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Speech by SEC Staff:
Remarks befor the World Economic Forum Industry Agenda Meeting Regarding Finance


Ethiopis Tafara

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

New York City, NY
September 21, 2004

Thank you very much, Mr. Daruvala.

I'm very happy to be here to participate on this panel to discuss the changing shape of financial regulation in today's world. I notice that the title of this panel is a bit of a misnomer. As a securities regulator, I can attest that today's financial markets are not fragmented - on the contrary, they are quite globalized, with capital flowing across borders even where jurisdictional impediments stand in the way.

But before I begin, I need to start with the SEC's standard disclaimer: that the Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views that I express are mine and do not necessarily reflect those of the Commission or other members of the SEC's staff.

With that said, I'll return to my original point. As we all know, modern capital markets are characterized by nothing if not their global reach. Communication and computer technology has made this physically possible, but legal and regulatory changes over the past few decades have accelerated this trend - or, I would argue, the standards have bowed to reality and been reformed to keep up with changes in the global market.

This panel's description touches on two separate issues. First, how do we effectively oversee, global, seamless markets when we only have national or local regulators? Second, how do we effectively oversee markets characterized by mergers between securities, banking and insurance firms, and the creation of financial products that blur the traditional distinctions between securities, banking, derivatives and insurance?

I'd like to address the second of these issues today. Not because it is more important, but because the way forward on the first issue is clearer. Indeed, the utopic solution to contend with global markets would be a global regulator. However, even the members of the European Union - who now share a common overarching legal structure and, in many cases, a common legal and financial history - have not yet been able to conclude that a single EU-wide financial regulator is feasible, or desirable. Instead, the issue has been reformulated to ask how, given national regulation, can regulators coordinate their enforcement and regulatory activities in ways that reflect the global nature of our markets.

Fortunately, fora such as the International Organization of Securities Commissions, the Basel Committee on Banking Supervision, the International Association of Insurance Supervisors, the Financial Action Task Force, and the Organization for Economic Cooperation and Development have gone a long way towards helping answer this question. Through these organizations, as well as through bilateral networks, financial regulators have created channels of collaboration cooperation, and information-exchange that allow national regulators to do their jobs effectively and efficiently in a world of global financial markets.


However, whether domestic markets should be regulated by a single, consolidated regulator or through functional regulators working in concert - well, that issue seems to be a matter of debate.

There is a trend taking hold around the world calling for the adoption of a single, consolidated financial regulator in place of different regulators for securities, banking and insurance markets. This trend began in Scandinavia in the mid-1980s, involving relatively small countries with relatively smaller financial markets where efficiencies may have been particularly compelling. Beginning with the formation of the United Kingdom's Financial Services Authority in 1998, however, this trend has rapidly expanded to larger countries with much larger financial markets. Today, Germany, Japan and a number of other jurisdictions have created some form of consolidated financial regulator overseeing multiple financial sectors. According to many observers, consolidated regulation is the wave of the future and functional regulators such as the SEC vestiges of the past.

I'm here to argue that functional regulators are highly evolved, hardy creations that hold certain advantages that justify -- and will ensure -- their continuing existence. I won't suggest that consolidated regulation is a bad thing or that it doesn't make sense under many of the circumstances which have led to its adoption. But I will suggest that functional regulation has many distinct advantages - in theory and in practice - that should not be tossed out with the bathwater in a rush towards a regulatory trend. And where multiple regulators exist for a single financial sector, the issue is not functional versus consolidated regulation at all. Rationalization within functions may indeed be desirable - but the overall functional regulatory framework still makes sense.


Before going into a discussion of the benefits of functional regulation, I should probably outline how the US system got as segmented as it is. Bismarck once said two things one should never watch being made are sausage and legislation - and the history behind the regulation of US financial markets probably proves this axiom, at least with regard to the latter.

Banks, insurers and stock markets in the United States were all originally unregulated or loosely regulated at the state level. By the 1860s, volatility in the nation's currency led to federal banking legislation and the creation of national banks regulated by the Comptroller of the Currency. Of course, state banking commissions still existed, leading to what one observer called, "probably the greatest mass of redundant, otiose, and conflicting monetary legislation and the most complex structure of self-neutralizing regulatory powers enjoyed by any prominent country anywhere."1

The US Federal Reserve Board was created following the banking panic of 1907. And the third main federal banking regulator - the Federal Deposit Insurance Corporation - was created by the Glass-Steagall Act of 1933, as numerous banks failed as a result of the Stock Market Crash of 1929 and the Great Depression. The Glass-Steagall Act, of course, also created the separation between investment banking and retail banking and essentially made retail banking a local affair in the United States until the Act's repeal in 1999.

Of course, another progeny of the 1929 Stock Market Crash was the Securities and Exchange Commission, created by the Securities Exchange Act of 1934. Neither the Exchange Act nor the Securities Act of 1933, however, preempted state-level regulation. And further adding to the tangle, the Exchange Act also granted regulatory authority, under SEC oversight, to self-regulatory organizations such as the New York Stock Exchange and the National Association of Securities Dealers. Interestingly, it was not until the Sarbanes-Oxley Act of 2002 that the SEC was given significant authority to regulate corporate governance matters. The SEC traditionally has had to address matters such as board independence and board audit oversight through its oversight of the SROs. Many of the SEC's foreign guests are still surprised to learn that most corporation law remains the province of the states and, indeed, no national registry of corporations exists in the United States.

