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Speech by SEC Commissioner:
Regulatory Reform That Optimizes the Regulation of Systemic Risk


Commissioner Luis A. Aguilar

U.S. Securities and Exchange Commission

ABA Systemic Risk Panel
New York City, New York
April 16, 2010

Good afternoon. It is my pleasure to be here at the Spring Meeting of the ABA's Section of International Law. It is also a privilege to participate with such distinguished panelists. The topic and timing of this panel on financial reform and systemic risk could not be more timely. Even as we speak, negotiations regarding financial reform legislation continue in Washington. Let me say at the outset, the views I express today are my own, and they do not necessarily reflect the views of the Commission, other Commissioners, or the staff.

As those in this room know, the essential role of the financial services sector is to facilitate the allocation of capital to economically productive uses.1 There has been a clear failure in this regard, with widespread mispricing of assets, trillions in losses, and, perhaps most disheartening, painful levels of unemployment and underemployment — together with an unprecedented concentration of wealth at the top.2 Moreover, putting aside acknowledged gaps in legislation, regulators facilitated this failure by choosing not to use authority within their power and mistakenly believing that private parties could police themselves far better than any regulator could.

Today, we live in a world where a significant amount of the profits and financial market activity arises from leverage-financed bets on stock prices and credit derivatives, with insufficient concern for the fundamentals of the underlying companies. This contrast between Wall Street and Main Street3— between the financial sector and the real economy—has ushered in an era of casino capitalism with severe ramifications that continue to reverberate through our capital markets. It is a situation in dire need of reform. Martin Wolf, the chief economics commentator for the Financial Times, stated that this casino capitalism "represents the triumph of the trader in assets over the long-term producer."4

As we discuss the way forward, I am going to concentrate my remarks on the following:

  • The definition of systemic risk;
  • The relationship between primary regulators and any systemic regulator; and
  • The danger of regulatory discretion becoming a substitute for regulatory reform.

The Definition of Systemic Risk

Clearly, the need to both define and manage systemic risk is at the heart of regulatory reform. Over the course of the debate, the term "systemic risk" has been mentioned so often it is easy to conclude that there is a universal understanding of the term, but this is not the case.

This is a problem the world over. As the Commission liaison to the Council of Securities Regulators of the Americas (COSRA), last week I participated in our bi-annual meeting, and we spent a significant amount of time discussing systemic risk and how it should be defined and regulated. There was no obvious consensus. Additionally, in a report prepared in October 2009 for the G-20 and Central Bank Governors, it was found that twenty-eight countries did not have a legal or formal definition of what constitutes systemic importance.5

Other than a general understanding that systemic risk is risk that has widespread impact, there seems to be little agreement of the types of events, or the nature of activities, that could actually cause the kind of market meltdown that a systemic risk regulator would be tasked with monitoring and preventing. For example, some countries focus on the impact of potentially systemic institutions, markets, or instruments on the financial system, while other countries consider the impact on the real economy, as opposed to the financial sector, to be the key consideration.6 The possible reasons for these differences are difficult to discern.

Regulators are not the only ones focused on the concept of systemic risk, we are seeing it in other contexts, including shareholder proposals.

In fact, SEC staff recently denied a company's request to exclude a shareholder proposal from its proxy materials because it focused on a significant policy issue — systemic financial risk7 The specific proposal in question asked for a report of the company's collateral policies for over-the-counter derivatives trades and its procedures to ensure that collateral is maintained in segregated accounts and is not re-hypothecated. The proposal indicated that it was intended to allow shareholders to adequately assess the company's sustainability and overall risk, in order to avoid future financial collapses. Given the role of collaterization and re-hypothecation practices in managing systemic financial risk, as well as the company's significant derivatives activities, staff was unable to agree with the company that this particular proposal could be excluded as relating to a matter of ordinary business. Rather, staff concluded that the proposal focused on a significant policy issue — systemic financial risk.

From shareholders to people around the world, there is widespread agreement that the global financial system has demonstrated vulnerability to systemic risk. However, how one defines systemic risk matters in terms of the resulting regulatory structure. It seems that identifying systemic risk is akin to the often referenced statement by Justice Potter Stewart about obscenity: "I know it when I see it."8 This lack of a common understanding is important because how you define systemic risk directly influences your ideas about how the financial regulatory system should be structured and operated.

Preserve Market Function Not Institution

Many think that the regulation of systemic risk should be primarily focused on preserving the viability of institutions that are "too big to fail" because of their size, interconnectedness, or risk concentration. But this view of systemic risk can result in a financial regulatory model that focuses too much on institutions, not enough on investors, and it positions a government regulator to pick winners and losers among companies at the expense of investors and market certainty — as we saw during the events of September 2008.

Another view is that systemic risk regulation should focus on ensuring the continuation of systemically important market functions, and on investor protections. This can be accomplished by regulation that affirmatively prevents institutions from growing too big to fail in the first place. This view requires that regulation go beyond setting prudential standards.

The process must also involve identifying the systemically important market functions that an entity provides and work to isolate these functions within the entity. The objective would be to ensure that the functions can be separately maintained should other parts of the entity fail. The regulation could also provide for cross-entity relationships to allow one or more entities to step in and continue the functions seamlessly. For example, let's think about the SEC regulation of the national securities market system: if the NYSE-Arca systems were to fail, the SEC has designed our market system so that NASDAQ would pick up the important market functions.

I believe systemic risk regulation should focus on the continuation of market functions, and not necessarily on the preservation of institutions.

Relationship between SEC and Systemic Risk Regulator

Another aspect of addressing systemic risk is defining the relationship between a systemic risk regulator and the primary regulators. If systemic risk regulation is truly focusing on the overarching risk concerns, the systemic risk regulator should be viewed as a supplement to — rather than a replacement for — the primary regulator, such as the SEC.

