U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks Before the SIFMA Compliance and Legal Conference


Commissioner Annette L. Nazareth

U.S. Securities and Exchange Commission

Phoenix, Arizona
March 26, 2007

Good morning. I'd first like to express what a pleasure it is to be here today at SIFMA's Compliance and Legal Conference — your first annual conference since the merger of the SIA and TBMA, and my first since becoming a Commissioner. This is truly like coming home (albeit to a rather large home with almost 2000 visiting cousins). I have grown up professionally alongside many of you, and I am honored that you have asked me to join you. I will focus today on a topic that has been highlighted recently in the discussions concerning U.S. competitiveness — that is, the notion that the SEC should move toward a more prudential approach to regulation. I will describe in detail what I mean by "prudential" regulation, where prudential regulation is already being applied by the Commission, and why I believe serious consideration should be given to finding opportunities to adopt such a model more broadly. But before I begin, I must remind you that my remarks represent my own views and not necessarily those of the Commission.1

We often hear the assertion that the SEC and other functional regulators should adopt a more principles-based regulatory approach as opposed to our current rules-based approach. I believe this is a false dichotomy. Good rules are derived from over-arching principles, but the specificity of the rules can provide useful guidance to the marketplace. The focus, it seems to me, should be on prudential regulation. Some use the term prudential regulation to mean less regulation or a laissez faire approach to oversight. That is not at all what I mean. Prudential regulation to me implies having a clear set of standards with a more flexible implementation approach for meeting those standards. It means permitting regulated entities to meet their obligations in a more customized, as opposed to "one-size-fits-all," manner. It means more efficient regulation, not less effective regulation.

Since the beginning of time (which in the SEC calendar means 1934), the SEC has operated as a rules-based regulator as opposed to a prudential regulator. Our generally prescriptive regulatory regime, backed by robust oversight and an aggressive "name and shame" enforcement program, has served our capital markets very well. And this was with good reason. The business models were simpler, the products offered were less esoteric, and everyone was above average (well, at least two out of the three). I thought it might be instructive to reflect on what the securities business was like just a few decades ago, and to consider the challenges of employing 1930s, or even 1960s, oversight techniques to many brokerage businesses today.

In the 1960s, virtually all broker-dealers were privately owned, and many were partnerships or mutual organizations. Brokers tended to be thinly capitalized and engaged in a narrow range of equity businesses, typically underwriting and customer facilitation. Since then, the growth in the size and complexity of our markets is also reflected in our securities firms. The largest of the firms are now shareholder-owned corporations with complicated corporate structures and brokerage subsidiaries engaged in multifaceted lines of business worldwide. To cite just one example, in its 2006 annual 10-K filing, Morgan Stanley reported for the first time a balance sheet in excess of a rather eye-popping figure of one trillion dollars. Other competitors are not far behind.

These numbers certainly evidence that these financial institutions have grown in size. But behind the numbers is an expansion into new and increasingly complex businesses that reflect, in part, market demand for an ever expanding array of financial services and products. Derivatives provide the most obvious example. Securitization structures, which finance assets, from mortgages to credit card receivables, also have become a substantial business for brokers. Over the years, broker-dealers have led the way in devising financial products and providing all the transactional pieces necessary to build complex financing packages, including underwriting of securities, derivatives, and hedging, origination of lending commitments, and advice.

But few of these new businesses are conducted in the traditional broker-dealer. The SEC's Net Capital and Customer Protection rules made it extremely costly, in capital terms, to conduct many of these activities in a broker-dealer. To avoid burdensome capital restrictions, firms established separate unregulated subsidiaries in which to do these transactions. Thus, as trading of over-the-counter derivatives, as well as securitization activities proliferated, organizational complexity increased as firms sought to avoid capital charges at the broker-dealer. This led to more intricate combinations of regulated and unregulated entities under a holding company structure.

Managing the risks posed by the rapid growth in both the amount and complexity of activity has proven a significant test for these firms which, fortunately, they seem to have generally passed quite well. And overseeing these activities has posed challenges for their regulators as well. We have had to reconsider our registered entity-based approach that was developed when broker-dealers had traditional structures and virtually all business was conducted in the regulated entity. It has become clear that to characterize certain subsidiaries within large financial conglomerates as "unregulated" and to focus our attention only on the "regulated" entities, would be foolhardy. The activities in the unregulated affiliates can easily eclipse those of the broker-dealer subsidiary, and threaten the economic viability of the entire organization, if not the broader financial system. Thus, the Commission has migrated to a more prudential approach to regulating certain brokers and their holding companies.

It is perhaps not widely understood that the history of this SEC journey toward prudential regulation actually goes back to 1990, with the failure of Drexel Burnham. This event served as a wake-up call that our focus on the capital and risk management practices of the broker-dealer entity, when such entity is housed within a complex financial conglomerate, was woefully inadequate. Drexel's broker-dealer remained in net capital compliance right up until its demise. However, the associated holding company, which was the broker's point of access to the public financial markets, lost the ability to raise capital in the public debt markets in the wake of the Milken and Boesky scandals. As a result, the holding company's ability to downstream funding to the broker-dealer was seriously curtailed and the broker-dealer essentially withered.

There were several key initiatives that resulted from the Drexel experience. The first was the Commission risk assessment rulemaking using authority granted by the Market Reform Act of 1990. For the first time we required larger broker-dealers to provide certain information about material affiliates. Two developments were even more significant in our march towards more prudential approaches. One was the formation of the Derivatives Policy Group, consisting of firms active in the OTC derivatives business. DPG firms agreed to voluntarily provide information to Commission staff about their activities. The other was the development by the SEC of a program for supervision of broker-dealers that register as OTC derivatives dealers (known as our "B-D Lite" program). These initiatives assisted the Commission in understanding how financial institutions with large broker-dealer subsidiaries manage risk globally at the group-wide level, and have, over time, allowed the Commission to develop a unique capacity to regulate securities firms.

