Speech by SEC Commissioner:
Remarks before the Transatlantic Corporate Governance Dialogue Conference on Corporate Governance Standards and Financial Stability
Commissioner Kathleen L. Casey
U.S. Securities and Exchange Commission
September 9, 2008
Thank you and good afternoon. I am honored to participate in this prestigious conference promoting trans-Atlantic dialogue on the issues of corporate governance and financial stability.
The Securities and Exchange Commission (SEC) greatly values the strong relationship it has with the European Commission, the Committee of European Securities Regulators, and member-state securities regulators in Europe.
This conference serves as an important venue to bring regulators and market participants together to discuss issues of mutual concern and interest.
The program appropriately focuses on some of the key questions and challenges that we have all faced over the course of the past year, as our markets have continued to suffer through one of the deepest and most extended market crises in recent times.
During this period, the SEC has been actively engaged in addressing issues arising from the market turmoil through its various supervisory, regulatory and enforcement functions.
The SEC also has been actively engaged in a number of important efforts to address the crisis through its participation in various coordinating bodies, such as the President’s Working Group (PWG), the Financial Stability Forum (FSF), the International Organization of Securities Commissions (IOSCO), the Senior Supervisors Group (SSG, comprised of regulators from France, Germany, Switzerland, the United Kingdom, and the United States), the Joint Forum, and the Basel Committee on Banking Supervision.
Today, I’d like to focus my remarks on some of these ongoing efforts, and on how issues of corporate governance can play a role in better achieving financial stability.
Before I continue, however, I must provide a standard disclaimer that the views I express here today are my own and do not necessarily reflect the views of the SEC or my fellow Commissioners.
It is axiomatic that our capital markets are highly dynamic. Indeed, whereas the value of global trade has tripled since 1990, the value of global investment flows has increased tenfold. And global capital flows have grown at an annual rate of 15 percent, three times the world economy’s nominal growth rate of about 5 percent.1
While this global expansion has benefited investors, consumers, and markets, bringing greater wealth and prosperity throughout the world, it also has made our markets more interdependent, and, consequently, more vulnerable to systemic risks that can threaten financial stability.
In keeping with the dynamic growth of global investment flows over the last two decades, it would be difficult to overstate the challenging nature of the market environment that we face today.
But with challenges come opportunities for constructive change.
And the current market turmoil has only drawn into sharper focus the importance and necessity of careful and deliberate responses that recognize our common interests in addressing the shared threats to global financial stability.
The nature of our response is crucial, however. For while we may share a goal of greater financial stability, we must also seek to ensure that we do not stifle the dynamism that drives our markets. Dynamic markets necessarily require important risk taking. It is this risk taking that fuels innovation, creates jobs, and fosters growth.
However, risk that is poorly gauged, priced, and accounted for can quickly contribute to systemic crises. For firms, this can mean death. For regulators and policymakers, it can mean significant harm to investors and our markets.
Our experience in the current market crisis is a clear testament to the consequence of such failure.
We saw a market environment characterized by rising housing prices, low interest rates, ample liquidity, fierce competition, and increasingly complex instruments lead to excessive risk taking throughout the marketplace.
Investors sought greater returns, but shirked important due diligence responsibilities, buying instruments whose complexities they often did not understand.
Credit rating agencies sought increased business opportunities and profits, but have themselves admitted that they failed to analyze and gauge credit risks adequately, for example, by moving into areas where historical data was limited, and did not reflect a full economic cycle.
Firms facilitated and fueled new investment opportunities in pursuit of fees and revenues, but ignored important risk-monitoring and risk-management functions.
And originators eagerly met demand for more volume with disregard for creditworthiness.
All along the chain, I would emphasize again, risk was passed on, but not appropriately gauged, priced, or accounted for. And that risk has now found its way home — but in a more systemic way than predicted or imagined.
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 PWG concluded that one of the primary causes of this turmoil was the 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 expected levels rippled 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 have been felt much more broadly. 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 affected 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.
As liquidity fell with respect to structured products, those firms needing to raise funds to meet margin calls and investor redemptions sold less-complex financial instruments such as equities. This, in turn, exerted downward pressure on prices in those markets.
Overall, these dynamics have significantly affected a wide array 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. The first of 2008 has scarcely been better, with a number of institutions reporting significant quarterly losses.
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 affected institutions.
