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U.S. Securities and Exchange Commission

Risk Taking -- Banks & Markets


Ethiopis Tafara
Office of International Affairs

U.S. Securities and Exchange Commission

Measures to Promote Competition, Efficiency and Innovation
7 July 2011
Paris, France

Thank you, Malcolm (Edey) for that kind introduction.

First, permit me to give the SEC's standard disclaimer- what I say represents my own views and not necessarily the views of the Commission or other members of the Commission staff.

The topic for this panel is measures to promote competition, efficiency and innovation. I'd like to focus my remarks on innovation, because I think it is the most likely of these three to suffer from our current regulatory trends. More particularly, I'd like to focus on real as opposed to financial innovation.

What are the prerequisites of real innovation? First and foremost, it requires the presence of entrepreneurs, who can bring together technology and resources in new ways, to meet evolving needs and wants, in the form of a viable business model. This, in turn, requires a rare combination of technical savvy, extraordinary boldness and risk taking. After all, it is something new that is being generated here. There are no studies to show you how to do it. There is no metric that can tell you these are risks worth taking. No one has done it before this way. That is the point. It is innovation.

Of all these ingredients to innovation, perhaps the most important is boldness.

The philosopher of science, Karl Popper, argued that there was a dynamic "logic" to scientific discovery, which entailed an interactive series of bold conjectures, criticism, response to criticism and further conjecturing. The "logic" of innovation is much the same. Entrepreneurs put forth the bold conjectures-in the form of their innovative vision. The market, of course, provides the criticism; the product or service is purchased only if it effectively fulfills needs or wants, and the enterprise is only profitable if it delivers this product or service with efficiency. If the market rejects the entrepreneur's vision, she can adjust and perfect it in light of the market's "criticism". Alternatively, if the entrepreneur fails to adjust her model, her enterprise will fail and other businesses will fill the void. The possibility-and even the likelihood-of failure is an intrinsic part of the process. Just as science evolves through conjectures and refutations, real innovation is driven by an interactive dance of bold ideas and the market's tough, pointed criticism.

And innovation, whether in the form of green or biotechnology, is critical to our future prosperity. As you may have noticed, I have failed to mention one of the key ingredients to innovation, and that is, of course, finance. In the wake of the recent financial crisis, our regulatory reform efforts have-quite properly-focused upon the reduction of systemic risk. Among the regulatory challenges here, I believe, is the grave danger that our efforts to reduce systemic risk may result in a reduction of the kind of risk taking that drives real innovation. This could result in substantially reduced economic growth-foregone economic growth that might, in fact, serve to address current economic straits.

Our policy challenge is the following: how do we ensure that finance continues to find its way to the kind of productive risk taking that I have described, while at the same time we effectively address the instabilities identified in the recent financial crisis? More specifically, we must ask ourselves: what is the right blend of regulatory tools to meet this challenge?

Traditionally, banking regulators have focused on prudential regulation, while securities regulators have focused on disclosure, transparency and enforcement. Where should we extend the traditional tools of the banking regulator and where should we extend those of the securities regulator?

There is little denying that the recent financial crisis, while involving all types of market participants, was essentially a banking crisis. Although unusual perhaps in the number of non-banks that undertook bank-like activities and certainly unique in that securitized financial products were the instigators, the pattern of the crisis differed from other banking crises only in its depth. Financial firms- closely linked to each other through leverage and counterparty arrangements-exposed themselves to too much risk. And when that risk became apparent, there was a "run" on these financial institutions.

As the heart of the problem is the maturity mismatch that characterizes traditional banking. The dangers of a maturity mismatch were amplified, however, by the potential for increased volatility on the asset side of the balance sheet attributable to the "embedded leverage" inherent in certain securitized products. Potential volatility was further increased through derivative products.

Now, clearly, it is important that we understand why these widely varying financial firms were acting like traditional banks. Moreover, I think most of us would agree that when systemically risky financial firms take on the role of banks, they should face the same kind of prudential regulation as do banks. But we must pause here and ask ourselves: if all major sources of financing today are to be treated as banks - with more or less one-size-fits-all capital requirements and conservative risk measurement mandates - where is the financing to come from for the next wave of high-risk/high-payoff innovations? Who will finance the next great development in transportation, or medicine, or artificial intelligence?

If we look back at the many fundamental economic innovations of the 20th century-Aircraft, antibiotics, the Internet, the transistor and semiconductor, the mass produced automobile and the plastics that Mr. McGuire told us to invest in the movie, "The Graduate"-we see relatively little bank financing, at least not at the inception of each innovation's lifecycle. This is unsurprising because, as we know, banks are the archetype of systemically risky financial entities. Consequently, banking regulation, when it is done properly, imposes a certain degree of financial conservatism.

But we must ask: as we reform our markets in light of the recent crisis, where will the financing come from for the truly risky enterprises of the 21st century? This is where the traditional tools of the securities regulator come into play. While banking regulation is designed to control and, to a certain extent, suppress risk taking, securities regulation is, in stark contrast, designed to facilitate it. In the financing of economic pursuits that entail substantial risk, the traditional tools of securities regulators-that is, disclosure, transparency and rigorous enforcement efforts to police fraud and abuse-have a substantial comparative advantage over banking regulatory tools. As mentioned above, failure is an essential part of the innovative process. But that's precisely what the banks should try to avoid.

In our collective efforts to reform our markets in light of the systemic crisis, the danger is that the tools of the banking regulator come to dominate the regulation of capital markets and thereby unintentionally suppress needed real innovation. As regulators, we must look at what capital needs to do to support economic growth. We must be careful to recognize why different avenues for financing exist. We need to recognize why securities regulation has historically differed from banking regulation. As legendary venture capitalist William Draper recently put it in an interview: "Facebook couldn't go to a bank and get a commercial loan to start up a company."

There is much at stake here. If we want to encourage innovation and realize its benefits, financial regulation has to make a space for risk-taking. Only by recognizing the inherent functional differences between capital markets and banking can we succeed in both addressing systemic risk while at the same time spurring economic growth through innovation. Those economies that recognize these differences, and which regulate and supervise accordingly, will grow and prosper and become the leaders in the 21st Century.

Thank you.



Modified: 07/15/2011