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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before Fintel's 2nd Annual Global Financial Services Centers Conference: "Reshaping the World's International Financial Services Centers"


Daniel M. Gallagher, Jr.

Co-Acting Director, Division of Trading and Markets
U.S. Securities and Exchange Commission

Dublin, Ireland
May 19, 2009


Thank you Patrick for the kind introduction. Before I begin, it is my obligation to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.1

As Patrick mentioned, I am currently the co-acting director of the SEC's Division of Trading and Markets. Before I begin my formal comments, I think I should explain the Division and how it operates within the SEC. Trading and Markets is responsible for the oversight of broker-dealers, stock and option exchanges, credit rating agencies, clearing agencies, and transfer agents. We are one of four main SEC Divisions, and we coordinate internally with the Division of Investment Management (advisors and mutual funds), the Division of Corporation Finance (issuer disclosure), and of course the Division of Enforcement, which is charged with enforcing compliance with the laws and rules applicable to each of the Divisions.

Today's theme asks us: how do we strengthen transatlantic and global dialogue between financial services centers to improve governance? No doubt, dialogue amongst the word's most important financial sector regulators is, and always has been, key to more effective supervision in all jurisdictions. In particular, an ongoing dialogue amongst regulators located in foreign jurisdictions helps us learn from each other's successes….and failures. It helps us to converge our regulatory standards to the highest levels and thus to protect more effectively investors and to work to maintain the integrity of our markets. Within the Division of Trading and Markets, the need for international cooperation and coordination was exemplified in the former consolidated supervised entity ("CSE") program, in which the SEC was the consolidated holding company supervisor of the five largest investment banks.

But international dialogue, although not new, has become an even more critical component of regulatory processes…indeed, I believe it is essential in order for us as regulators to do our jobs. This is particularly true as regulators seek to identify effective responses to restore investor confidence in global financial markets, to minimize systemic risk, and to seek to prevent future crises. From a Division of Trading and Markets perspective, I believe that it is important to continue to engage in this dialogue, particularly with regard to the CSE successor program, the Broker-Dealer Risk Office ("BDRO"). I will speak in more detail about both the CSE and BDRO programs, but first a bit of historical perspective.

This year marks an historic event for the Commission; the Commission is celebrating its 75th anniversary. As you already may be aware, the SEC emerged during the financial crisis of the Great Depression with the twin goals of protecting investors and restoring investor confidence. The SEC and the world find themselves faced again with a global financial crisis, albeit with a far different markets than existed in the 1930s.

Today our societies and our markets are truly globalized and interconnected. For example, the NYSE Group and Euronext combined to create NYSE Euronext. Shares of the NYSE Euronext are listed on the NYSE trading in U.S. dollars and on the Euronext Paris trading in Euros. The U.S. headquarters of NYSE Euronext are in New York, yet its international headquarters are in Paris and Amsterdam. The combined company operates at least seven exchanges in six countries. Other examples of our globalized markets include: (1) the transaction between Nasdaq and the Borse Dubai to acquire the Nordic and Baltic stock exchange operator OMX; and (2) the merger of the ISE and Deutsche Börse's Eurex, just to name a few. But cross-border mergers are just one aspect of the globalized capital markets; there are also associated risks. Indeed, the globalization of markets can facilitate the spread of risk, as we have experienced with the current global financial crisis.

The current crisis was caused, in my view, by both poor risk management practices and regulatory weaknesses. For example, I believe lenders' standards were inadequate and thus mortgages were given to persons who should not have qualified. The regulatory umbrella may not have been sufficiently broad, particularly with regard to unregulated over-the-counter derivatives, including credit default swaps. But activities that led to the current financial crisis also stemmed from the failings of some regulated entities, including broker-dealers, banks, insurance companies and credit rating agencies. As a result of all of this, many systemically important institutions around the world in the banking, insurance and securities markets either succumbed to bankruptcy or required unprecedented government intervention and support to continue business.

And so regulators face major challenges. How do we begin to fix the problem? Regulators need to consider and tailor their responses to the global crisis within the context of the unique characteristics of their domestic financial sector and their regulatory framework. But, as I mentioned earlier, dialogue amongst regulators will continue to play an important role in solving these problems. As we speak to one another about possible solutions, the overarching goal should remain the same: regulators need to take whatever steps are necessary to protect investors and the integrity of the financial markets. And the Securities and Exchange Commission is taking those steps.

