Speech by SEC Commissioner:
Address to Institute of International Bankers
Commissioner Kathleen L. Casey
U.S. Securities and Exchange Commission
New York, NY
November 17, 2008
Thank you for that kind introduction. You have certainly brought together an impressive group of speakers today and I am honored to join you and be a part of such an important discussion on the global financial crises and the future of regulatory restructuring and reform. Before I begin, I must remind you that my remarks represent my own views, and not necessarily those of the Commission or my fellow Commissioners.
I was asked first to discuss some of the key actions the Securities and Exchange Commission has taken in response to current crises and then to share some of my thoughts about the future of reform of the U.S. financial regulatory system.
Without question, it would be difficult to overstate the challenging nature of the market and economic environment that we continue to face as regulators, policymakers, legislators and market participants. But, I believe that, through crisis, there exists, perhaps for the first time in almost twenty years, the real opportunity to make critically important, highly constructive changes to our financial regulatory system. As I will discuss a little later in my remarks on long-term reform, the shortcomings of our existing financial regulatory structure have been recognized for many years. Yet, crisis is often necessary to effectuate such fundamental and significant policy changes and I expect the SEC to be in the forefront of advocating change that is in the best interests of investors and our capital markets.
The SEC's mission of protecting investors, maintaining fair, orderly and efficient markets, and promoting capital formation remains more vital today than ever. Over the past year, the SEC has been actively engaged in using its supervisory, regulatory, and enforcement authority to fulfill this mission.
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, the Basel Committee on Banking Supervision, and the Joint Forum.
The growing interdependence and global nature of financial markets have reinforced the importance and necessity of greater collaboration and coordination among regulators in responding to market crises and threats to financial stability. This weekend's meeting of the G-20 is a testament to this new market paradigm, outlining as it did numerous areas where reform and better coordination are needed. The SEC has already been actively working to address many of these reform issues — both in cooperation with the PWG, as well as internationally through IOSCO and the FSF.
In the months following the precipitous fall of Bear Stearns, the Commission focused increasingly on the role and impact of potentially abusive naked short selling and other manipulative market practices in the securities of financial firms.
Amid growing concerns about significant downward pressures on financial institutions identified by the Federal Reserve as "systemically important" and eligible for access to the Fed's discount window, the SEC issued an emergency order aimed at preventing naked short selling in the securities of Fannie Mae, Freddie Mac, and certain primary dealers.
The order required anyone effecting short sales in these securities to arrange beforehand to borrow the securities and deliver them at settlement. The SEC took this action based on concerns that false rumors, combined with abusive naked short selling, were leading to a loss of confidence and an artificial decline in the price of these securities. Our concern was that, if such declines touched what the Fed had identified as systemically important financial institutions, then the stability of our markets could be threatened. During this time, the Commission was also contemplating what additional protections against abusive naked short selling could be quickly adopted for the broader market.
In the weeks following the expiration of the July order, concerns about diminishing market confidence continued and, indeed, grew more acute, culminating in the unprecedented events we witnessed in September, including the failures of Fannie, Freddie, AIG, and Lehman Brothers. Pursuant to its efforts to adopt market wide protections against naked short selling, the SEC took further action through another emergency order on September 17th. Three provisions were adopted, each of which remains in effect:
- First, the SEC adopted a requirement that short sellers and their broker-dealers deliver securities by close of business three days after the sale transaction date, or T+3.
- Second, the SEC adopted a rule eliminating the options market maker exception from the close-out requirement of Regulation SHO.
- Third, the SEC put in place a new antifraud rule, Rule 10b-21, which expressly targets fraudulent short selling transactions.
In addition to these three measures targeting "naked" short selling, the very next day, the SEC took even more extraordinary action and issued an emergency order prohibiting short selling in the securities of financial institutions whose health may have an impact on broader financial market stability. This action, as well as the Commission's other emergency actions, were taken in consultation with the Federal Reserve and the Treasury Department. In addition, the SEC also consulted and sought to coordinate with other securities regulators around the world. The short sale ban was also intended to be a temporary protective measure to give Congress and the Administration the requisite time to adopt and pass more comprehensive solutions to the financial crises and threats to market stability. The Commission therefore tied the expiration of the emergency order to the anticipated passage of the Emergency Economic Stabilization Act. When this legislation was passed and signed into law on October 3rd, the ban expired, as planned, three business days later.
I should pause to tell you that the effects of the ban, as well as the previous emergency orders, are still being formally studied by the SEC's economists. However, we know from talking to market participants that the short selling ban created significant disruptions and distortions in business activities across a wide spectrum of financial market participants.
