Speech by SEC Commissioner:
An Agenda for Europe and the United States
Commissioner Kathleen L. Casey
U.S. Securities and Exchange Commission
Sixth Annual Symposium on Building the Financial System of the 21st Century
Armonk, New York
April 3, 2008
Good evening. And thank you Pierre for that kind introduction. It is an honor to join you this evening as part of this prestigious symposium. The roster of panelists for the discussions tomorrow and Saturday is incredibly distinguished and the symposium topics are clearly timely and relevant. I look forward to hearing more about the discussions that will follow in the coming days. But before I go any further, I must provide the standard disclaimer that the views I express tonight are my own and do not necessarily reflect the views of the Securities and Exchange Commission or its staff.
It would be difficult to overstate the challenging nature of the market environment that we continue to face. But with all challenges, come new opportunities for constructive change. And in this spirit, I believe that the current market turmoil has drawn into sharp focus the importance and necessity of greater international regulatory cooperation and, increasingly, uniform approaches in addressing shared threats to global financial stability.
Unquestionably, there continues to be a growing recognition that our markets are increasingly global and that our regulatory approaches must adapt to such changes if they are to continue to be effective. The U.S. and European Union — through its formal financial services dialogue, to cite one example — have cooperatively led the way in forging key progress in this respect. And the SEC has clearly recognized, through its active engagement and leadership both bilaterally and multilaterally with regulatory counterparts, that in order to continue to achieve its mission of protecting investors, ensuring fair and orderly markets and promoting capital formation in a global marketplace, more cooperation and coordination with and reliance on international regulators will be necessary.
Tonight, I would like to highlight some of the Commission's ongoing efforts in the area of international accounting standards and the development of a mutual recognition framework, but first I think it is important to put in perspective the current market turmoil, recent events and ongoing regulatory efforts.
Over the past year, the rise in defaults on mortgage obligations by home purchasers with subprime credit has had a broad and significant impact. The primary cause of this trend appears to be a considerable decline in loan underwriting standards over the past several years, a period when interest rates fell, home prices rose, and many loans were originated by lenders who intended to sell these loans for securitization rather than hold them in their own portfolios. The sharp rise in defaults above previously expected levels propagated through the financial markets. Not surprisingly, a variety of securities that referenced pools of subprime mortgages were directly affected.
But, in a demonstration of the degree to which markets are linked, the effects were much more broadly visible. As defaults on subprime mortgages exceeded expectations, market participants began to question their ability to value a variety of related financial products. And as valuations came into doubt, liquidity fell sharply, further complicating the task of valuing particularly complex instruments. This impacted not only derivatives referencing mortgages, but also a variety of other complex financial products that involved the structuring of cash flows from assets other than mortgages into different tranches. As liquidity fell with respect to structured products, those needing to raise funds to meet margin calls and investor redemptions sold less complex financial instruments such as equities, placing downward pressure on prices in those markets.
Overall, these dynamics have significantly impacted a wide range of market participants, from individual investors to systemically important financial institutions. Last fall, a number of these large financial institutions reported significant losses linked to their holding of instruments related to subprime mortgages, with several reporting losses for the quarter and, in some cases, for the year. These losses were unexpected, in the sense that they far exceeded the institutions' own ex ante estimates of their exposures. In addition, there were in many cases delays in understanding and recognizing the losses even after they occurred because of weaknesses in the valuation processes at the impacted institutions.
Supervisors in the U.S. and Europe, led by the NY Federal Reserve and including the SEC, responded in part by constituting a "Senior Supervisors Group" that was charged with identifying the common themes across the institutions where unexpected losses and valuation issues arose. The group, in an important report issued last month, identified several areas where firms that navigated the recent market events successfully seemed to differ from other firms that were less successful. Characteristics associated with success included a strong risk management culture; involvement of and understanding by senior management of the firm's entire range of business activities; and a strong process to govern usage of the firm's balance sheet.
On March 13th, the President's Working Group on Financial Markets ("PWG") released its Policy Statement on Financial Market Developments providing insight into the causes of the recent turmoil, identifying deficiencies and weaknesses within the financial system and proposing recommendations intended to restore investor confidence, strengthen market discipline, enhance efficiency and risk management, and improve market stability. Key PWG policy recommendations included the need for stronger: transparency and disclosure; risk awareness; risk management; capital management; regulatory policies and market infrastructure. The PWG's efforts are also complemented by the work of the Financial Stability Forum on a global basis as it completes work on its report and recommendations on enhancing market and institutional resilience.
