial service organizations having different perspectives and regulatory philosophies is advantageous. It reduces the likelihood that innovation will be stifled by a single, stodgy regulator. Sometimes, regulatory arbitrage has its benefits. Suffice it to say, however, given today s current multi-regulator environment, enhanced international cooperation is highly desirable and possible, and we need to work more on international coordination then we are currently doing. 4. Enhancing the Knowledge of Financial Service Consumers Finally, the changes I discussed earlier will require that regulators take a more proactive role in educating consumers and investors and even themselves about financial products, services and investments. The goal is to educate consumers so that they are able to avoid fraudulent investments, and so that they are better able to make their own decisions regarding the types of products and services that best meet their particular needs. With respect to the former, I was shocked early on in my tenure as a Commissioner to see the amount of blatant fraud that occurs in the market. While the victims of financial fraud are often small investors, that is not always the case and frequently -------------------- BEGINNING OF PAGE #8 ------------------- the frauds are so egregious it makes you wonder about the level of sophistication among even supposedly sophisticated investors. As the world becomes more complex, and globalization becomes more obvious, scams that many would have dismissed as ridiculous seem to take on an air of respectability. For example, the Commission and other financial regulators have been active in prosecuting swindles involving so called "international prime bank" instruments. According to their purveyors, these instruments have no risk, are issued by the largest international banks and promise returns as high as 150% per year. Is there a better way of defining fraud ? Nevertheless, many investors, including sophisticated ones, are taken in by these scams. Since October of 1993, the Commission has instituted 10 administrative and 31 injunctive actions involving prime bank securities, involving at least $ 94 million of investments made by approximately 1,200 investors. In the absence of better education of consumers of financial products, instances of financial fraud will only become more frequent. Even in the absence of fraud, consumers of financial products and services would benefit from better education as to how to make appropriate decisions in an increasingly complex and fast moving world. And the Commission is doing its best to facilitate their understanding. Two areas for clarification quickly come to mind -- enhancing understanding of the differences between bank and non-bank products and services, and clarifying the relationship between risk and return. With respect to the former, many consumers apparently do not distinguish between traditional federally insured bank products and non-insured securities products. The NASD and others in the industry have been working to address this matter for some time. How to describe risk and return presents a fascinating issue. Everyone here knows that high risk investments demand higher expected returns, and that searching for higher returns entails incurring additional risk. Sounds relatively simple doesn t it? But how much risk for how much extra return? And what does risk really mean? And how best would you measure it? And, once measured, how best would you describe it, especially to individuals not expert in finance? When one considers the results of various studies, such as that conducted by Towers, Perrin last year -- which indicated that 39% of employees polled did not know how their 401(k) or savings plan dollars were invested, and that 50% of employees polled said that a guaranteed return on their investment was the most important factor in making retirement fund investment decisions -- you have to wonder whether all consumers have a solid grasp on the fundamentals.-[3]- Similarly, the general public often tends to view those things that are not well understood and that have risk -- such as derivatives -- as inherently bad, instead of what they are -- in this case, tools for managing risk. The danger here is readily apparent. Without a sufficient understanding of risk and return, investors may eschew risk that they ought to be willing to incur -- at least for long-term retirement fund investments. In that case, these investors will not have sufficient funds for their later years. That portends poorly for them as well as for our economy going forward. --------- FOOTNOTES --------- -[3]- See Recent Developments in Retirement Planning -- Workers Need More Retirement Planning Information, TAX MANAGEMENT FINANCIAL PLANNING JOURNAL 113-114 (May 16, 1995). -------------------- BEGINNING OF PAGE #9 ------------------- Similarly, an overreaction to complex and novel instruments such as derivatives caused by a lack of understanding of risk could lead to a stifling of innovation in these areas and the loss of their accompanying benefits. At the Commission we have begun to focus on these issues. This past January we published a proposal that would require registrants to provide better disclosure of market risk sensitive instruments generally -- not just derivatives.. The proposal would require disclosure of both qualitative and quantitative information on market risk, as well as disclosure of the assumptions underlying, and limitations associated with, such disclosure. The goal is to make investors aware of the impact of market risk more generally on the operations of SEC registered companies. We are also working on ways to communicate risk better to investors in mutual funds. Last March, we issued a concept release on this topic which generated about 3,700 comment letters. The staff has reviewed these letters and has come to a couple of preliminary conclusions. First, although it would be nice if we could, it appears the staff believes it is unlikely that we will be able to arrive at a standardized risk measure. That said, I believe we will propose a series of measures designed to improve disclosure of fund risk. In addition, we also are considering whether investors might be aided in understanding risk by something as simple as focusing more attention on the names that funds are permitted to use to ensure that they do not convey an inappropriate indication of fund risk. Finally, my personal view is that, ultimately, the Commission will follow in the footsteps of banking regulators and move more towards a risk-based capital standard with less reliance on haircuts and the net capital rule. Conclusion I recognize that I have touched on a number of issues -- some large and some small -- in a relatively short period of time. They all relate to how those of us who are regulators will do our jobs effectively in the face of rapid developments in the market for financial services caused by technology advancements and increasing globalization. The answers to the issues raised are not all as clear as we might like, and the views I have offered for your consideration are only my own. I would be interested in hearing your perspective on this issue. Of course, if you have other questions related to the agenda of the Commission, I would be happy to respond as best I can. Thank you for your attention.