The 1929 Crash was accompanied by rampant fraud in the nation's futures markets as well. Originally, President Roosevelt called for regulation of futures and commodities markets to be included in the federal securities legislation. However, legislative oversight of national commodities trading resided within Congressional agricultural committees, while securities markets were overseen by Congress's banking committees. And, of course, neither would cede authority to the other. Consequently, the Commodity Exchange Act of 1936 vested oversight of these markets with a separate Commodity Exchange Authority - which became the US Commodity Futures Trading Commission in 1974 after market manipulation and price inflation led to calls for an even stronger regulator.

Then there is the regulation of the US insurance industry. The insurance industry in the United States, like corporate governance, is regulated almost entirely at the state level. The reason for this is that the first major insurance industry scandal occurred in New York in the early 1900s. New York then barred the insurance industry from engaging in securities or banking activities and other states followed suit. The end result was to insulate the US insurance industry from the 1929 Crash and the Great Depression. And because the insurance industry wasn't tarred by the crash and didn't fail under the weight of the Depression, it managed to escape the raft of laws passed by Congress at that time.


So, as you see, the US financial regulatory structure is largely a result of reaction to catastrophic events. If it were created from scratch today, the US financial regulatory system might look different. But if we were going to build a financial regulatory system today, we would first have to ask what are the objectives of regulation?

For banking regulation, the Basel Committee's Core Principles for Effective Banking Supervision states that "the key objective of supervision is to maintain the stability and confidence of the financial system." The top nightmare for a Basel member is a contagious liquidity crisis, where depositor concerns about one bank leads to a run on the entire banking system.

The Core Principles of the International Association of Insurance Supervisors, by contrast, 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.

The fundamental goals of securities regulation, according to the IOSCO Core Principles, are "investor protection, fair, efficient and transparent markets, and the reduction of systemic risk." The enabling statute of the SEC in particular emphasizes investor protection and "the maintenance of fair and honest markets."

There are similarities among these fundamental objectives. For example, insurance, banking and securities regulators all have an interest in prudential regulation - 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, "consumer protection" and systemic stability for insurance and banking regulators, often means that enforcement activities are 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.

But there are differences in regulatory approaches. In the United States, for example, bank deposits frequently are insured by the government. Consequently, banking regulators tend to be very concerned about the moral hazard problems that such insurance may create - that banks will make reckless loans in hopes of higher returns, knowing that any depositor losses will be made good on by the government. With investors in securities markets, there is no such investor insurance scheme. Securities regulators emphasize disclosure rather than prudential regulation, letting presumably fully informed investors make their own investment choices based on their tolerance for risk.


Given these similarities and differences, what then are the advantages to having a single, consolidated regulator? The benefits most frequently cited in favor of consolidated regulation, perhaps described most succinctly by former UK FSA chairman Howard Davies, are:

1. First, modern cross-sectoral financial conglomerates and the blurring of the boundaries between financial products make consolidated regulation a necessity, because, without it, these conglomerates may face multiple regulators and possibly conflicting regulation;

2. Second, a consolidated regulator offers economies of scale and scope and is better able to allocate scarce regulatory resources efficiently and effectively;

3. Third, a single consolidated regulator can set clear and consistent objectives and responsibilities for the entire financial market, and resolve any trade-offs between those objectives and responsibilities within a single agency; and,

4. Fourth, that a single regulator is better at being clearly accountable for its performance against statutory objectives, for the cost of regulation and for regulatory failures. By contrast, responsibility is divided with functional regulation, with a risk that no agency will take responsibility for overall regulatory costs and regulatory failures will occur as certain cross-sectoral matters will "fall between the cracks."2


Some of the advantages ascribed to a single, consolidated regulator are certainly true. It is probably true that a financial conglomerate would prefer to deal with one regulator for all of its functional divisions, than with different regulators depending on which financial products it is selling. A consolidated regulator can offer certain economies of scale and scope, though perhaps not to the degree some advocates believe.

At the same time, I would argue that some of the other claims made in favor of consolidated regulation are based on untested assumptions. And these assumptions themselves underscore problems that consolidated regulation may hold, particularly when viewed from the overarching objectives financial regulation is meant to achieve.

1. Dominance of one regulatory culture

Take, for example, the arguments that a single regulator is able to offer economies of scale and scope. While it is true that insurance, banking and securities regulators all impose capital requirements, they may impose different requirements because they hope to achieve different regulatory objectives. Achieving economies of scale and scope may be possible, but may entail sacrificing certain regulatory objectives.

