Speech by SEC Commissioner:
Remarks at Midwest SIFMA & St. Louis Regional Chamber and Growth Association Luncheon
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
St. Louis, Missouri
March 24, 2010
Thank you for that warm welcome. Before I begin, I must tell you that the views I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
I am delighted to be back in St. Louis to join you at this afternoon's event co-sponsored by Midwest SIFMA and the St. Louis Regional Chamber and Growth Association. Since leaving St. Louis in the summer of 2008 to assume my current responsibilities at the Commission, a lot has happened. We have no less than persevered through a period of financial and economic strain unlike anything since the Great Depression. I look forward to hearing your thoughts and perspectives on the crisis and what we, as lawmakers, should be doing as we reconsider our financial regulatory regime. But first, I would like to share a few thoughts.
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The starting point for my remarks today is this: The financial crisis has evoked a historic expansion of the government's role in the economy, with the government intervening in unprecedented and sometimes unpredictable ways. As proposals for sweeping regulatory change continue to be advanced, the extent to which government regulation may increasingly displace and distort private sector decision making in our financial markets is disquieting. This concern is not academic, but has real-life dimensions to it.
There is a fundamental role for government in overseeing our financial markets and our economy more generally, and we need a regulatory framework that is current and fits our increasingly vast and complex financial system. The government, including the SEC, must be adaptive and nimble, which requires having the human and technological resources needed to help anticipate systemic breakdowns before they occur. We have to learn from our mistakes and take appropriate steps to ensure that we have a state-of-the-art regulatory regime that allows us to respond to new challenges. Without question, change is warranted. Indeed, as I see it, there is widespread support for regulatory reform in principle. The difficulty arises when we move beyond concepts and attempt to fashion concrete features of the reform agenda in detail.
The real-life benefits of averting a future financial crisis and the misfortune and hardship that such a crisis would spawn are clear. Less self-evident are the real-life costs if the regulatory response to the recent crisis goes too far, unnecessarily burdening and hampering the financial system. In short, even as we welcome the prospect of securing the financial system, we need to mind the risk that, if the government unduly restricts the scope and activities of certain banks, hedge funds and other private pools of capital, and other financial firms, financing may be more costly for companies and individual borrowers to come by; businesses and investors may have a more difficult time managing their risks; investors may miss out on valuable investment opportunities; and innovation and competition in the financial sector may be dampened. The constraints of a rigid regulatory regime may not permit financial firms the business flexibility they need to provide the full range of products and services companies, individuals, and investors desire or to adapt effectively to ongoing market developments and competitive pressures. New regulatory strictures that, notwithstanding the best of intentions to avoid these costs, end up burdening the financial system in this way can ultimately impede economic growth at the expense of our long-term standard of living.
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With this backdrop in mind, I want to spend the balance of my time this afternoon addressing a topic that has been a particular focus of debate: the regulation of systemic risk. Much could be said. In the interest of time, I will hone in on one aspect of the larger discussion — namely, the prospect of a new council of regulators charged with guarding against systemic risk.
The regulatory overhaul that the Obama Administration proposed last year, the bill the House passed in 2009, the initial version of the bill that Senator Dodd forwarded, and the more recent version of the Dodd bill released earlier this month all contemplate some sort of systemic risk council comprised of other leading financial regulators, including the SEC. The shared goal is to ensure that risks that could jeopardize the financial system are identified early on and to provide for a more robust institutional framework, in the form of a new regulator that, in addition to monitoring systemic risk, would be charged with advancing regulatory changes to protect the system against identified threats.