Over the course of the past year, a tremendous amount of work has been done by various prominent organizations and coordinating bodies, such as the FSF, IOSCO, the SSG, and the Basel Committee, as well as private-sector groups such as the Counterparty Risk Management Policy Group (CRMPG), to examine and analyze the root causes, failures, weaknesses, and deficiencies that led to these market dynamics.
The SEC has actively participated in many of these efforts and continues to engage in some of the important work streams that have developed from their findings and recommendations.
Central to many of these findings was the focus on weaknesses and deficiencies in important governance mechanisms, such as effective risk-monitoring and management practices by financial firms, as well as the substantial role and failures of credit ratings and credit rating agencies in the securitization process.
We have learned once again that a strong corporate governance culture can play a key role in achieving necessary and beneficial risk taking while also minimizing potential detrimental effects to financial stability.
This was one of the central findings of the work of the SSG which undertook an assessment of risk-management practices among a sample of global financial services firms.
In March, the SSG, in which the SEC is also a participant, identified several corporate governance characteristics of firms that negotiated the recent market events better than their competitors.2
In general, the SSG found that the firms that most successfully navigated the financial turmoil during 2007 used information developed across their firms to adjust their business strategy and risk-management practices.
Specifically, four factors distinguished those firms that fared better than the rest:
- effective firm-wide risk identification and analysis;
- consistent application of independent and rigorous valuation practices across the firm;
- efficient management of capital, liquidity, and the balance sheet; and
- informative and responsive risk measurement and reporting.
Well-governed firms generally did a better job of sharing quantitative and qualitative information effectively across the organization, from the senior management team down through the control functions.
Perhaps as a consequence of creating an active cross-disciplinary oversight of risk factors, these firms were skeptical of rating agencies’ evaluations of complex structured financial products and relied instead on in-house expertise to execute rigorous internal valuation processes.
And unlike some competitors that were caught unprepared, they also were able to prevent the morphing of risk from forms that were readily measured and controlled into less easily governed forms, such as credit exposure to monoline insurers and liquidity risk from off-balance sheet vehicles.
The SSG's survey of how the private sector is responding to the financial turmoil is complemented by the work of the CRMPG, which recently issued a report on containing risk.3
The CRMPG report also highlighted that the culture of corporate governance at individual financial firms is highly determinative of how well a firm is prepared to respond to periods of instability and crisis.
Consistent with the SSG’s findings, the CRMPG report found that a comprehensive, firm-wide approach to risk management is vital, and that firms must undertake more critical and active qualitative risk analysis rather than relying solely on inherently backward-looking quantitative risk metrics.
Equally important was an effective risk-control function that requires an independent and strong voice within the firm in both the reporting as well as the decision-making context.
Like the work of the SSG and FSF, CRMPG’s report identified the role of incentives, such as those created by compensation structures, that can increase risk appetite and undermine risk controls if not properly managed.
The CRMPG and SSG reports suggested that more needs to be done to foster a healthy culture of corporate governance to ensure that incentives are properly aligned with risk taking and risk tolerance across corporate management.
One such mechanism to help align such risks is a rigorous valuation and marking process of instruments that accurately prices that risk for the firm.
While many of the reports’ findings identified the critical nature of effective governance functions, the CRMPG report draws a more fundamental conclusion that no single standard or common framework exists for achieving a strong governance culture.
This point also is important from a supervisory and regulatory perspective as we seek to address global threats to financial stability. Corporate governance systems vary greatly across the world, and they are often the product of distinct cultural and legal traditions that can result in highly divergent approaches.
In the United States, corporate governance is largely a matter of state substantive law, complemented by the federal securities laws which focus mainly on transparency and disclosure as primary tools for protecting investors and promoting fair and efficient markets.
The Commission’s executive compensation rules are one example of this approach.
The SEC also administers and enforces laws passed by Congress that reflect more targeted legislative responses to market scandals, abuses, or deficiencies, like the Sarbanes-Oxley Act or the more recently enacted Credit Rating Agency Reform Act.
The unique circumstances that have shaped regulation in the United States help to underscore that governance issues do not always lend themselves so easily to singular approaches or increased harmonization of standards.
Nonetheless, despite differences among jurisdictions, regulators and supervisors have engaged in greater consultation, collaboration, and cooperation in order to identify common principles that might achieve largely comparable approaches to shared threats to financial stability.