In my view, the DPG initiative was an important development not only because it gave the Commission its first comprehensive look at the securities firms' off-balance sheet exposures, but also because it was one of the first instances in which we responded to a topical issue not merely by writing rules. Rather, we encouraged risk managers to craft reports customized to best reflect their own internal risk oversight that we could review and discuss. Other examples of reliance on closer cooperative efforts between the private sector and the regulatory community have followed over the years, including the work of the Counterparty Risk Management Policy Group after the failure of Long-term Capital Management in 1998. More recently, the "Group of Fourteen," the major dealers in credit derivatives, convened at the invitation of the Federal Reserve Bank, to develop voluntary goals for infrastructure improvement after problems emerged during 2005.

 The best example, to date, of our adoption of a prudential regulatory approach is our Consolidated Supervised Entity (CSE) Program. Under this prudential regime we supervise five of our largest investment bank holding companies. The Program is crafted to allow the Commission to monitor for, and act quickly in response to, financial or operational weaknesses in a supervised entity's holding company or unregulated affiliates — that may jeopardize bank and broker affiliates or the broader financial system. I believe the success the Commission has had to date in its oversight of CSEs presages the direction regulation needs to take in the future.

The aim of the Consolidated Supervised Entity Program is to supervise holding companies of well-capitalized broker-dealers in a manner broadly consistent with the Federal Reserve's bank holding company oversight. The Program operates along side, but not in lieu of, the Commission's compliance program for broker-dealers. The aim is to effectively monitor the holding company, and unregulated entities within the group, for financial and operational weaknesses that might place regulated entities or the broader financial system at risk. The Commission has authority under its CSE rules to take action in the event of a weakness or potential weakness.

In the broker-dealer within a CSE entity, the firm is permitted to use an alternative model-based capital regime, similar to that applicable to B-D lites. Not surprisingly, this regime is beneficial for those firms doing substantial business in over-the-counter derivatives, because it is built upon internal statistical models that capture risk on a portfolio basis. But other parts of our broker-dealer regulatory program, including all of our sales practice rules, remain in effect as for other brokerage firms as well.

Broadly speaking, under the CSE Program firms are required to document their systems of internal controls. The SEC does not mandate the particular controls through "cookie cutter" rules. Rather, we review the adequacy of the controls and then implementation. We also monitor the firms for financial and operational weaknesses, again taking into account the unique business of the firm. An important component of the CSE program is the regular interaction of Commission staff with senior managers in the firm's own control functions, including risk management, treasury, financial controllers, and the internal auditor, as well as examinations to test whether the firms are implementing robustly their documented controls.

A benefit to the Commission from this program has been the insights provided into the most important financial changes affecting the large securities firms. This program has informed us in real time about matters like subprime lending problems, energy trading operations, hedge fund derivative innovation and many other evolving areas.

Through consolidated supervision, I believe that we have rapidly and effectively implemented, in this one particular focused area, a new regulatory approach at the SEC. The question is whether and how we might take our experience with this approach and apply it more broadly throughout our regulatory program, particularly for those firms that would find it beneficial given their business models.

One area where we might make further progress relates to portfolio margining. Portfolio margining is a more risk-sensitive approach than the more traditional Regulation T and NYSE Rule 431 approaches to margining customer positions. Progress is currently underway to permit firms that demonstrate that they have adequate procedures to manage the credit risk associated with portfolio margining to use SRO models to calculate margin on a portfolio basis. Certainly, one might envision a day when firms that demonstrate that they have robust controls to manage market and credit risk, and who choose to do so, may be able to use their own proprietary models for portfolio margining.

But query whether the Commission may utilize a prudential approach, or some hybrid, in other areas of our regulatory regime? Clearly, prudential supervision works well in the risk management context. I would be much more cautious about extending it to, say, sales practices, where investor protection concerns may necessitate a more rules-based model. Nonetheless, the challenge, and indeed the opportunity, for us all is to consider how to adopt regulation that is more flexible, and I believe more responsive to changing market practices, while preserving strong investor protections.

The era of a one-size-fits-all regulatory regime is rapidly becoming outmoded. While prudential approaches can serve more complex business models well, smaller firms that continue to be focused on more traditional broker dealer businesses may find that rules-based regulation is more efficient and effective than creating unique proprietary models. And the capital cushions that are appropriate when such models are employed may not exist in all firms. Indeed, operating under a prudential regime would require heavy investment in internal controls and infrastructure that likely would be too burdensome for some firms. Even so, there surely is a place for more flexibility within a rules-based regime. Going forward, as we consider how all firms, large and small, expand their operations and modify their structures, we should look for opportunities for prudential supervisory principles in conjunction with a rules-based regime. And we at the SEC will also have to ensure that we can effectively implement such a program more broadly with appropriate levels of staffing and training.

Overall, one lesson is clear. In our current financial marketplace, a high degree of public and private sector cooperation must occur to meet the challenges of rapidly evolving financial markets, trading ever more complex products. As financial services firms continue to create new products and services, a more flexible regulatory regime crafted in response to today's business, and tomorrow's, will serve us well. It is incumbent on all of us to work together to craft a dynamic model that will serve the markets, and more importantly, investors, well in the future.

Thank you.



Modified: 03/27/2007