Allow me to flesh this out some by briefly highlighting select aspects of the four formulations of the potential new regulator I referenced, beginning with the Obama Administration's initiative.1 The Administration proposed a "Financial Services Oversight Council" to "identify emerging risks" and "potential regulatory gaps" in the oversight of systemic risk.2 The Oversight Council, chaired by the Secretary of the Treasury, would "facilitate information sharing and coordination among the principal federal financial regulatory agencies regarding policy development, rulemakings, examinations, reporting requirements, and enforcement actions"; "provide a forum for discussion of cross-cutting issues among" financial regulators; and report to Congress on systemic threats and potential regulatory steps that might be justified to fend off possible dangers that appear.3 Relatedly, the Council would be empowered to collect information from financial firms and would be charged with referring "emerging risks" to other financial regulators with the authority to take action4 and with "advis[ing] the Federal Reserve on the identification of firms whose failure could pose a threat to financial stability due to their combination of size, leverage, and interconnectedness."5
Next is the House bill,6 which, in establishing a body by the same name — the "Financial Services Oversight Council" — builds on the Obama Administration's proposed framework for a new systemic risk council to complement the Fed and other government authorities. The House version of the Council also would be chaired by the Treasury Secretary and would include, among others, the Chairman of the SEC as a voting member. The Federal Reserve would serve as the Oversight Council's "agent."7 In addition to other duties, the new regulator would be responsible for spotting and monitoring "potential threats"; preparing strategies in anticipation of "potential threats"; "subject[ing] financial companies and financial activities to stricter prudential standards in order to promote financial stability and mitigate systemic risk"; recommending to federal agencies that are members of the Council options for tightening their own prudential oversight of financial firms; and serving as a forum for financial regulators to resolve their own jurisdictional disagreements.8
Notably, the council of regulators would have wide discretion to initiate more restrictive prudential regulation of a financial company if the Council determines that either the "material financial distress at the company" or the "nature, scope, size, scale, concentration, and interconnectedness, or mix of the company's activities," "could pose a threat to financial stability or the economy."9 The Oversight Council would base its assessment on a host of criteria, such as a company's leverage; off-balance sheet exposures; interconnectedness with other firms; importance as a source of credit in the economy; nature, scope, and mix of activities; or any other factors the Council "deems appropriate."10 The more restrictive oversight would include, among other things, tightened capital, leverage, liquidity, concentration, and "overall risk management" requirements for a firm deemed to be systemically important.11 If a financial firm is found to pose a "grave threat" (as opposed to a "threat") to the financial system, the bill affords the systemic risk regulator additional authority to regulate a firm's conduct, including restricting or even terminating certain activities of the firm; limiting the firm's ability to enter into a business combination with another company; restricting the firm's ability to offer certain products; and requiring the firm to divest itself of certain assets or businesses.12
The initial Dodd bill, put forth in late 2009, provided for a new "Agency for Financial Stability" headed by an independent chairperson appointed by the President by and with the advice and consent of the Senate.13 The SEC, along with other financial regulators, would comprise the Agency's membership. The Agency's purposes would be to "identify risks" to the financial system that "could arise from the material financial distress or failure of large or complex financial companies"; "promote market discipline by eliminating" market participants' expectations that the government will support such companies as being "too big to fail"; and "respond to emerging risks in financial activities and products that could destabilize" financial markets.14 To enable the Agency to fulfill its purposes, the bill would empower the regulator, among other things, to subject significant financial firms to heightened regulation.
For example, if, based on a number of criteria — including an evaluation of a financial company's assets, liabilities, off-balance sheet exposures, transactions and relationships with other major financial firms, and importance as a source of credit in the economy, along with any other criteria the Agency "deems appropriate" — the Agency finds that the "material financial distress" of the company "would pose a threat to . . . financial stability or the . . . economy during times of economic stress," the Agency would designate the company for "enhanced supervision and prudential standards."15 Such enhanced regulatory oversight would include, among other things, more stringent capital, leverage, liquidity, concentration, and "overall risk management" requirements.16 Further, the Agency may obligate a financial firm to dispose of certain assets or restrict or terminate certain of its activities if the Agency determines that the size or activities of the firm threaten the firm's "safety and soundness" or the financial system's stability.17
All of this resonates with similar provisions in the House bill. As do other Agency duties the initial Dodd bill contemplates, such as facilitating cooperation among financial regulators and recommending how other regulators could better discharge their own regulatory duties; identifying gaps in the regulatory scheme; providing a forum for financial regulators to resolve their jurisdictional differences; and reporting regularly to Congress on potential systemic risks, including recommending options for ensuring the competitiveness and soundness of financial markets, promoting market discipline, and maintaining investor confidence.18
