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Speech by SEC Staff:
The New Financial Landscape: Lesson of the Financial Crisis1


Ethiopis Tafara

Director, Office of International Affairs
U.S. Securities and Exchange Commission

2009 ICGN Annual Conference: The Route Map to Reform and Recovery
Panel on the New Financial Landscape: What will be the phoenix to rise from the ashes?
Sydney, Australia
July 14, 2009

ABA Annual Meeting 2009, Banking Law Committee
Panel on "Recent Developments in Banking Law, including how the regulation and resolution of systematically [sic] important financial firms is changing and will that be a good thing for the industry, the country and the interconnected economies of the world?"
Chicago, Illinois
August 2, 2009

I would like to start by thanking [ICGN] [ABA] for the invitation to join this very eminent panel. The views I express today are of course strictly mine and do not necessarily reflect those of the Commission or its staff.

Today we are discussing the changing regulatory environment for financial firms, as a response to the financial crisis, with emphasis on systemically significant institutions. This crisis has brought the financial industry to the brink of collapse, and revealed serious shortcomings in the regulatory system governing it. Despite the severity of the crisis, however, the financial industry and the financial system as a whole are emerging from the downturn, albeit in a substantially reformed regulatory environment.

The new shape of the financial regulatory system will closely depend on what the financial crisis has revealed. It is said that this crisis is a once-in-a-century event. If viewed narrowly in terms of the proximate causes, this is true. But closer examination of the crisis reveals a fertile ground for additional crises, albeit with each crisis perhaps displaying unique features. So in devising reforms, we must not only address the most immediate causes of this crisis. We must also address the root causes that gave rise to this crisis.

In essence, the current crisis has at its origin the evolution of markets and financial services. Over the past 15 years, the world's financial system has undergone dramatic change to its structure and principal characteristics. The current turmoil, history will show, is the result of the system having failed to adapt to these fundamental changes.

The four characteristics of the modern financial market are:

  1. its global nature and the resulting mobility of capital;

  2. the significantly increased competition among financial service providers;

  3. the elimination of differences between historically separate financial products, sectors, and actors; and

  4. the development of a large and relatively liquid unregulated institutional financial market paralleling the regulated markets.

I would describe the connection of each of these factors to the current crisis, but in the interest of time I will cut to the chase and address the type of reform called for by this modern market.

First, of course, the new regulatory framework must address the issue of increased systemic risk, while not suppressing risk-taking per se. This is crucial if we are to address problems, yet not undermine economic innovation. To sustain the experimentation and innovation needed to drive modern growing economy, financial capital must afford to take risks.

As a corollary, we need a regulatory framework that provides prudential regulation for those financial intermediaries that are "too big to fail." Surely, the essence of our financial system is to let people take chances with their money — and to enjoy most of the benefits, and to endure most of the pain associated with taking risks. However, if we are in a world where financial entities are too big, too indebted or too interconnected to fail, we know that those entities will have an incentive to take on excessive risk at the ultimate expense of the public. From a policy perspective, we want to end up in a world where, in fact, we can afford to let financial entities fail if they make bad decisions.

Second, we need regulatory reform to address the misaligned incentives that lead to taking excessive risk. In a world where one can slice and dice risk any way that is desired by trading highly opaque, difficult-to-value instruments, it is challenging to monitor well the people hired to manage money and address agency costs. Part of the answer will lie in finding different compensation schemes. Part of the answer will also lie in fuller disclosure, so that investors in the market can tell what intermediaries are doing, and the source of returns. Part of the answer will lie in extending the regulatory framework to cover the various entities not currently regulated or supervised.

Third, we need a regulatory framework with better disclosure, so that lenders can better determine counterparty risk. Credit markets dried up when this crisis hit, because nobody was able to assess anyone else's exposure. A major step in this direction could be to introduce clearing houses and exchanges in, for example, derivative markets for standardized derivative products and impose basic disclosure requirements with respect to financial products that achieve a certain prevalence.