By the same token, the argument that a consolidated regulator can resolve regulatory trade-offs between competing regulatory objectives assumes that functional regulators cannot. As a practical matter, the SEC's experience working with other regulators and as part of the President's Working Group on Financial Markets shows that functional regulators are quite capable of working with each other to resolve conflicting regulatory objectives. More to the point, however, the underlying assumption that a single regulator is better able to address these conflicts underscores what I believe is a very real problem of the single regulator approach - that one functional approach, philosophy, or set of objectives will come to dominate within a single regulator.

This dominance of one approach over others may not be planned. It may just be cultural. For example, even among other securities regulators in the world, the SEC is recognized for its strong enforcement program. Part of this is statutory - the SEC has investigatory powers that, until recently, made it somewhat unique, even among other securities regulators. Some of this may be professional culture - the SEC historically has been dominated by lawyers, who may be more comfortable with enforcement litigation than the economists who typically lead banking regulators. But whatever the reasons, the fear is that a consolidated regulator, as a practical matter, will come to have a single regulatory culture. And a single one-size-fits-all regulatory philosophy may not serve industry or investors best.

A single financial regulator may also stifle regulatory experimentation. One benefit of functional regulation that we have observed in the United States is that it not only allows different regulatory philosophies to be applied to different types of financial products, but it also allows for different regulatory approaches to be used more broadly. Sometimes an approach used successfully in one sector is found to be equally useful for other sectors. In this way, functional regulators learn from each other, can test new approaches, and can better judge when a given approach is not successful.

2. Resource allocation and priorities

Another, more practical, concern I have regarding a consolidated regulator is resource allocation. Supporters of consolidated regulation argue that a consolidated regulator is better able to allocate scarce regulatory resources according to where they are most needed. There is something to this argument. For example, prior to Enron and other recent financial scandals, it was obvious that the SEC was under-funded. And many observers, including the majority in Congress, have concluded that this under-funding contributed to these problems arising. Certainly, a single consolidated regulator, overseeing insurance, banking and securities, could have recognized this risk and reallocated its resources to this issue.

But, as a practical matter, would it? Would a consolidated regulator, created to achieve economies of scale and rationalization of regulatory resources, have allocated more resources to reviewing the filings of securities issuers - a type of oversight unique to securities regulation and which offers the consolidated regulator no economies of scale or scope? And, if it did, which regulatory function would be on the losing end of that reallocation? Would we have forestalled a scandal in our securities markets in exchange for a meltdown in the banking sector or an insurance failure?

My fear also is that, because a single, consolidated regulator would incorporate the budgets of three separate regulatory functions, the expected savings due to economies of scale and scope would mean, over time, less resources devoted to all three. Government budgets are always under stress and, with a consolidated regulator, it may be harder for a legislature to notice if the single regulator has insufficient resources to carry out one or more of its functions.

3. Regulatory responsibility and regulatory gaps

This takes me to my final concern. Rather than being more accountable for its performance, precisely because a single, consolidated regulator is charged with doing so much, it may be difficult for the public to know if the regulator is doing its job or if it has the resources it needs to do its job. Trust me, as it stands, there is no confusion under functional regulation about whom to blame when things go wrong. And when one regulatory function is under-funded or lacks sufficient resources, it is usually more apparent where separate agencies are involved.

Further, I believe the US experience demonstrates that concerns about functional regulation creating "regulatory gaps," particularly where new financial products are concerned, is not only unfounded, but perhaps more of a concern for consolidated regulation. Functional regulation does not involve solid walls where, for instance, the SEC's jurisdiction ends and the Federal Reserve's begins. On the contrary, regulatory oversight tends to overlap at the functional boundaries. This could, of course, lead to contradictory regulation. But functional regulation in the United States has been around for quite some time, and the SEC, the federal banking regulators, the CFTC, and the state insurance supervisors have all learned to coordinate their oversight. This, I would argue, has led to even more thought being put into the regulation of new financial products than would otherwise be the case.


Finally, I'd like to address what the hosts of this session have termed the need to "strike a balance between protecting consumers and maintaining the competitiveness of the regulated industry" - and, in particular, the possibility that functional regulation makes the US system "vulnerable to over-regulation of detail."

To describe investor protection and industry competitiveness as being in opposition to each other is, to put it frankly, a false dichotomy. A regulatory system that is an effective model for addressing the needs of investors and consumers is very much in the best interests of the financial industry. One can always argue, of course, over whether US regulators "get it right" or whether functional regulators produce overly detailed regulation, despite their best efforts to coordinate policies. But if the regulatory approach, in fact, "is an effective model for addressing consumer needs," the competitiveness of the industry will be strengthened, not harmed.

In short, on occasion, addressing the concerns of investors may be costly, but issuers will be well compensated by paying less for investors' capital.


While consolidated financial regulation no doubt holds certain advantages, the benefits of functional regulation should not be ignored. Consolidated regulation is still unproven. Although consolidated regulation offers several theoretical advantages to market participants, it is as yet unclear whether it can deliver these benefits in practice. By contrast, functional regulation in the United States has existed for quite some time. The Comptroller of the Currency has existed for 140 years, the Federal Reserve for nearly a 100 years, and the SEC for 70 years. This divided approach has continued precisely because functional regulation has proven so adaptable to changes in our financial markets.

Thank you.



Modified: 10/05/2004