The more recent version of the Dodd bill contains some differences. A new "Financial Stability Oversight Council," chaired by the Treasury Secretary and comprised of leading financial regulators, such as the SEC, would be charged with monitoring and overseeing systemic risk.19 The Oversight Council would have wide discretion to find that a non-bank financial firm should be subject to more demanding oversight; but the Council's determination would require a supermajority vote — two-thirds to be precise — of the Council's members, plus the approving vote of the chairperson.20 Upon such a determination by the Council, a non-bank firm would be subject to Fed oversight. The Oversight Council would offer the Fed recommendations for overseeing systemically-significant non-banks, along with recommendations for how best to monitor certain "large, interconnected bank holding companies," that are more stringent than prudential requirements that non-systemically-significant financial firms are subject to.21 For example, the heightened oversight would include, among other strictures, more restrictive capital, leverage, liquidity, concentration, disclosure, and "overall risk management" mandates as determined by the Fed.22
The Dodd bill also provides a framework for the Council to make recommendations to a firm's primary financial regulator for subjecting the firm to heightened standards if the Council determines that some "activity or practice [of the firm] could create or increase the risk of significant liquidity, credit, or other problems spreading" throughout the financial system.23
Finally, the current Dodd bill, like the House bill, distinguishes between "threats" and "grave threats," with financial firms that pose a "grave threat" to the financial system's stability subject to even more stringent regulatory oversight.24 If the Fed determines that a bank holding company with $50 billion or more in assets or a non-bank financial company poses a "grave threat," then, upon a two-thirds vote of the Oversight Council, the Fed could limit the activities of the firm or require the firm to sell or transfer assets to contain its impact on the economy were the firm to become strained.25
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I understand the argument that some government body should have explicit responsibility for monitoring and overseeing the entire financial system. Each existing financial regulator has a determined set of authorities to match its delimited sphere of responsibilities; yet the reality of the financial system is that it is a highly-interconnected complex whole that is not best conceived of as a cluster of parts. Separately, in making decisions, individuals in the private sector tend to emphasize the personal costs and benefits of their actions without necessarily taking full account of the broader social impacts that may follow. For example, profit-and-loss considerations, as compared to ensuring the financial system's stability, primarily determine a financial firm's decisions regarding its leverage, liquidity, and trading. There is, therefore, a central role for the government in ensuring a sound, well-functioning financial system — a "public good." The Obama Administration's plan put it this way: "In effect, our proposals would compel [the largest financial firms] to internalize the costs they impose on society in the event of failure."26
Although the concept of a new systemic risk regulator made up of other financial regulators sounds promising, I have considerable reservations about how the concept would be implemented in practice. The following are among my concerns.
My principal concern turns on the potential reach of the systemic risk regulator's authority. As a threshold matter, there still is no satisfying definition of what constitutes a systemic risk. Systemic risk is easy enough to conceptualize in theory, but it is much more difficult to identify in practice. At what point is a firm "so big" or "so interconnected" as to justify subjecting the firm to more exacting government oversight? And exactly what regulatory constraints should be imposed on such a firm? A sort of "I know it when I see it" approach to regulating systemic risk is untenable. Such open-endedness affords the regulator too much discretion and is too unpredictable.
Yet each of the proposals I took time to reference would, in my view, result in just this sort of open-endedness. For example, by allowing the new regulator to consider so many factors in deciding whether a firm is systemically significant, the bills in Congress go far to empower the regulator. The council of regulators could readily find some basis, among the host of factors it is permitted to consider, to justify designating a financial firm for heighted prudential oversight. Equally uncertain are the extent and character of the more restrictive standards that may be imposed to bind the size or activities of a systemically-significant firm; there are no clear limits on the degree of government intervention that could be expected.
I appreciate that, because no two "tail events" are the same, government officials need room to maneuver in guarding against threats that jeopardize the financial system's stability. Regulatory flexibility is valuable because the regulatory challenges that may be faced are uncertain. Nonetheless, the regulator's authority should be circumscribed and defined in advance. It would be troubling if ultimately there were no clear guidelines and parameters to constrain the systemic risk regulator, as it would then be difficult to foresee how the new regulator may act or to hold the regulator accountable in any meaningful way when it does act. I do not welcome the prospect of such unbounded power, even if exercised with the best of intentions. It would inject too much uncertainty into the system and aggregate government authority to a worrisome degree.