Undertaking such precipitate action required the balancing of several important considerations and interests. And so, while extraordinary market conditions led us to impose the temporary ban, we sought to carefully balance concerns about potentially abusive short selling against the likelihood of increasing volatility, diminishing liquidity, and inhibiting efficient price discovery. In addition, the very nature of our emergency actions added a further element of uncertainty to an already volatile and fragile market environment. In some instances, such uncertainty may act to diminish the effectiveness of our actions and unduly contribute to market instability. We must therefore be as sensitive to the process by which we act as we are to the policy we seek to achieve. While extraordinary times can demand extraordinary measures, wherever possible we should seek to signal clearly and provide greater regulatory certainty to markets and investors.
I look to our economists to continue to draw lessons from the impact of the temporary ban so that, in the future, we are prepared to fine tune our responses in order to minimize potential collateral consequences.
In addition to emergency orders and rulemaking initiatives related to short selling, the SEC has continued its investigations into alleged market manipulation. On September 19, 2008, the SEC announced a sweeping expansion of investigative efforts across numerous firms. These ongoing efforts, which in many cases have been undertaken in conjunction with the SEC's regulatory partners at NYSE Regulation and the Financial Industry Regulatory Authority ("FINRA"), further illustrate the SEC's commitment to addressing the problems of potential market manipulation.
As with all our recent actions related to short selling, the Commission's goal has been to protect investors, identify and prevent manipulative behavior, and work to ensure orderly markets. We emphatically do not want to interfere with legitimate short selling. And we understand the important role short selling can play in promoting price discovery and mitigating market volatility.
Fair Value Clarification and Mark-to-Market Study
Beyond short selling, perhaps no other issue has dominated the Commission's time and attention in recent months as the issue of fair value or "mark-to-market" accounting. Accounting issues often find their way to center stage in severe market environments, and the current subprime turmoil and credit crisis is no exception.
Significant uncertainty and concern have been raised about the use and application of fair value in inactive markets and illiquid securities. Further, many have raised broader concerns about whether fair value has contributed to the current crises by requiring financial institutions to mark assets to firesale prices rather than management's estimate of "fundamental value" or "true value." Further concern has been expressed that requiring the reporting of such significant write-downs results in a downward spiral of further write-downs by other financial institutions across the market.
Proponents of fair value argue that it is the best, albeit an imperfect, measure of the value of securities — especially in a troubled market — and that any effort to suspend or repeal fair value in favor of some other historical cost-based approach would only result in a further lack of investor confidence. Investors have also continued to make clear that more, not less, disclosure and transparency is critical to regaining market trust.
Recognizing the need for clear and full disclosure to the markets, the Commission has sought to provide necessary guidance on fair value disclosure and implementation issues. With respect to questions and issues on disclosure, the Commission, through our Division of Corporation Finance, has issued several "Dear CFO" letters discussing disclosure issues that public companies might wish to consider in preparing their annual and quarterly reports. In mid-September, the Division issued a letter on fair value measurement disclosures that preparers should consider in their quarterly MD&A discussion. This letter built upon "Dear CFO" letters from December 2007 and March 2008 relating to fair value measurements under FAS 157 and off-balance sheet arrangements.
The Commission also has undertaken to actively address various fair value implementation and audit practice issues. In consultation with auditors and preparers, and working with standard setters at the FASB and IASB, the Commission has sought to provide needed clarity and guidance on the use of fair value measurements under FAS 157.
In late September, the SEC's Office of Chief Accountant, in coordination with the staff of FASB, jointly issued a release providing clarification on certain aspects of FAS 157. The goal of the guidance, in part, was to address certain questions cited by preparers as most urgent in the current market environment and thus to provide additional clarity to firms in valuing instruments in their portfolios. Issues addressed by the release include guidance on the proper use of management's internal assumptions to measure fair value when relevant market evidence does not exist; the appropriate use of "market" quotes; factors to be considered in determining whether an investment is other-than-temporarily impaired; and the impact of disorderly or distressed transactions or transactions in inactive markets on fair value determinations. The FASB Board supplemented this guidance expeditiously finalizing additional authoritative guidance relating to the application of FAS 157 in an inactive market.