March also saw, however, the first stark example of the fragile and unstable nature of our market environment. In a nutshell, Bear Stearns, the fifth largest U.S. investment bank, experienced what amounted to a "run on the bank."
Despite being well-capitalized at both the broker-dealer and holding company level, the speed and unprecedented nature of the run on the bank sapped Bear of vital liquidity and left it on the verge of bankruptcy. Prior to Monday, March 10th, Bear Stearns' capital was well above required levels, and sufficient to meet the "well capitalized" standard for U.S. bank holding companies. The firm maintained a substantial liquidity "pool," ranging between $15 and $20 billion, to deal with any interruption in the firm's ability to access unsecured funding. Over the preceding weeks, SEC staff — both on-site and at headquarters — monitored closely the liquidity positions of all the Consolidated Supervised Entities (CSEs), and in the case of Bear Stearns, on a daily basis.
However, on Monday, confidence in Bear started to erode amid market rumors about liquidity problems. A manifestation of this severely diminished confidence in Bear's creditworthiness among counterparties, lenders and clients was the novation of large volumes of over-the-counter derivatives trades by counterparties to dealers other than Bear. This trend caused little or no direct liquidity drain that day, but signaled concern about Bear Stearns' creditworthiness to other market participants.
The decision by prime brokerage clients to move their cash balances elsewhere did impact liquidity, even if only temporarily. Generally, beginning on Monday, March 10, the decisions by some counterparties, clients and lenders to no longer transact with Bear Stearns through various channels appears to have influenced other counterparties, lenders and clients to take similar actions. Repeated assurances by Bear Stearns' senior management about the adequacy of its capital and liquidity were unsuccessful. Indeed, even assurances from other major dealers of their willingness to transact with Bear apparently failed to stem the flight of counterparties and clients.
While ceasing to transact in the face of a growing flurry of rumors may have been rational and, for those with fiduciary responsibilities to their own clients, prudent, the impact was ultimately devastating on Bear Stearns' ability to continue in business. At the start of business on Tuesday, March 11th, the holding company liquidity pool contained some $18 billion in cash equivalents. But by the end of the day on Thursday, March 13th, the end-of-day liquidity estimate was only $2 billion. The drain on the parent liquidity pool Thursday was due primarily to widespread refusal by Bear's counterparties to lend to Bear on a secured basis, for example, through repurchase agreements, first on non-Fed eligible collateral, and later on any eligible collateral, such as agency securities. Each of the CSEs has contingency plans in the event the firm cannot obtain unsecured funding for an extended period of time. However, and this is perhaps the critical point, these plans all operate on the assumption that secured funding of quality collateral remains. Bear's inability to borrow against even high-quality collateral on March 13th and March 14th — an unprecedented occurrence — has raised serious questions concerning the regulatory approach to the measurement of liquidity, not just in the U.S., but throughout the world.
It was in this connection that, on March 20th, SEC Chairman Christopher Cox sent a letter to Dr. Nout Wellink, the Chairman of the Basel Committee on Banking Supervision, expressing strong support for their planned updated guidance on liquidity management for banking organizations in light of the recent market turmoil. In addition to facilitating the acquisition of Bear Stearns by JP Morgan, the Federal Reserve also moved quickly to make additional secured funding available to securities firms through the so-called "Primary Dealer Credit Facility" or "PCDF."
In conjunction with this move, the Federal Reserve and SEC staffs are working closely together to monitor the availability of secured funding to other securities firms and their efforts to secure more term financing and further diversification of counterparties. The experience of Bear Stearns highlights important policy considerations regarding liquidity risk management, orderly resolution processes, leverage, as well as more fundamental regulatory structure changes. The work of the PWG, the FSF and Basel Committee, among others, will be instructive here.