It is not hard to imagine a world where the mission of a systemic risk regulator is in direct conflict with that of the primary regulator. For example, envision a situation where a primary regulator is "encouraged" to drop an enforcement action because it may shake public confidence in a "too big to fail" firm. In such circumstances, a systemic risk regulator could crowd out the specialized regulatory agencies and, even more importantly, undercut their mission.

With these potential conflicts, it then becomes that much more important to analyze the current systemic risk regulation regime being contemplated by Congress and to ask the hard questions about how it will work. Currently, the legislation that was approved in the House of Representatives authorizes a new Financial Services Oversight Council (FSOC) with the task of monitoring systemic risk.9 This Council will be chaired by the Treasury Secretary, and the Federal Reserve Board (Fed) will operate as its agent. The Fed would be empowered to impose additional requirements on institutions and activities deemed systemically important.

The proposed legislation that has advanced from the Senate Banking Committee has a similar structure with a few differences.10 It also proposes a Council, the Financial Stability Oversight Council (Oversight Council) chaired by the Treasury Secretary, and charges it with monitoring and overseeing systemic risk. The Oversight Council, however, would be required to consult only with primary financial regulators rather than with both the Fed and such agencies as under the House bill. Non-bank entities would be subject to Fed oversight only if the Oversight Council made that determination by a super-majority vote.

Two crucial similarities between the House legislation and the proposed Senate bill are that the proposed systemic risk Council is chaired by the Secretary of the Treasury and would have wide-ranging authority to identify systemically important firms and impose enhanced prudential standards, and that the Council would rely heavily on the regulatory decisions and activities of the Fed.

As Congress considers authorizing this new regime, there must be consideration of its ramifications for the entire regulatory system. First, for example, there will be inherent tensions and conflicts that arise when one regulator has combined responsibility over monetary policy, a vested interest in the safety and soundness of particular institutions, and powers to address systemic risk. There is a danger that any organization with a focus on a particular industry and very broad powers could favor that sector to the potential detriment of others.

A second concern would be that any new legislation will take financial regulators that are independent entities and subject them to the leadership of a political figure — in this instance the Treasury Secretary. The independence of most financial regulators has benefited the financial system and the American public, and it should be maintained. If a systemic risk Council is created, we need to ask what safeguards will be put in place to insure that the independence of the regulators and of their regulatory decisions will not be tainted. How can we safeguard from political considerations dominating the process?

Substituting Regulator Discretion for Regulatory Reform

Apart from the structure of the regulatory regime itself, it is important that investor protection and the fairness of our markets not depend solely on the discretion of regulators. It is important that any regulatory reform put laws on the books that create clear principles that can stand the test of time as cornerstones of a regulatory program.

It is well established that, prior to the financial crisis, regulators had abandoned vigorous governmental oversight and placed their faith in the ability of the markets to self-police and self-correct. Even as the credit crisis unfolded in early 2008, the prevailing view in the industry and among many agencies and government leaders was that too much regulation, rather than too little, was eroding the competiveness of the U.S. markets. In fact, the financial crisis has proven the opposite. It is clear that insufficient and ineffective oversight, rather than over-regulation, facilitated the crisis. As I have spoken about many times, beyond this misplaced faith in the markets, regulators lacked the will, knowledge and resources to respond appropriately to rapid financial innovation and market expansion. When the regulatory structure and those who operate it are so seriously hindered, as we have experienced, systemic risk escalates.

Thus, regulatory reform will not succeed if market participants are engaged in the exact same behavior as before, and regulators are simply encouraged to be more active. This regime would lack a principled core, and it is likely to encourage activity that promotes systemic risk rather than corral it. We do not want regulatory reform that creates, as the well-known financial journalist Steven Pearlstein said, "the kind of complexity, the opportunities for regulatory arbitrage and the lack of accountability that got us into this mess in the first place."11

Statutory provisions should be written to affirmatively reduce or eliminate sources of systemic risk. Take, for example, the issue of capital requirements for financial firms. The House Bill authorizes regulators to enforce a simple mandatory leverage limit of 15 to 1, whereas the Senate bill leaves the decision to impose capital requirements to the discretion of regulators. The problem with discretionary authority, of course, is that you need to know when to use it, and you need to have the will to use it when appropriate. Financial journalist, Ezra Klein, recently wrote on this topic and advised that "the trick is building protections that work even when the people in charge don't realize that they're needed."12

I agree with Thomas Hoenig, the President of the Federal Reserve Bank of Kansas, who stated that "Congress should mandate simple, easily understood and enforceable rules — rather than guidelines so regulators can restrain and rein in the financial firms."13 With clear rules in hand, regulators should then be given broad authority to customize these rules. Of course, the regulator should be required to make appropriate findings that the proposed changes are in the public interest and do not increase systemic risk. Given an unpredictable future, regulatory reform will be most effective if rules are straightforward and regulators are empowered to address future needs.

Let's face it — No matter how broad the reach of any new legislation, an army of lawyers will work to find loopholes and to structure products and relationships to fall within the gaps. Regulators must therefore operate from a set of principles and rules that will stand the test of time.


As I conclude, let me reiterate that the current chasm between Main Street and Wall Street must be closed. There need to be clear, enforceable rules of the road wherever possible. As Congress returns its attention to financial reform, I urge it to do so with investors and the American public foremost in mind. It is my hope that we can shift the dialogue from the discussion of how best to preserve "too big to fail" financial institutions to what is best for investors and to our long-term economic growth. Political leaders, market participants, regulators, and other interested parties have to remember that financial services exist to serve investors — and in turn, our economy. To that end, it's important that the focus on "too big to fail" doesn't ignore ordinary Americans by thinking of them as "too small to matter." Thank you.




Modified: 04/16/2010