Speech by SEC Commissioner:
Remarks Before the Global Financial Services Centres Conference
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
June 16, 2008
Thank you, Patrick Young, for the warm introduction. Céad mile Fáilte! I am pleased to take part in the Global Financial Services Centres Conference here in vibrant Dublin, Ireland. I am honored to join Charlie McCreevy to discuss ideas for developing a positive regulatory and financial governance environment for successful financial centers. The views I express here are my own and not necessarily those of the United States Securities and Exchange Commission or my fellow Commissioners.
First, I should wish all of you happy Bloomsday. Originally, in lieu of any speech, I thought that I would just do a reading of Ulysses, but that would take up much more than my allotted 20 minutes and you can probably hear a better version, with a native Irish lilt, on North Great George's Street. Also, I knew that I could not pull it off when my airline lost my bag from the States that has my vintage 1904 tailcoat in it. The bag should be here tomorrow, alas, too late for Bloomsday.
One hundred and fifty years ago today, a candidate for the US Senate, Abraham Lincoln, who went on to become president, famously said, "A house divided against itself cannot stand."1 Although he was speaking about the divide in the United States over the issue of slavery, that same observation can apply to us today in the global financial markets. The world's financial markets are more interconnected than ever before. If we, as regulators, are to foster the free flow of capital between the world financial centers, we must take steps to ensure that we reach mutual understanding of the basic tenets for regulating our markets, particularly under these difficult times.
I was here in Dublin about a year ago at Dublin Castle for the Finance Dublin conference speaking about the challenges and opportunities for the global financial services markets. My, how things have changed in a year! The global financial markets have experienced a bit of turmoil, to say the least. This is not just an American phenomenon, but it affects Ireland and the rest of Europe, as well.
Responding to the Current Economic Situation
The recent credit crisis has prompted calls in the United States and abroad for greater regulation and a new regulatory order. But regulation is only the solution where there has been a widespread failure of the market. We must not immediately jump to the conclusion that failures of firms in the marketplace or the unavailability of credit in the marketplace is caused by market failure or indeed regulatory failure. The reality is that companies will flourish and companies will fail, depending on business judgments and regardless of the regulations in place governing them. Regulators cannot, and indeed should not, interfere with the marketplace to guarantee success or ensure against failure. Instead, the role of regulators is to enforce contracts, protect property rights, and to strive for a transparent marketplace free of fraud.
In addressing the recent problems in the credit markets, regulators also must be cognizant of other, longer-term challenges that face our capital markets. The longer-term issues include concerns about whether our current regulatory framework is preventing U.S. capital markets from performing efficiently; whether we are spending our resources wisely to protect investors not from the vagaries and risks of the market, but from lying, cheating, and stealing; and whether we need to make changes to maintain the international competitiveness of our capital markets. Of course, a strong regulatory structure that is designed to ensure fairness, predictability, and efficiency is a crucial prerequisite for any healthy capital market. Investors need and demand effective recourse to the rule of law and enforceability of contract. They rely on a system of integrity.
If, however, we get the balance wrong, regulation can become part of the problem rather than part of the solution. Central to the issue of attractiveness of our markets is regulatory effectiveness and efficiency. Investors ultimately pay for regulation. If regulations impose costs without commensurate benefits, investors suffer the costs of lack of effectiveness and efficiency, not only through higher prices but also through constrained investment opportunities. That ultimately hurts them in their investment performance, because it means less opportunity for diversification.
Broader concerns about market competitiveness and regulatory efficiency also have been the subject of a long overdue examination of the regulatory structure in the United States by the Department of Treasury. In March, Treasury released its long-awaited Blueprint for a Modernized Regulatory Structure. Given the multiplicity of potentially affected parties, the debate about the proposals will no doubt be interesting — and lengthy. The Blueprint recommends short-, medium-, and long-term steps to address regulatory issues in the financial markets, including a long-term reordering of the regulatory structure in the United States. This would involve a shift to an objectives-based regulatory approach, in which regulatory authority would be allocated according to regulatory objective rather than industry segment.
The Blueprint identifies three broad categories of regulation: market stability regulation, prudential financial regulation, and business conduct regulation. Treasury envisions an optimal regulatory structure in which the Federal Reserve would be the market stability regulator. A newly created Prudential Financial Regulatory Agency would oversee capital adequacy, impose investment and activity limits, and supervise risk management at institutions that enjoy government guarantees. Finally, business conduct regulation, including most current SEC and Commodity Futures Trading Commission functions, would be carried out by a new Conduct of Business Regulatory Agency.
I look forward to the debate on the Treasury proposals. The Blueprint suggests a gradual approach to a new way of thinking about the US financial services regulatory system. The underlying premise is that regulators need to work better together, with the benefit of better disclosure, better financial reporting, and better information gathering to deal with potential systemic events.
Some see regulation differently. Some proponents of a change in our regulatory philosophy say that a greater role for regulators is needed. Somehow, they argue, regulators should be smarter than market participants and be able to prick bubbles before they grow too big.