Beyond these immediate regulatory measures, Congress has also directed the SEC to review and study the use and effects of fair value accounting standards. The Emergency Economic Stabilization Act of 2008 ("EESA") included among its provisions a requirement that the SEC conduct a study of mark-to-market accounting, in consultation with the Secretary of the Treasury and the Federal Reserve. Under the terms of the EESA, the mandated study focuses upon:
- The effects of mark-to-market accounting standards on a financial institution's balance sheet;
- The impacts of such accounting on bank failures in 2008;
- The impact of such standards on the quality of financial information available to investors;
- The process used by FASB in developing accounting standards;
- The advisability and feasibility of modifications to such standards; and
- Alternative accounting standards to those provided in FAS 157.
Immediately after the EESA was adopted, the SEC announced a series of public roundtables for investors, accountants, standard setters, financial institutions, and other interested parties to provide input into the fair value study.
I attended the first of these roundtables on October 29th, which was characterized by spirited and thoughtful discussion, and I intend to participate in a second one set for later this week on Friday, November 21st. Drawing from other comments we receive, as well as our own further review, the Commission intends to complete the study by the end of December in order to submit it to Congress by the beginning of 2009.
Money Market Funds
Another area where the SEC has both witnessed and sought to address some of the consequences of the recent market turmoil is in the money market fund space.
As you may know, the SEC oversees the statutory and regulatory provisions governing money market mutual funds, a sector that has grown since the early 1970s into a $3.3 trillion industry comprised of over 800 funds. Historically, money market funds have provided a stable source of liquidity for investors and the capital markets. In particular, they have been large participants in the market for commercial paper — agency and asset-backed. As a result of recent market disruptions in that market, liquidity all but evaporated in the critical commercial paper market.
Before September 2008, the industry only once witnessed an SEC-registered money market fund "breaking the buck." Recently, we have seen several series of a money market fund known as the Reserve Fund affected by write downs of holdings in distressed companies such as Lehman Brothers. In light of this issue, and larger concerns about the money market fund industry, the Commission has taken action in several regards, including issuing a temporary order permitting a series of the Reserve Fund to suspend the right of redemption.
Additionally, the SEC's Investment Management Division has worked with the Treasury to establish a $50 billion Temporary Guaranty Program to help money market funds that encounter a similar threat of "breaking the buck." I understand that there is almost universal participation by qualified money market funds in this temporary guaranty program.
Before and after the Reserve Fund incident, SEC staff has also provided guidance and relief to money market funds to allow affiliates to provide support for these funds through capital infusions or through the purchase of distressed securities, to relax shadow pricing requirements for certain instruments of short duration, and to foster participation in the Treasury Guaranty program. Each of these examples represents part of a larger effort to help "restart" the troubled credit markets where money market funds are such significant participants.
Credit Rating Agencies
Another key area of focus arising from the current crisis has been examining the role and failures of credit ratings and 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 has revived longstanding concerns that the extreme concentration of market power in this industry dominated by only three firms, controlling over 90% of revenues, has led to inferior ratings quality, oligopolistic pricing power, and a lack of accountability.
For nearly a century, rating agencies were self-regulated. That changed in 2006 with the passage of the Credit Rating Agency Reform Act ("Rating Agency Act"). The Rating Agency Act, whose primary purpose was to promote competition in the rating industry, established a transparent registration system and granted the Commission comprehensive supervisory 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.
Pursuant to the timetable established under the law, the SEC acted quickly to propose and adopt initial rules to establish a registration scheme for NRSROs, require important disclosures relating to their business operations and policies and procedures, and address conflicts of interest. Shortly afterward, in August 2007, the SEC staff initiated in-depth 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;
- conflicts of interest were not always managed appropriately; and
- processes for monitoring ratings were less robust than the processes used for initial ratings.
In June of this year, 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 market and further the Rating Agency Act's goals of enhancing transparency, competition, and accountability. The breadth of these comprehensive reforms were considered by the Commission in three separate proposed rulemakings.
As part of the first proposal, 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 intended to create opportunities for unsolicited ratings and thereby allow competing agencies to demonstrate superior credit analysis.
The SEC also proposed that NRSROs publicly disclose all rating actions in order 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. 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. The SEC also proposed certain prohibitions on rating agency analysts to reduce conflicts of interest.
Also in June, as part of the second rulemaking, the SEC 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. This proposal was designed to address concerns that some investors may not have performed sufficient internal risk analysis on structured finance products before purchasing them. The goal of the proposal therefore is to alert investors that there are different rating methodologies and risk characteristics associated with structured finance products and encourage them to perform greater due diligence.