Second, accurately predicting threats to the financial system is exceedingly difficult, if not unachievable — especially if those threats are building up during good economic times when risk may tend to be mispriced and precautions that could put a drag on the economic expansion are not welcome. It takes a great deal of information, knowledge, and understanding to spot risks and monitor the financial system effectively; and the challenge only grows as the financial system becomes more complex and global. Even if the systemic risk regulator gets a good handle on some current situation, none of us is well-equipped to forecast the economic future, particularly given that constant fluctuation characterizes the financial system and the private sector more generally. Forecasting danger to the system is further complicated because the mere fact that the systemic risk regulator stands watch and is prepared to subject a firm to heightened oversight can distort how financial firms and other market participants behave. Accordingly, no matter how conscientious and well-intentioned the systemic risk regulator may be, there is a high likelihood of error in the form of both "false positives" and "false negatives." The council of regulators inevitably will identify risks that turn out to be benign, or at least not worth the cost of regulating, and overlook threats that are real. The trouble with false positives is that they can precondition the stage for overregulation; the trouble with false negatives is that the next crisis may not be ferreted out, as threats that actually exist go unrecognized. Even if some risk is accurately calibrated, tailoring regulation to address the risk in a balanced way will be keenly difficult.
This introduces my third concern — that is, that once an emerging threat is identified, the systemic risk regulator too often will urge a one-size-fits-all approach to regulating financial firms to fend off the threat. Not only do banks differ from non-bank financial companies, but banks differ from each other and important differences distinguish among non-banks. A great deal of data and insight will be required for the granular firm-by-firm distinctions that are needed if the regulator is going to refrain from advocating heightened standards across financial firms uniformly once some firms are subjected to stricter oversight. As a practical matter, the regulator would have to justify why differences among firms argue for different regulatory treatment. Furthermore, the regulator may be reluctant to take a less aggressive stance to the oversight of some firms having initiated aggressive intervention with respect to others on the basis of some perceived systemic threat. The heightened standards may become the new regulatory baseline, with anything less stringent seen as a regulatory gap that is too permissive of risky conduct.
Finally, I am troubled that the systemic risk regulator will be too precautionary. Systemic risk regulation contemplates an anticipatory approach to regulation. To this point, the various legislative initiatives talk in terms of "emerging risks" and "potential threats" and of dangers that "could" jeopardize the financial system. These are low thresholds for triggering regulatory action.
At core, the systemic risk regulator is charged with spotting and responding to risks earlier to avoid infirmities that threaten the system. When given this charge, the natural tendency may be to act increasingly quickly and aggressively to minimize systemic risk. The regulator may overemphasize the downside — as its mission is to prevent the buildup of risk — without giving appropriate due to the potential benefits of the conduct and practices presenting the worry. Indeed, a singular focus on reducing systemic risk may crowd out an appropriate consideration of the economic benefits that flow when the regulatory regime affords financial companies room to innovate and compete in response to the demands of the marketplace. Once a risk is spotted, there may be a bias to avoid it, notwithstanding the cost of doing so if the financial sector is unduly burdened and the flow of capital unduly impeded.
We need to take steps to ensure that our regulatory framework addresses systemic risk. My observations hopefully have highlighted some of the challenges associated with empowering a systemic risk regulator with the kind of far-reaching and indeterminate authority that has been proposed. A more focused regulatory step would be to hone in on refashioning capital requirements and introducing liquidity standards, which themselves might be a function of a financial company's size, activities, and interconnectedness with the rest of the financial system. This more targeted approach to systemic risk oversight would afford a financial firm flexibility to manage its business and operations in meeting the needs of our dynamic economy, so long as the firm meets appropriate capital and liquidity parameters that would position the firm to withstand a shock or period of particular strain. Although fixing capital requirements and liquidity standards is itself complicated, the task would seem to be less complicated than the task envisioned for the systemic risk regulator, which, to discharge its duties responsibly, would need considerable expertise about particular firms and their operations, role in the economy, and competitiveness. Moreover, regulatory reform that emphasizes sound capital and liquidity levels would generate less uncertainty for the private sector and, I predict, fewer unintended consequences than would allowing a systemic risk regulator such wide discretion to initiate a more confining regulatory regime for financial companies.
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I will leave you with one final thought. As lawmakers, we need to approach the challenges we face with humility. We need to appreciate the complexity of what is before us and guard against being overconfident that we can craft well-calibrated solutions. Striking appropriate balances is never easy, but it is fundamental if regulation is to do more good than harm.