The Commission participates in several international organizations to participate in global dialogue pertaining to the markets. The Commission is a member of International Organization of Securities Commissions ("IOSCO"). Commission staff are members of all of IOSCO's standing committees, and participate in all IOSCO task forces dedicated to specific issues pertaining to the financial markets. For example, as a result of the G-20 meeting in November of 2008, IOSCO established a Task Force on Unregulated Entities to develop recommended approaches to mitigate risks associates with the trading and lack of transparency involving hedge funds. This task force published a paper in March of this year with possible recommendations. And just a few weeks ago, IOSCO's Task Force on Unregulated Financial Markets and Products, of which the SEC was a leading member, published a consultative report for public comment. The Commission is also a member of the Financial Stability Board ("FSB")(formerly known as the Financial Stability Forum or FSF), the Joint Forum and participates on all Joint Form working groups, as well as coordinate with Treasury with respect to the G-20 and other international organizations and projects.

Now, a few more details about the CSE program, and the successor BDRO, as I believe that they exemplify the strengthened role that an international dialogue between financial services centers has played and will continue to play in order to improve the risk management practices at large regulated entities.

CSE Program

The CSE firms — Goldman, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Sterns — were active in regulated and unregulated, as well as domestic and international, markets. The CSE program was established in 2004 to allow each firm to qualify its broker-dealer subsidiary to use Value at Risk models to compute capital charges, while agreeing to group-wide supervision of the entire entity. An impetus for the creation of the program was the EU requirement that these firms satisfy the EU's Financial Conglomerates Directive, effectively requiring internationally active financial institutions that do business in Europe to be supervised on a consolidated basis beginning in 2005.2

The alternative method of computing deductions to net capital provided for by the CSE program permitted a broker-dealer for the first time to use mathematical models to calculate net capital requirements for market and derivatives-related credit risk. A broker-dealer using the alternative method of computing net capital was subject to enhanced net capital, early warning, recordkeeping, reporting and certain other requirements, and was required to implement and document an internal risk management system. As a condition to its use of the alternative method, a broker-dealer's ultimate holding company and affiliates (collectively the CSE) were required to consent to group-wide Commission supervision. This supervision would impose reporting (including reporting of a capital adequacy measurement consistent with the standards adopted by the Basel Committee on Banking Supervision), record-keeping, and notification requirements on the ultimate holding company. The ultimate holding company (other than an "ultimate holding company that has a principal regulator") and its affiliates also would be subject to examination by the Commission. Additionally, the CSE were required to regularly report on the financial and operational conditions of the holding companies, and make available to the Commission information about the holding company or any of its material affiliates that is necessary to evaluate financial and operations risks within the holding company and its material affiliates. If any CSE failed to maintain capital sufficient to meet the Basel well-capitalization standards, they were required to report that condition to the SEC, and the SEC would coordinate with the relevant foreign regulators — the UK Financial Services Authority in particular since these firms had large London operations.

Beginning in August 2007, the interbank lending markets (including markets for secured funding) were profoundly dislocated. Additionally, assets based on mortgages deteriorated due to weak or non-existent underwriting standards. This resulted in rising defaults, and ratings previously issued by credit rating agencies on mortgage-related structured products were found to be severely lacking. The following year, in 2008, the business and funding model utilized by the US investment banks, which relied on secured and unsecured lending from third parties, was arguably inadequate and made it difficult for these banks to survive in the new environment. Bear Stearns and Merrill Lynch merged with bank holding companies; Lehman Brothers filed for bankruptcy in mid September of that year; Goldman Sachs and Morgan Stanley converted to bank holding companies in recognition that the previous funding model was no longer viable without a lender of last resort, even with the new-found access to the Federal Reserve Discount Window. As a result, former SEC Chairman Cox issued a press release on September 26, 2008, which stated that "[t]he CSE program within the Division of Trading and Markets will now be ended."