This view means that regulators must be able to predict future market conditions. How can regulators, or any one else, have that ability? If we had that ability, we all would be wealthy and sipping a cold cocktail on a beach. Equally problematic is to expect regulators to be able to predict where problems will hit the financial system hardest.
It was about a decade ago, when the Dow Jones Industrial Average was around 6,000, that Fed Chairman Alan Greenspan famously spoke about "irrational exuberance" in the equities markets. It is very difficult for the Federal Reserve, our central bank, to prick an asset bubble in the equities markets. What should it have done? Raising interest rates probably would not have affected the market. At any rate, the market is now more than 12,000, after having gone through the bursting of the technology stock bubble in 1999-2000, with many people saying that the market is not now overvalued. Thus, just think about all of the foregone gains in the marketplace if the government would have guessed wrong? How can we assume that anyone can have that sort of knowledge?
Can regulators do the jobs of industry better than industry can? In his last book, The Fatal Conceit: The Errors of Socialism, Friedrich Hayek, the Austrian-born economist, wrote in 1988 about the dangers of a paternalist attitude toward regulating the economy.2 He labeled as the "fatal conceit" the idea that "man is able to shape the world around him according to his wishes."3 Hayek argued: "To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm."4
As Hayek teaches, at some point, we must recognize that businesses are better than governments at business. To suggest that regulators somehow know more than a company about its own business and the risks its faces is both egotistical and naïve. In addition, by removing any risk management from firms and placing it in the hands of government, there is a danger that firms will become careless and take on additional risk, believing regulators are protecting them. This is the moral hazard that we all try to avoid. Simply put, the risk management function must remain in the hands of the firms that face the risk. The shareholders ultimately must bear that risk and the results of the decisions — good and bad — that their employees (corporate management) make.
International Financial Reporting Standards
As we work through these and other issues, I am happy to say that we have seen greater efforts to achieving better cooperation between the United States and foreign nations. For example, in April 2007, the European Council and the United States signed the "Framework for Advancing Economic Integration between the United States of America and the European Union." The Framework created the Transatlantic Economic Council, which is co-chaired by a cabinet-level official of the United States and a member of the European Commission. I had the privilege of participating in the meeting of the Transatlantic Economic Council in May with Commissioner McCreevy.
One of the topics discussed at the Transatlantic Economic Council was for U.S. generally accepted accounting principles (US GAAP) and international financial reporting standards (IFRS) to be recognized in both jurisdictions without the need for reconciliation. Underscoring the need for this project is our common interest in creating high-quality internationally accepted accounting standards.
This project comes in response to a move by much of the rest of the world to shift to IFRS. Strong arguments were made for the elimination of the reconciliation requirement. An ever-growing number of issuers are using IFRS, and investors are becoming more comfortable with IFRS. For foreign issuers registered in the United States, reconciliation to US GAAP is an additional cost that is hard to justify. Indeed, last year, the U.S. Securities and Exchange Commission (SEC) held a public meeting, where a number of participants took the position that US GAAP reconciliations are of limited use to those who read financial statements and generally offer little new information.
As a result of these criticisms concerning reconciliations, the SEC in December 2007, adopted rule changes that allow foreign private issuers to file using IFRS, as promulgated by the International Accounting Standards Board (IASB), without reconciling to US GAAP. Had you told me five years ago that the SEC would take that step, I would have said that you were crazy.
These changes were effective immediately, starting with fiscal years that end on or after November 15, 2007. I hope that investors will benefit from the elimination of the costly reconciliation requirement and businesses will be able to refocus their resources on more productive measures.
Nonetheless, challenging work remains to make sure that the development of IFRS proceeds smoothly. The SEC is working with its fellow international securities regulators and accounting standard setting bodies to achieve the consistent application and interpretation of IFRS, since IFRS is still a work in progress and there are areas in which standards are needed. The U.S. Financial Accounting Standards Board (FASB) and the IASB have much still to do in converging US GAAP and IFRS, but both are committed to this work. The SEC and the European Commission and national regulators need to be involved in resolving the issues related to the funding and governance of the IASB, supporting the further development and consistent implementation of IFRS, encouraging education in IFRS, and working towards continued convergence.
The SEC is now considering whether to take the additional step of permitting U.S. companies to select between using US GAAP and IFRS. For example, multi-national American companies that access international capital markets and have foreign-based competitors may be better off reporting in IFRS. If the SEC were to proceed with allowing that option, then the choice between US GAAP and IFRS would, in essence, be left to the markets. If investors prefer one set of accounting standards over another, they may well reward with premium pricing those issuers that use the preferred set.
My understanding is that the European Union side is preparing its "equivalence mechanism" to permit acceptance of third country accounting standards. This year, US GAAP will be assessed under this mechanism. In January, the Committee of European Securities Regulators (CESR) held an open hearing on the equivalence of US GAAP to IFRS as part of the technical advice it is providing to the European Union on this issue. CESR also recommended finding equivalence. I hope that the European Parliament will take the final step soon.