Fourth, the regulatory framework needs to account for the fungibility of financial products, actors and markets. Many products, actors and markets have the same underlying economic characteristics, motivations or clientele, yet are regulated based on connection to an institution that can be described as having either a securities, banking or insurance function. This leads to market participants searching for the path of least regulatory resistance and pursuing regulatory arbitrage. Although this is often in the interest of the regulated community, it is frequently to the detriment of consumers and investors. By the same token, we need to be vigilant not to pursue uniform regulation for the sake of ease given that there are instances where the fundamental differences in the nature of securities, banking and insurance — and hence their regulation — are legitimate and indeed important.

Fifth, the regulatory framework of the future must be responsive to the fact that capital and market participants are mobile, markets are interconnected, and technology makes this movement and connectedness irrepressible. Capital travels in search of investment opportunities, which means companies, intermediaries and markets can choose their preferred location. Preference is frequently a matter of regulatory comfort. As a consequence, we need to ensure that our regulation is optimal in providing the best protection for investors and at the same time comparable across developed markets. Otherwise, we will create opportunities for jurisdictional regulatory arbitrage in contrast to functional arbitrage.

Sixth, as we consider regulatory reform, we should not lose sight of the differences between market regulation and the supervision of institutions. Insurance, banking and securities regulators all historically have a common interest in maintaining the health and soundness of financial firms by, for example, requiring the firms to maintain capital reserves. And all functional regulators have an interest in enforcing the law.

But there also are differences. For example, the inherent tension between "consumer protection" and systemic stability often means that enforcement activities of insurance and banking regulators are negotiated and conducted more discretely. This happens because banking and insurance regulators are concerned that public enforcement activities will lead depositors or consumers to lose faith in the firm involved, possibly leading to a run on the bank or a dramatic reduction in the insurers' ability to distribute risk as consumers leave. By contrast, securities regulators tend to have aggressive and public enforcement programs — with punishment meted out in the public square, as it were. Indeed, securities regulators believe public enforcement actions are necessary to deter fraud and reassure investors in the integrity of the system.

In short, for bank supervisors, the key objective is to maintain the stability of and confidence in financial institutions. The top nightmare for a bank supervisor is a contagious liquidity crisis, where concerns about one bank lead to a run on the entire banking system. Insurance supervisors, for their part, emphasize consumer protection and the solvency of the insurers — which makes perfect sense, since the worst time to learn that an insurer does not intend to live up to its promises is when an insurance claim is made.

Securities regulators are focused on investor confidence. Trust is the lubrication that keeps the wheels of a capital market from grinding to a halt. It is the faith that a buyer is buying what he or she expects, and the faith that the seller will receive the payment promised at the time promised. And this faith has never been blind. Without this basic trust, no market in the world will succeed. In the diamond markets of New York and Amsterdam, trust is based on ethnicity, religion and the personal interaction of a handful of traders. The markets work because of reputation and the small community that makes up these markets.

With the anonymous trading that characterizes modern capital markets, this personal trust, perforce, has been replaced by a surrogate — clear, useful and timely information about the products bought and sold, rules on fair dealing between buyers and sellers, and vigorous enforcement by securities regulators with the powers and resources necessary to do the job.

Finally, the fear of regulatory arbitrage can be the cause of regulatory inaction. Being a first mover may place your market at a competitive disadvantage. Indeed, domestic regulation is undermined unless it is matched in the major markets around the world. To this end, we must revise the architecture of international financial regulation in order to develop a common approach to rules. This important task should be left to entities such as the Basel Committee on Banking Supervision, International Association of Insurance Supervisors, and the International Organization of Securities Commissions, subject to international political direction of the G20, but devoid of international political interference.

We need experts in regulation to devise common regulatory principles and standards. The mobility of the factors of securities trading — capital, issuers, trading platforms and intermediaries — means that regulatory differences can and will be arbitraged. Regulators and supervisors must come to agreement on broad parameters of action and coverage, while leaving room for unique implementation taking into account local circumstances. The interaction between service providers and investors and consumers in these markets should cover the sale to investors of all securities, banking and insurance products. This will ensure that fungible products are subject to common standards with regard to disclosure and conduct of business.

Let's hope that lessons learned from this crisis as well as an appreciation of the fundamentals of capital markets will help us redesign the financial system in a substantially more stable form.

Thank you for your attention.



Modified: 08/03/2009