Remarks at the George Washington University Center for Law, Economics and Finance Fourth Annual Regulatory Reform Symposium
Oct. 26, 2012
Thank you for that kind introduction.
And thank you for hosting this Financial Regulatory Reform Symposium. It is always good to be back at my Alma Mater.
Four years ago this month, this nation was suffering from a near-collapse of our financial system.
While there are differences of opinion as to what was the most significant trigger, a bi-partisan Senate Committee report -- known as the Levin-Coburn Report -- asserted that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street.”
While this period of our history will be written and re-written over and over again, Congress and the Administration knew that the status quo was unacceptable. So together they passed landmark legislation to address many of the issues that were highlighted by that tumultuous period.
The Dodd-Frank Wall Street Reform and Consumer Protection Act is a vital and comprehensive response to the financial crisis – an event that devastated the American economy, cost the American people trillions of dollars and millions of jobs, and undermined the confidence that our financial system requires if it is to thrive and support a growing economy.
The sweeping scope of this financial reform legislation sometimes obscures the fact that, despite its breadth, it is rooted in a handful of sound principles that should have been more firmly in place before the crisis, and whose embrace serves to make markets more stable and efficient. Simple principles like. . . .
- Markets should be transparent.
- Regulation should be consistent, without gaps that can be exploited by those who wish to indulge in risky, destabilizing or illegal behavior.
- Market participants, not taxpayers, should bear the risks of their market activities.
- And regulators should have the willingness and the tools they need to apply these principles to the day-to-day workings of the financial markets.
The Dodd-Frank Act translated these principles into law that is the foundation for effective regulation.
Interestingly, the title of this historic legislation may seem to suggest that there are two parts to the bill -- “Wall Street reform” on the one hand, and “consumer protection” on the other. Yet, a closer examination of the law reveals that both portions are rooted in those same important fundamentals.
That is because opacity, flaws and regulatory gaps make the system less able to perform its vital capital allocation function, more likely to collapse and more likely to subject investors to unnecessary harm.
When I was invited to join you today, Dean Berman offered me a broad variety of topics on which to speak, largely but not entirely focused on the Dodd-Frank Act. As someone who has lived and breathed Dodd-Frank since well before its passage in July, 2010, I’m sure I could speak for hours on even the most arcane aspects of that legislation.
After all, when I arrived as Chairman of the SEC in January 2009, there were some calling for the agency to be abolished or split up and divided among other entities – so when the financial reform legislation was being drafted I took a particularly active role in advocating for the importance of the SEC’s mission – a mission to protect investors and ensure the efficient operation of our markets and formation of capital. And, I impressed upon policy-makers that the SEC could step up and fulfill its mission.
In the process, I worked with those on the Hill and in the administration to ensure the SEC would have its authority bolstered, not weakened – and I am pleased that occurred. It was a sign that Congress appreciated the need for a strong SEC.
At the same time, I am also proud that Congress gave us the tools in Dodd Frank that I sought: to create a new whistleblower program that is resulting in high-quality tips from insiders at financial firms; to require hedge fund advisers for the first time to register and be subject to our rules; to proceed with additional clarity in establishing a uniform standard governing the conduct of investment advisers and broker-dealers; and to develop a comprehensive regulatory regime for over-the-counter derivatives, among many other things.
Today I want to focus on a few specific provisions of the Act, tying them back to the fundamentals I mentioned a moment ago, in hopes that, should the students who are with us today ever put your impressive educations to use as public servants, you will look at potential regulation in this light.
Let me start with Title VII of Dodd-Frank – the part of the Act that for the first time creates a comprehensive regulatory regime for the over-the-counter derivatives market.
Title VII illustrates the importance of financial fundamentals on a vast scale, addressing a derivatives market with a global notional value of some $650 trillion.
Derivatives are financial products that ‘derive’ their value from some underlying thing. One common type of derivative is a swap, which is a financial contract in which two counterparties agree to exchange or "swap" payments with each other as a result of such things as changes in a stock price, interest rate or commodity price.
Back in the early 90s, when I served as a commissioner at the SEC, and later as Chairman of the CFTC, it was difficult to imagine the sheer size or potential impact of this emerging market.
At that time, the notional value of the derivatives market hovered around $10 trillion – and much of that was comprised of hedging by end users against the risk of currency or commodity price fluctuations. That is, companies were essentially using these transactions as insurance against an adverse event.