As a participating member in the FSF, the SEC, joining with other U.S. financial-market authorities, including the Treasury, the Federal Reserve Board, and the New York Fed, has sought to implement key recommendations that were made in the April 2008 Report on Enhancing Market and Institutional Resilience.
A key focus of the FSF’s recommendations, as well as the important work of the IOSCO Task Force on Credit Rating Agencies, was enhancing the accountability, transparency, and credibility of ratings and addressing the significant conflicts of interest that can act to compromise ratings’ integrity.
Since the passage of the Credit Rating Agency Reform Act of 2006, the SEC has actively used its new authority under the law to address the significant role credit rating agencies play in our market and to implement necessary reforms in response to specific problems and weaknesses exposed during the current market turmoil.
The Rating Agency Act ended a century of industry self-regulation by establishing a comprehensive supervisory program, including inspections and examinations, and eliminated the three decades-old opaque SEC staff system for selecting Nationally Recognized Statistical Rating Organizations (or NRSROs), replacing it with a transparent registration system that relies upon defined criteria for rating agencies seeking to be designated as NRSROs.
Importantly, Congress, rather than seeking to prescribe a particular governance structure for rating agencies to address issues of conflicts of interest or abusive practices, empowered the Commission with necessary oversight and authority to promote competition, transparency, independence, and accountability in the ratings industry.
It also relied heavily on promoting competition as a mechanism for achieving and ensuring greater integrity and credibility of ratings.
In August 2007, the SEC staff initiated examinations of the three major rating agencies and over the ten-month investigation uncovered significant deficiencies in the rating agencies’ policies, procedures, and practices.
The examinations found that:
- the rating agencies struggled significantly with the increase in the number and complexity of subprime RMBS and CDO deals since 2002;
- none of the rating agencies examined had specific, comprehensive written procedures for rating RMBS and CDOs;
- significant aspects of the rating process were not always disclosed or even documented by the firms; and
- conflicts of interest were not always managed appropriately.
Further, the processes for monitoring ratings were less robust than the processes used for initial ratings.
In June of this year, informed by and consistent with these findings, and the earlier findings and recommendations of IOSCO and the FSF, the SEC voted to issue proposals designed to address the role of rating agencies in the troubled structured finance sector and further the Rating Agency Act’s goals of enhancing transparency, competition, and accountability in the rating industry.
Importantly, these rulemakings embodied certain principles consistent with those statutory objectives, such as recognizing the inherent limitations of ratings and the obligations of other market participants, refraining from one-size-fits-all supervision or micromanaging the industry with largely symbolic gestures, and reducing undue reliance on NRSRO credit ratings.
Let me touch on some of the highlights of the SEC’s proposals in this area.
We proposed that an NRSRO could not rate a structured finance product unless the information provided to the NRSRO and used by the NRSRO in determining the initial and subsequent credit ratings was publicly disclosed.
This proposal is designed to create opportunities for unsolicited ratings and thereby allow competing rating agencies to gain market share by demonstrating superior credit analysis.
The SEC also proposed that NRSROs publicly disclose all rating actions.
The purpose of this disclosure is to provide users of credit ratings, investors, and other market participants the raw data with which to compare how the NRSROs initially rated a debt instrument and, subsequently, adjusted those ratings, including the timing of the adjustments.
This proposal would create opportunities for the marketplace to develop additional performance measurement statistics that would supplement those already required to be disclosed.
Firms issuing ratings with greater accuracy would be able to distinguish themselves based on such performance.
Similarly, the SEC proposed to require the disclosure of performance measurement statistics in a more granular way, thus enhancing comparability of ratings among NRSROs.
Specifically, the proposed amendments would require the disclosure of performance statistics, covering one-, three-, and ten-year periods, that are specific to each class of credit ratings for which the NRSRO is registered, and that are less susceptible to manipulation.
This is intended to enhance comparability of ratings accuracy on a class-by-class basis. And like the disclosure of historical rating actions, this proposal will help investors identify those rating agencies issuing the most credible and reliable ratings.
The SEC also proposed certain prohibitions on rating agency personnel to reduce conflicts of interest.
Under these proposals, rating agency personnel would be prohibited from determining or approving ratings if they were engaged in structuring or designing the product to be rated, participated in fee discussions, or received any gifts from the entity seeking a rating, unless the gifts are incidental to normal business meetings and are less than $25 in value.