Credit Rating Agencies
Another key area of focus arising from the subprime market turmoil has been the role of credit rating agencies, particularly with regard to structured finance ratings. The lack of market confidence resulting from the weakness and underperformance of many of these highly rated securities have revived longstanding concerns that the extreme concentration of market power in an industry dominated by only three firms controlling over 90% of revenues leads to inferior ratings quality, oligopolistic pricing power, and a lack of innovation.
For nearly a century, rating agencies were self-regulated. That changed in 2006 with the passage of the Credit Rating Agency Reform Act. The Act, whose primary purpose was to promote competition in the rating industry, established a transparent registration system in place of the opaque and anticompetitive SEC-staff designation system created in 1975. In addition, the Act granted the Commission authority to conduct a robust inspection and examination program to ensure that the rating agencies are complying with the federal securities laws and operating in a manner consistent with their disclosures.
Since last summer, SEC staff has been conducting a comprehensive review of the three dominant rating agencies. The Commission will receive preliminary reports from these examinations soon, with a final report expected by early summer.
The Commission intends to consider additional rules this year under the authority granted by the Credit Rating Agency Reform Act. In my view, our rulemaking effort should be guided by the following principles. First, we must be faithful to the spirit and letter of the Act, in particular its primary purpose of promoting competition in the rating industry. Second, we should reduce, to the greatest extent possible, any undue reliance on credit ratings. At a minimum, this means the Commission should carefully reevaluate all the references to NRSRO ratings in our rules. Third, we should not favor one business model — qualitative or quantitative, issuer-paid or subscriber-paid — over another. Fourth, we must be mindful that underwriters have due diligence obligations and institutional investors have fiduciary responsibilities. Rating agencies are not supposed to assume those obligations, nor are they equipped to handle such tasks. Finally, we should not attempt to micromanage the industry with symbolic gestures. Doing so would only add costs, offer at best negligible benefits, and likely have the unintended consequence of further enhancing the franchise of the entrenched incumbents.
The Commission's work in this area also involves close coordination and collaboration with the President's Working Group on Financial Markets, the International Organization of Securities Commissions, and the Financial Stability Forum. We are actively participating in all of these important and deliberative bodies.
Earlier this week, much fanfare accompanied the U.S. Treasury Department's release of its highly anticipated Blueprint for a Modernized Financial Regulatory Structure. The Blueprint is the culmination of Treasury's year-long review that began with Secretary Henry Paulson's U.S.Capital Markets Competitiveness Conference. Participants agreed that outdated and inefficient U.S. financial regulation was hampering the competitiveness of the financial services sector.
I think it is important to correct some apparent misconceptions about the Blueprint. To begin with, it was not intended to address recent market events such as the Bear situation. Nor was it intended to be a list of legislative proposals that could be quickly implemented by Congress. And it is neither a President's Working Group document, nor an SEC document. Instead, it is a product prepared exclusively by Treasury intended to provide policymakers with valuable perspectives on the current regulatory landscape should they consider a restructuring of the regulatory system to ensure that it keeps pace with the rapid changes in the markets brought on by globalization, technological advances, and financial innovation.
The Blueprint provides short-, medium-, and long-term recommendations for improving the U.S. regulatory framework. It follows a long history of previous Administration and congressional reports, GAO publications, and recent competitiveness studies such as the one issued by the Committee on Capital Markets Regulation, which is led by our host this evening, Harvard law professor Hal Scott. Most of the Blueprint's recommendations would require congressional action, so conventional wisdom suggests it is unlikely that many of them will be implemented this year. Even if true, that certainly does not diminish the value of the Blueprint. It is a thoughtful document that is sure to stimulate a robust debate over the next several years, and perhaps beyond, and it deserves serious consideration by policymakers.
Global Accounting Standards
Set against this extraordinary backdrop of events and activity, the Commission has also continued to make considerable progress in its ongoing effort to promote, and ultimately adopt, a single set of high-quality global accounting standards. Consistent with our 2005 roadmap, the Commission approved the elimination of the reconciliation requirement to U.S. GAAP for foreign private issuers that file in IFRS as issued by the International Accounting Standards Board (IASB).
Eliminating the reconciliation requirement was predicated on three key conditions. One, the Commission had to be satisfied that there was a robust process toward convergence. Two, we needed assurance that IFRS as published by the IASB was being consistently and faithfully applied. And three, we needed to have confidence in the IASB and its oversight by the IASC Foundation.