While some regulators appreciated the need to get a better handle on what was going on behind the curtain, industry strenuously objected to any regulation. And, with the Commodity Futures Modernization Act of 2000, Congress created a huge gap in the regulatory structure by specifically excluding most OTC derivatives transactions from regulatory oversight.
The result was a vast market operating behind an opaque curtain, whose transactions were not visible to regulators or other market participants. The gap in regulation allowed a fundamental tenet of thriving markets – namely, transparency – not only to be ignored, but to be actively rejected.
Unfortunately, as we found during the financial crisis, firms that entered into OTC derivative transactions to reduce their market risk had simply swapped one risk for another – market risk for counterparty risk. Opacity in the markets made it such that firms could not be sure that the counterparties to their swaps would be able to make good on their transactions if circumstances demanded.
In fact, as more and more OTC derivatives were transacted across the system, an elaborate network of risk was built up. Firms were not only subject to the risk that their own counterparties could not make good on a transaction, but that their counterparties’ counterparties’ might fail to live up to the terms of a transaction, increasing risk to the original counterparties and thereby transmitting it back to the original firm.
This type of cross-firm connectivity has the ability to greatly magnify the systemic shocks of a significant default by any single firm.
According to the Financial Crisis Inquiry Commission, during the crisis there was a real possibility that the default of a single large counterparty could set off a chain reaction that would spread through many interconnected institutions. Traders, in the Commission’s words, “rushed for the exits,” asset values fell, risk management – in the absence of liquid derivatives market – became vastly more complicated and credit dried up.
Title VII of Dodd-Frank addresses challenges in the OTC derivatives market by closing the gap created by the Commodity Futures Modernization Act and bringing the OTC derivatives market into the daylight. And, working with the Commodity Futures Trading Commission, we have been writing rules that fill out an entirely new regulatory regime – one that strengthens the stability of our financial system.
These rules do this by:
- Improving transparency and facilitating the centralized clearing of security-based swaps, helping, among other things, to reduce counterparty risk.
- Enhancing investor protection through increased disclosure regarding security-based swap transactions; and
- Mitigating conflicts of interest of dealers and other major participants involved in security-based swaps.
By promoting transparency, efficiency, and stability, this framework is intended to foster a more nimble and competitive market and enhance regulatory oversight and monitoring by facilitating improved access to comprehensive data on the security-based swap market.
A report released by a major market participant last year underscores the benefits of bringing financial fundamentals into this market: It predicts that the market for interest rate and credit default swaps will grow by more than 10 percent by 2013. “Notional values in derivatives…are expected to rise, due to increased transparency and counterparty risk mitigation,” reads the report.
Instead of transacting business behind closed doors, this new system will require certain transactions to be conducted on a public trading platform. Once a transaction has occurred, the rules will require information about the trade to be reported to a data repository, and in turn that information will be shared with the public. And, many of the trades will be handled by a clearing house – essentially a middle man that steps in the place of the original counterparties and effectively assumes the risk should there be a default.
Despite being handed the lion’s share of the rulemaking under Dodd-Frank, I am pleased that the SEC has now proposed substantially all of the rules that create this new regulatory regime for derivatives within our jurisdiction, and in some cases has adopted the final rules.
This spring and summer, jointly with the CFTC, the SEC adopted key definitional rules and interpretations on which this new derivatives trading system will be built.
The SEC has also recently adopted rules regarding our clearing infrastructure, that group of “middle men” that are critical for achieving the goals of Title VII. In June of this year, we adopted rules specifying how clearing agencies are to submit information to the SEC so we can decide which types of security-based swap transactions must be cleared And, just this week, we adopted rules outlining standards for the risk management and operations of clearing agencies. Even without the regulatory regime fully in place, more and more swaps are already being cleared—a trend that reduces risk and should accelerate as the rules come online.
To help ensure the system comes on line in an orderly fashion, we have drawn a road map setting forth the anticipated sequencing of compliance dates for when the various rules will take effect. The goal is to avoid the cost and disruption that could result if compliance with all of the rules were required simultaneously or haphazardly. Market participants have provided comments on this road map, and we look forward to completing the adoption process for rules already proposed but not yet final.
Building a comprehensive regulatory regime from the ground up, in close coordination with the CFTC and in consultation with numerous other domestic and overseas regulators is an immense task, involving uncounted actions and details – not to mention hundreds of meetings with, and thousands of comment letters from, stakeholders.