Finally, in July, in its third rulemaking, the SEC proposed removing references to ratings found throughout SEC regulatory requirements and rules that have had the effect of elevating NRSRO ratings to a status that does not reflect the actual purpose and limitations of credit ratings. The SEC's references to NRSRO ratings were never intended to establish, enhance, and preserve a valuable franchise for the large rating agencies, while simultaneously inoculating them from market competition and discipline. Nor were these references intended to serve as a substitute for adequate due diligence by investors and other market participants. But these have been the effects.
We have been reviewing comments on these proposals and it is my expectation that we will be able to adopt final rules in this critically important area in the very near future.
What I have described should give you a broad sense of some of the actions the SEC has taken over the past year in response to the extended market turmoil. I also want to highlight some of our examination and enforcement actions, including the sweeping examinations and investigations by our Office of Compliance Inspections and Examinations and our Enforcement Division that have been undertaken to expose possible market manipulation activity, as well as preliminary settlements addressing fraudulent Auction Rate Securities disclosures and practices which saw thousands of investors trapped in the frozen auction rate securities market earlier this year.
Our Trading and Markets staff also continues to closely coordinate and cooperate with the Federal Reserve, as envisioned in the memorandum of understanding concluded this summer, as well as with other banking regulators in providing appropriate oversight of broker-dealers applying Appendix E to the net capital rule, which relies on a broad range of firms' internal risk management practices. The Broker-Dealer Risk Office, staffed with a multidisciplinary team of economists, financial engineers, attorneys, and accountants, continues to monitor financial risks, capital, models, leverage, liquidity, and related internal controls of these broker-dealers.
Rethinking the Regulatory Landscape
I hope that this summary conveys some sense of the range of engagement and action by the SEC during these extraordinarily challenging times. Every division has been engaged, across the spectrum of our mission and through the agency's various supervisory, regulatory and enforcement functions. I do not doubt that this has been the same experience for many other regulators and market participants as well. Throughout the crises, despite extraordinary pressure and intense scrutiny, the staff of the SEC has performed exceptionally well in serving market and investor interests. It would be an understatement to say how enormously impressed I am by their professionalism, expertise and dedication. And, I have no doubt that they will continue to bring these qualities and skills to bear as the Commission seeks to meet new challenges ahead, including the SEC's role in the broader debate on the future of financial regulation and the reforms to our regulatory structure.
As I mentioned earlier in my remarks, calls for fundamental, comprehensive reform of our financial regulatory structure are not new. For years, experts have recognized that the changing financial services landscape, including "globalization, consolidation within traditional sectors, conglomeration across sectors, and convergence of institutional roles and products" had resulted in greater complexity and sophistication in the industry and was "changing the kinds and extent of risks" faced by the market, including potentially increasing risk to the system as a whole.1
Further, several reports by the Government Accountability Office ("GAO") and others also highlighted that there existed no mechanism for monitoring cross market or cross industry risks and that existing information sharing was insufficient to identify and head off potential crises.2
In its most recent report on financial regulation, the GAO concluded that "[t]he development of large, complex, internationally active firms whose product offerings span the jurisdiction of several agencies creates the potential for inconsistent regulatory treatment of similar products, gaps in consumer and investor protection, or duplication among regulators" and that modernizing the financial regulatory system should be an imperative. 3
It is understandable that the structure of the current federal regulatory system, which has been characterized as having evolved largely a "result of periodic ad hoc responses to crises,"4 should have found itself challenged by recent events. We, like other regulatory bodies, have felt these strains acutely.
The statutory underpinnings of the SEC, first instituted in the 1930s and 1940s, could not have anticipated the array of instruments and entities that have developed over the past seventy years. Today, we have an opportunity to begin to address those issues and to better rationalize the system of regulation under which our markets operate. With the time we have left, I would like to share some brief thoughts on a few particulars and a few broad principles I think should inform regulatory reform as we go forward.
First, reform efforts must maintain a focus on investor interests. I believe that the work of the GAO,5 the Group of 306 and the Treasury Blueprint7 all provide excellent foundations for considering the various functions, policy choices, and trade-offs associated with different regulatory roles. Much of the focus of these reports is to address the weaknesses in the current structure for identifying, assessing and addressing broader systemic risks to the financial market as a whole. There is no question this is of the utmost importance. But, I share the view of Mary Schapiro, FINRA's Chief Executive Officer, who noted recently that "both the management of systemic risk and the protection of individual investors are important to the smooth operation of our financial markets. … [T]hey represent two sides of the same coin."8
This is critical to understand, because as Congress looks to reform, any effort to address broader systemic risk and management of that risk must appreciate the interests of investors as they are vital to the confidence that supports our markets.