My hope is that both the United States and Europe will continue to push for a seamless global capital market in which investors have access to the information that they need to make investment decisions and companies have access to the capital that enables them to innovate, produce, and serve their customers.
Steps Toward Mutual Recognition
The SEC also has taken strikes toward achieving mutual recognition of foreign securities regulatory regimes. Mutual recognition is a process by which the SEC would allow foreign exchanges or broker-dealers to participate more freely in U.S. markets, provided that they are subject to a satisfactory foreign regulatory regime. At the May meeting of the Transatlantic Economic Council meeting that I attended, we discussed the importance of proceeding toward achieving meaningful mutual recognition.
I have long been a proponent of more flexible treatment of foreign firms in the U.S. markets. Increased access by foreign and U.S. securities exchanges to each others' markets should produce great benefits. Investors will be the ultimate beneficiaries through lower costs and more choice, if restrictions are eased.
Last year, the SEC hosted a public meeting on this subject, focused primarily on the issue of whether to allow mutual recognition of foreign regulatory regimes that are substantially equivalent to the U.S. rules. However, we need to be very careful about proceeding in this manner.
Mutual recognition does not mean consolidation or reconciliation of the regulations of two jurisdictions. Mutual recognition must not be an attempt at harmonizing regulations from the U.S. and a foreign jurisdiction through a side-by-side, rule-by-rule comparison.
Such a bottom-up approach would result in a completely unworkable and potentially never-ending process. Would the slightest statutory, judicial, or regulatory change cast doubt upon another country's regime? How would those changes be monitored and addressed? Imagine the effort and personnel that would be needed to monitor and respond to regulatory changes in a dozen or more jurisdictions. Would the SEC find itself with effective veto power over other countries' regulations? It might be good material for an academic publication, but it would not work in the dynamic, resource-constricted real world.
A better framework would be a top-down approach, similar to one employed by other U.S. regulators, such as the U.S. Commodity Futures Trading Commission and the Federal Reserve. Under this approach, the SEC would first identify the important elements that a compatible regulatory jurisdiction should embody. This might include investor protection standards, such as protection against misappropriation of customer assets, fraudulent sales practices, financial responsibility of registered entities, and effective examination, licensing and qualification of brokers.
Instead of examining each rule of the foreign jurisdiction, we would generally assess the adequacy of that jurisdiction's oversight. If the foreign jurisdiction's regulatory regime is deemed adequate, a firm could be eligible for exemption.
In evaluating a foreign jurisdiction's regulatory oversight, we also must resist calls for the country to have the same agencies that we have in the U.S. After all, as we saw with the recent publication of the US Treasury Department's recommendations for change to American financial services regulation, our own system of regulatory oversight may see changes in the coming years. Therefore, a foreign jurisdiction need not mirror our own system. Here in Ireland, for example, you have a principles-based regulatory model that is based on strong consultation. That model has been seen to serve the country well during these challenging times.
The SEC's plans toward mutual recognition include long-overdue amendments to our Rule 15a-6, which governs the relationships of foreign broker-dealers with U.S. customers without registering as U.S. broker-dealers. The Final Communiqué from the May meeting of the Transatlantic Economic Council included the recommendation that Rule 15a-6 be amended so that "sophisticated investors" in the United States be allowed to deal directly with foreign broker-dealers and thereby trade foreign securities.
Along with these proposed reforms to Rule 15a-6, the SEC is in the process of working with Australia, Canada, and the European Union with respect to mutual recognition. We are conducting top-down comparability assessments of one another's regulatory regimes. I applaud the push to reduce or eliminate unnecessary barriers to each other's jurisdictions. A workable mutual recognition regime would go far within the context of the transatlantic framework towards fostering cooperation and reducing regulatory burdens. We should work diligently to craft a practicable top-down approach, and recognize that the alternative bottom-up approach will never work.
Predictably, some voices in Washington and elsewhere are claiming that the current situation stems from the folly of the supposedly deregulatory past few years and that yet more government regulation of risk-taking is needed. Any impartial observer would hardly call the last few years deregulatory. No matter how many regulations there are, they are no substitute for market participants' making sound decisions based on good information. No one can guarantee success in any investment. I have now done more than forty town hall meetings with investors of all types — military, retirees, students, investment clubs, and others. The one message that I stress the most is to try to understand your risk and diversify. That goes for everyone from the novice investor to the professional. Government can never substitute for these sound investment principles.
Friedrich Hayek stated that "'Emergencies' have always been the pretext on which the safeguards of individual liberty have been eroded."5 As regulators, let us ensure that the current economic situation is not used a pretext to misguided regulation. We must stand together as a united front and take balanced and thoughtful approaches to address the concerns we face.
Thank you very much for listening. I appreciate the opportunity to be here today.