But we will not lose sight of the big picture: if the new marketplace is truly transparent it will work better and more efficiently for all parties; if we close the regulatory gaps, financial markets will be safer for investors and for economies around the world.
The market participants focused on Title VII are – generally speaking – large players: airlines that want to hedge the price of a year’s worth of jet fuel, hedge funds that want to place a billion dollar bet on the direction of the Euro.
But the provisions of Title IX, unlike Title VII, are much more likely to directly touch the lives of you and me. Designated the “consumer protection” section, it is in fact full of systemic safeguards, designed to limit practices which at first seem only to affect individual investors or specific kinds of participants in the financial system.
But these practices, cumulatively, shook the financial system to its foundation. And despite the difference in the size and nature of the players engaged by Title IX, the need to have the playing field defined by the same sort of fundamentals remains.
Take home mortgages. Persuading potential homebuyers to assume a mortgage they have no ability to repay sounds like a classic consumer protection problem. But when millions of bad mortgages were written, bundled and chopped into securities, the financial system shuddered.
It’s impossible, of course, to pinpoint the exact moment the financial crisis began. But, clearly, a major turning point was when Bear Stearns collapsed in March, 2008, dragged down by the billions of dollars in toxic mortgage-backed securities two of its affiliated hedge funds had acquired.
But the problems with the mortgages underlying these securities began long before they found their way into the portfolios of the High-Grade Structured Credit Fund and the High-Grade Structured Credit Enhanced Leveraged Fund. Again, a fundamental principle of financial regulation was being circumvented: institutions which profited from the origination and bundling of subprime mortgages had found a way to do so with little or no risk to themselves.
During the housing bubble, companies found that they could write mortgages and then sell them off – pocketing the origination fee and passing the risk down the securitization chain.
Since originators bore no risk, they had every incentive to let underwriting standards slide. In the era of “Interest Only,” “OptionARM” and “liar loans,” mortgage originators pushed loans out the door with little or no consideration of whether mortgagees would be able to pay.
Even before the Dodd Frank Act passed, the SEC had proposed regulation to bring reform to this market, by requiring that securitizers of these ABS provide investors with the data and time needed to analyze independently the soundness or risk offered by the assets underlying the securities – bringing, as we are working to do in Title VII –greater transparency to an important financial product.
This sort of regulation would have given investors insight into the quality of the sub-prime loans underlying the securities they purchased, giving them the opportunity to discover just how much risk they were assuming, and would have required some risk retention. Title IX attacks the problem even more broadly. This provision attempts to incentivize high quality origination by requiring that securitizers retain at least five percent of the credit risk of any asset it sells. It also prohibits a securitizer from directly or indirectly hedging or otherwise transferring that credit risk.
Using risk retention to align the interests of originators and securitizers with investors, minimizes the moral hazard that contributed to the mortgage crisis. The Commission, jointly with the banking agencies, has proposed rules that are designed to improve the quality of underwriting and research by originators and securitizers and it does so as much by ensuring that market forces are in place as it does through regulatory prescription. It protects investors and the financial system as a whole.
The Commission has also adopted other rules for asset-backed securities pursuant to Title IX. In January of 2011, the Commission adopted rules that require securitizers to conduct due diligence on the assets they are securitizing and that require them to disclose asset representation demand, repurchase and replacement history. Again, this will help to protect investors and the financial system as a whole.
Credit Rating Agencies
But that’s just a start. The negligence and sometimes outright fraud that too often marked bubble-era mortgage underwriting was compounded by excessive investor reliance on fatally flawed ratings of securities built on top of those loans.
As late as January, 2008, 64,000 asset-backed securities were rated Triple A. Unfortunately, as the Senate Investigations Subcommittee stated, “analysts have found that over 90% of the AAA ratings given to subprime [residential mortgage-backed securities] originated in 2006 and 2007, were later downgraded by the credit rating agencies to junk status.”
As I mentioned a moment ago, the SEC had begun rulemakings designed to lessen investors’ dependence on rating agencies in the ABS market by dramatically increasing visibility into the underlying assets. The Dodd-Frank Act furthered that effort.
For instance, in January, 2011, the Commission adopted the first of approximately a dozen required rulemakings related to Nationally Recognized Statistical Rating Organizations – known as NRSROs. And in May 2011, the Commission published for public comment a series of proposed rules that would further strengthen the integrity of credit ratings, including by improving their transparency.
Additionally, the SEC is acting to end regulator reliance and reduce investor reliance on credit ratings, and to ensure that ratings are produced independently of client influence, yielding more accurate data for investors to analyze.