International dialogue was a core component of the CSE program. The CSEs had international business that covered a range of activities and had footprints in various financial jurisdictions. Commission staff therefore worked on a day-to-day basis with the CSE firms as well as with other regulators around the globe. In addition, CSEs needed to calculate their capital at the holding company level in accordance with the Basel standard. The SEC established an important relationship with the Basel Committee, including sending a representative to the Policy Development Group (PDG). Commission staff also continues to participate in the Trading Book Group, a working groups that reports to the PDG. The Trading Book Group addresses issues relating to the application of Basel II standards and focuses on the appropriate capital treatment of event risk in the trading book The SEC was also a leading member of a joint Basel-IOSCO working group that led to the publication by the Basel Committee in July 2005 of a report on the Application of Basel II to Trading Activities and the Treatment of Double Default Effect.

BDRO Program

Although the CSE firms have either been acquired or become bank holding companies, this Commission is still charged with a responsibility to regulate broker-dealers and evaluate whether they maintain adequate capital…and to continue international dialogue. The successor program, developed from the lessons learned from the CSE program, is the BDRO. The BDRO conducts ongoing supervision of broker-dealers registered with the Commission that calculate net capital using the Value at Risk models I mentioned earlier, including certain broker-dealers who are conducting only over-the-counter derivatives business. BDRO also supervise holding companies that apply for consolidated supervision under section 17(i) of the Securities Exchange Act of 1934 — this is a very narrow program, however, as 17(i) only applies to firms that have no banking entities within the holding company. In order to be part of the BDRO program, a firm must apply and agree to make available to the Commission detailed information that encompasses controls relevant to the broker-dealer, but reside in the holding company; information about the ultimate holding company or any of its material affiliates that is necessary to evaluate financial and operational risks within the ultimate holding company and its affiliates, and of course capital adequacy measurements computed in accordance with Basel Standards. It is important to note that a firm subject to regulation under the BDRO program is also subject to the Commission's broker-dealer regulation, including, for example, the requirement that broker-dealers make and preserve accurate books and records.

The BDRO is tasked with providing prudential oversight of firms, but this does not displace the Commission's examination program, which is conducted by the Office of Compliance Inspections and Examinations, or the Enforcement program.

The BDRO operates much like that of the CSE program in that it is also prudential in nature and continues ongoing dialogue between the regulated entities and the Commission staff. Since the firms subject to the oversight of the BDRO have global operations, the international dialogue that grew under the CSE program continues and will increase in importance.


Substantial challenges remain for regulators of the financial sector, and enhanced global dialogue will play a key role in meeting those challenges. One of the biggest challenges includes the identification of firms whose failure would have profound global systemic implications. I believe regulators will need to ask ourselves hard questions as we address this and other problems. Regulators and politicians will need to consider the moral hazard risk of identifying such firms and the implied government backing that this might imply. Regulators will undoubtedly need to be a bit tougher and demanding in our expectations and requirements with regard to risk management at all financial firms, and all the while politicians will be looking to change current regulatory framework in an attempt to avoid another crisis similar to the one that we continue to experience.

In striving to develop the optimal regulatory solution there has been an ongoing debate over whether the optimum is a principles-based or rule based regime. As Hector Sants has noted recently, principles serve a useful purpose in explaining regulatory intent to regulated entities. However, principles are only effective on principled market participants, and because we all know that there will never be 100% compliance with even the clearest principles, there will always be a role for rules and strong enforcement. Right now, it seems to me that the debate about principles versus rule-based regulatory approaches would be better focused on the importance of creating globally regulatory structures that protect investors, maintain and enhance market integrity, and minimize the opportunities for the spread of systemic risk.

I believe that the SEC will continue to fulfill its mission to protect investors and the integrity of the financial markets and work with its international colleagues to ensure that we do not face a financial crisis of this magnitude again. Chairman Schapiro, as CEO of the Financial Industry Regulatory Organization, once noted that "[t]he pursuit of an efficient regulatory system that protects investors, markets and our economy while retaining the potential for competitiveness and innovation must be a matter of common purpose between the regulator and the regulated." And I would add that a "global dialogue" is a prerequisite to achieving that goal in a comprehensive fashion.

Thank you for the opportunity to present these ideas and to highlight the importance to continue transatlantic dialogue as we work together to stabilize the financial markets to better protect investors and restore investor confidence.



Modified: 11/18/2009