A correlative to this, in any reform debate, is how the SEC's mission of protecting investors, ensuring fair and orderly markets, promoting competition, efficiency and capital formation fits in with a greater regulatory focus on addressing systemic risk and threats to financial stability. Each mission objective, importantly, informs and supports the other. Therefore, any reform that would divide these functions among different regulators would risk undermining the effectiveness of achieving each of these important goals.
If the mission of the SEC were to be narrowed to a singular function, such as solely a consumer or investor protection agency, it would lose the expertise it now has, it would become distant from the markets and its knowledge base, and it would have less of an understanding of the trends and risks in the markets that may pose threats to investor interests.
As a market regulator, the Commission's comparative advantage is a deep knowledge of the workings of the securities markets, and the institutions and individuals that participate in them. This expertise runs to an understanding of market mechanisms, institutional detail and the behavior of investors. To be fully effective, it must also include comprehensive market knowledge and the ability to oversee the risk management practices of those firms dealing with the investing public.
Second, reform efforts should seek to eliminate overlaps, gaps, and weaknesses and increase market transparency. While our regulatory scheme has remained largely static, marked by historical divisions between multiple regulators, at both the federal and state level, and characterized by overlapping jurisdictions on the one hand and overly narrow views of regulatory focus on the other, our markets have not stood still. Indeed, regulatory lines have been blurred as financial markets have globalized, converged and consolidated, placing greater need for firm-wide and market-wide risk perception, management and supervision. These trends have also blurred investors' appreciation and understanding of the role and responsibilities of various intermediaries.
Accordingly, as a key step, Congress should seek to merge or harmonize the regulatory oversight responsibilities of the SEC and CFTC in order to provide more comprehensive authority and real-time information to span markets that have become highly inter-related.9 The evolution and growth of financial products that are increasingly indistinguishable in economic function and purpose, yet continue to straddle and be hampered by statutory and regulatory definitions and boundaries serves neither the interest of investors nor the efficiency and competitiveness of our markets.
I have confidence that Congress will be able to value the efficiency and effectiveness of the principles-based approach to regulating the futures markets, while also recognizing the importance and focus of the securities laws on protecting investors.
To the degree reform efforts are focused on addressing concerns of financial stability or systemic risk, identifying where those risks lie or may lie in the future and what manner of threat they pose to the broader market is another important step to defining whether and how much additional regulation is needed.
As we saw with Bear Stearns and more recently with AIG, the potential exposure to broader markets caused by the unwinding of credit default swaps was the basis of systemic concern by the Federal Reserve and the Treasury, which motivated interventions. Where unregulated instruments, such as CDS, can have such an impact on financial stability or give rise to concerns of market manipulation by potentially driving the market in the underlying security, greater regulatory focus is required. There is no question that greater transparency would go far in helping mitigate these concerns.
While Congress considers the degree and appropriateness of new oversight authority over CDS and the OTC derivatives markets more generally, I am pleased that, this past Friday, the SEC, the CFTC, and the Federal Reserve made progress in this regard by signing a memorandum of understanding designed to facilitate the regulatory approval for potential central counterparty providers for credit default swaps as well as a framework for consultation and information sharing among regulators on CCPs.
In looking at reform from the investor's perspective, Congress should also consider how financial intermediaries such as broker-dealers, investment advisers and insurance agents are differentially regulated despite often providing similar products and services to investors. Investors should have more seamless and comprehensive disclosure and regulatory protections based on the nature of the products and services they seek.
Third, consistent with the recommendations of the PWG, FSF, and the most recent statement of the G-20, reform efforts should facilitate greater communication, coordination, and cooperation among regulators and supervisors. The SEC continues to work cooperatively through memoranda of understanding with the CFTC and the Fed, as well as internationally with other market regulators. Congress nevertheless should consider additional authority and flexibility to promote important information sharing in order to facilitate more effective regulation of our global markets.
While I am not endorsing a particular model and fully recognize the inherent complexity that remaking our regulatory scheme entails, I believe that the principles discussed today should help inform reform efforts. In sum, we should urge that any reform effort seek to enhance transparency and efficiency in the marketplace, rationalize the regulatory structure by eliminating overlaps, gaps and weaknesses, maintain a focus on investors, and ensure regulatory flexibility and cooperation. These are not new ideas, but their time has surely come.
Thank you for your kind attention this afternoon.