The SEC's consideration of IFRS continues to focus on whether U.S. issuers should similarly be able to choose between filing in IFRS or U.S. GAAP. We issued a concept release last August and held roundtables in December probing this question. The concept release, seeking information about the extent and nature of the public's interest in allowing U.S. issuers to prepare financial statements in accordance with IFRS as issued by the IASB, generated many thoughtful responses. The comment period closed in November and we have been carefully reviewing all of the comments submitted.
Although the roundtables offered differing perspectives on key particulars, including the desirability or necessity of threshold preconditions to allowing U.S companies to use IFRS, it was interesting to observe a high level of agreement, particularly given the diverse constituencies represented, on important fundamental issues. There was broad consensus that the ultimate goal should be a single set of high-quality, globally accepted accounting standards. There was also a general belief that the uniform global standard will ultimately be IFRS, not U.S. GAAP. And, panelists suggested that a roadmap should be established to transition U.S issuers to IFRS.
Although there are significant challenges ahead that will require strong leadership from all stakeholders, the roundtables offered encouraging news with respect to the level of agreement concerning some threshold issues and anticipated the Commission moving forward in the months ahead to layout the next leg in the road map toward global accounting standards.
Finally, tonight, I would like to touch on another of the Commission's top priorities, an issue that in my view is even more important to address in light of recent market events. Over the course of the past year, the Commission and its staff have been actively exploring the development of a collaborative process to recognize regulatory regimes administered by securities regulators that share similar regulatory philosophies rooted in strong investor protections and underpinned by robust oversight and enforcement.
Global markets require more cooperative regulatory frameworks among like-minded national regulators. Indeed, we must increasingly rely on each other to effectively address market problems, and continue to meet our shared objectives of promoting strong investor protection and market efficiency.
On February 1st, Chairman Cox and the European Commissioner for the Internal Market and Services Charlie McCreevy met in Washington, D.C. Their wide-ranging discussion included an agreement that the goals of a mutual recognition arrangement would be to increase transatlantic market efficiency and liquidity while enhancing investor protection. As a first step, SEC and European Commission staff, assisted by the Committee of European Securities Regulators, would need to develop a framework for mutual recognition discussions.
Chairman Cox and Commissioner McCreevy, noting the compelling need for a cooperative approach given that the U.S. and E.U. comprise 70 percent of the world's capital markets, jointly tasked their respective staffs to intensify work on a possible framework for EU-US mutual recognition for securities in 2008.
Further, in a "next steps" press release in March, the Commission announced that it would explore a limited agreement with one or more foreign regulatory counterparts that could provide the basis for the development of a more general approach to mutual recognition through rulemaking. And less than a week ago, Chairman Cox and Australian Prime Minister Kevin Rudd announced that the SEC, the Australian Securities and Investment Commission (ASIC), and the Australian Treasury Department have begun formal discussions to develop a mutual recognition arrangement for the two nations' securities markets.
Specifically, the SEC and ASIC agreed to undertake a formal assessment of each other's regulatory systems to determine the extent to which each jurisdiction produces a comparable level of investor protection. The results of the comparability assessment would be published for public comment before being made final. Once it is completed, the comparability assessment would provide the basis for further discussions between the SEC and ASIC regarding a formal mutual recognition arrangement.
As you can see, the U.S.-Australia agreement is a promising development in the establishment of a mutual recognition framework by the Commission.
Over the course of the past several years and in response to market events we are facing today, we continue to see the evolution of a new paradigm in regulatory approaches and responses reflecting the global nature of our marketplace. We see efforts to identify common principles and objectives of regulation through either international standards, where they lend themselves to harmonization or convergence; or use of best practices, where market-based approaches offer effective solutions; or cooperative frameworks facilitating greater regulatory reliance.
The SEC values the longstanding and strong relationship it has with its European counterparts, the European Commission and through organizations such as CESR. Maintaining vibrant, resilient and competitive markets is a shared goal and I look forward to continuing our work together in the years ahead to make even greater progress in pursuit of this common purpose. Once again, I want to thank Professor Scott for providing this opportunity to be with you this evening and I sincerely wish that all of you have a successful and productive symposium.