The SEC further proposed that NRSROs differentiate the ratings they use on structured products, either through issuing a report disclosing how procedures, methodologies, and credit-risk characteristics for structured finance products differ from other debt securities, or using different symbols, such as attaching an identifier to the rating.
The proposal is designed to address concerns that certain investors assumed the risk characteristics for structured finance products, particularly highly rated instruments, were the same as for other types of similarly rated instruments.
It also is designed to address concerns that some investors failed to perform internal risk analysis on structured finance products before purchasing them.
The goals of the proposal, then, are to alert investors that there are different rating methodologies and risk characteristics associated with structured finance products and to encourage investors to perform more rigorous internal risk analysis on these products so that they do not overly rely on NRSRO ratings in making investment decisions.
Finally, the SEC proposed removing the regulatory requirements that have had the effect of elevating NRSRO ratings to a status that does not reflect the actual purpose and limitations of credit ratings.
This evolution in the use of, and reliance on, ratings has been recognized by numerous commentators and market participants, including the rating agencies themselves, who have sought to emphasize what a credit rating is intended, and not intended, to represent.
Although it is quite understandable why they were first incorporated in the Net Capital Rule applicable to U.S. broker-dealers and in subsequent rules here and elsewhere, over time it has become increasingly evident that there are disadvantages to the use of credit ratings for certain regulatory purposes.
The SEC’s references to NRSRO ratings were never intended, I am quite confident, to establish, enhance, and preserve a valuable franchise for the large rating agencies, while simultaneously inoculating them from market competition. Nor were these references intended to serve as a substitute for adequate due diligence by investors and other market participants.
Unfortunately, as recent events demonstrate, this appears to have become the case in far too many instances, reflecting a key governance failure on the part of many market participants.
The two public comment periods on these three proposals have only recently closed. I look forward to continuing my review of all the comments, and I expect the SEC to move to consider adopting releases on these proposals by the end of this year.
Before I leave you today, I would like to offer a few concluding thoughts.
First, as regulators and market participants, we must continue to work cooperatively together to address the many challenges that dynamic, global markets pose — and will continue to pose — to financial stability.
We should also be mindful of the “law of unintended consequences”: in markets of such complexity and interconnectedness, ill-conceived and considered responses can have adverse repercussions that can quickly ripple through our global marketplace.
And, finally, more basically, we also have to appreciate and understand our own limitations in perceiving and predicting the timing and causes of the next crisis to affect our markets. As Judge Richard Posner has cogently observed:
The subprime mortgage “crisis” follows a classic pattern that should help us to understand the inevitability of intelligence failures. . . . These failures typically are not due to lack of essential information or absence of warning signs or signals, but to lack of precise information concerning time and place, without which effective response is impossible except at prohibitive cost. Alarms over risky mortgage practices had been sounded for years, and ignored for years. Someone, whether a home buyer or an investment bank buying home mortgages, who had heeded the warnings when they were first made, or indeed until years later, would have left a good deal of money on the table.4
As the work of the many groups I have cited properly recognizes, the interdependence of our markets also creates collective action problems that make even the best-managed firms — with the best governance culture and risk-management practices — vulnerable to loss in investor confidence with resulting loss of liquidity triggered by the weaknesses or excesses of other market participants.
A strong corporate governance culture is a function both of firm-specific risk management and controls and of effective supervision.
As we continue to seek appropriate reforms to enhance financial stability, we must also remain humble and vigilant in recognizing and appreciating the limits of even the most rigorous supervision and best private-market practices. As the authors of the CRMPG report put it, “there is no substitute for sustained discipline in both public policy and private action.”
Thank you again for inviting me to speak to you this afternoon, and please accept my best wishes for a successful and productive conference.
1 Chris Edwards & Daniel J. Mitchell, Global Tax Revolution 16-17 (2008).
2 Senior Supervisors Group, Observations on Risk Management Practices
During the Recent Market Turbulence (Mar. 6, 2008), available at http://www.occ.treas.gov/ftp/release/2008-29a.pdf.
3 Counterparty Risk Management Policy Group, Containing Systemic Risk: The Road to Reform (Aug. 6, 2008), available at http://www.crmpolicygroup.org/docs/CRMPG-III.pdf.
4 Richard Posner, The Subprime Mortgage Mess, Becker-Posner Blog, Dec. 23, 2007, http://www.becker-posner-blog.com/archives/2007/12/the_subprime_mo.html.