For instance, we’ve removed references to credit ratings in 18 of our rules – and about half of those were removed before the Dodd-Frank Act was even passed.
And, earlier this year, as required by the Dodd-Frank Act, we established the Office of Credit Ratings within the SEC, which will play a key role as we move to finalize rules -- including, among other things:
- proposals designed to prevent sales and marketing activities from influencing the production of ratings;
- proposals to make the actual performance of NRSRO ratings visible to investors;
- proposals that would require certification by third parties retained for the purpose of conducting due diligence related to asset-backed securities;
- proposals that would establish standards for rating analysts’ training, experience and competence, as well as putting in place a testing program;
And proposals to require NRSROs to report on their internal controls. .
In addition, we are also considering proposing regulations that would require NRSROs to among other things, be required to:
- Protect against any conflicts of interest more effectively;
- Provide – along with the publication of any credit rating – enhanced disclosure about the credit rating and the methodology used to determine it; and,
- Remove yet further references to credit ratings from our rules.
The commitment to fundamentals as the basis of reform carries into areas where the connection may seem less obvious. So-called “say on pay” regulations, which give shareholders regular, non-binding up-or-down votes on executive compensation packages and golden parachutes is one such case.
The SEC expresses no opinion regarding the level of executive compensation. Rather, our interest is in ensuring that in this matter – as in other areas of corporate governance -- the shareholders who own a company receive the information they need to make an informed judgment, and that they have a vehicle through which they can express their judgment to the board.
Today, it appears that the say-on-pay regulation effectuated through SEC regulation under Dodd-Frank is leading to improvements in communication in both directions. It has given shareholders a clear channel to communicate to their boards, satisfaction -- or lack of satisfaction -- with executive compensation practices. And it is giving boards a powerful incentive to clarify disclosure to shareholders, and to make a clear, coherent case for the compensation plans they have approved.
The outcomes of these votes are not binding on the company or its board of directors, and they do not affect the validity of executive officer compensation arrangements. The advisory vote does, however, let boards know what shareholders think of compensation arrangements. And companies now have to disclose in proxy statements, in the year following the vote, how they have responded to the most recent say-on-pay vote.
Few compensation packages have actually been rejected. But even in many cases in which shareholders approved the board’s compensation strategy, a significant percentage of shareholders have often voted “no.”
It is our expectation that “no” votes or even a significant vote against a company’s executive compensation practices will force boards to ask themselves some very tough questions about their compensation policies and about whether they are communicating effectively with shareholders about those policies.
The say on pay regulations also require companies to provide shareholders with an advisory vote on the frequency of say-on-pay votes at least once every six years. I understand that most companies, consistent with the preferences of shareholders, have determined to hold say-on-pay votes every year.
This demonstrates that shareholders want boards to maintain a focus on executive compensation. I am hopeful that these say-on-pay votes will focus boards on the incentives they are creating through their executive compensation policies. In this respect, Say-on-pay builds on regulations the SEC adopted in 2009 that ask companies to detail the relationship between risk and compensation, and to more fully discuss their approach to managing risk.
Regulation that broadly facilitates board-shareholder communications on the subject of risk management – whether through disclosure or say-on-pay deliberations – will result in greater board attention to risk taking incentives and companies that are more resistant to the kind financial epidemic that spread so rapidly from firm to firm in 2007 and 2008.
The financial world is full of zero-sum games. If one party to a currency swap wins, the other party loses. If you short a stock, your profit or loss is exactly the same as the loss or profit incurred by the entity that bought your shares.
But financial reform isn’t like that. Of course, in individual cases, investors and consumers of financial products may have different priorities than brokers and banks. But broadly speaking, good regulation, rooted in fundamentals that are frankly no secret -- transparency, risk management, fairness – broadly benefits all stakeholders.
Transparent markets more efficiently distribute capital. Fair markets bring investors and their capital into the game. Properly allocated and managed risk curbs irrational behavior that can have devastating consequences. It’s not hard to figure out.
Unfortunately, there are powerful individuals and entities which profit – at least in the short run -- from inefficiencies and opacity, from differentials in information and power and from taking irrational risks, knowing that profits and compensation will accrue to them, while losses are often assumed by consumers, shareholders and the economy at large.
Dodd-Frank recognizes this, and builds a comprehensive structure on strong principles that protect investors and make Wall Street work better. Thank you.
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