Testimony Concerning the Consolidated Supervision of U.S. Securities Firms and Affiliated Industrial Loan Corporations
by Erik Sirri
Before the Committee on Banking, Housing, and Urban Affairs, United States Senate
October 4, 2007
Chairman Dodd, Ranking Member Shelby and Members of the Committee:
I am very pleased to have the opportunity this morning to describe the Securities and Exchange Commission's program for supervising U.S. securities firms on a consolidated basis. I look forward to explaining how this system of supervision provides protection to all regulated entities in the consolidated group, including the Industrial Loan Companies that are the topic of this morning's hearing. Recent events in the credit markets have emphasized the importance of having a robust regime for supervision of financial institutions.
The Commission currently supervises five of the major U. S. securities firms on a consolidated, or group-wide, basis: Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley. For such firms, referred to as consolidated supervised entities or "CSEs", the Commission oversees not only the US registered broker-dealer, but also the holding company and all affiliates on a consolidated basis. These affiliates also include other regulated entities, such as foreign-registered broker-dealers and banks, as well as unregulated entities such as derivatives dealers. Four of the firms, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley own ILCs that account for 1.0%, 0.6%, 7.2% and 1.2% of consolidated assets, respectively. Three of the firms, Lehman Brothers, Merrill Lynch and Morgan Stanley also own thrifts that account for 3.3%, 1.7% and 0% of the consolidated assets of each firm respectively.
The CSE program provides consolidated supervision to investment bank holding companies that is designed to be broadly consistent with Federal Reserve oversight of bank holding companies. This prudential regime is crafted to allow the Commission to monitor for, and act quickly in response to, financial or operational weakness in a CSE holding company or its unregulated affiliates that might place regulated entities, including US and foreign-registered banks and broker-dealers, or the broader financial system at risk. When a CSE firm has a regulated entity in the consolidated group that is subject to oversight by another functional regulator, the Commission defers to that functional regulator as the supervisor of the regulated affiliate. We also share relevant information concerning the holding company with our fellow regulators, both domestically and internationally. Indeed the Commission's CSE program has been recognized as "equivalent" to that of other internationally recognized supervisors, including the U. S. Federal Reserve, for purposes of the European Union's Financial Conglomerates Directive.
While maintaining broad consistency with Federal Reserve holding company oversight, the CSE program is tailored to reflect two fundamental differences between investment bank and commercial bank holding companies. First, the CSE regime reflects the reliance of securities firms on mark-to-market accounting as a critical risk and governance control. Second, the design of the CSE regime reflects the critical importance of maintaining adequate liquidity in all market environments for holding companies that do not have access to an external liquidity provider.
Before I describe the CSE program in detail, I will provide some historical perspective. Over the past twenty years, the Commission, in its role as the functional regulator of US broker-dealers, became increasingly concerned about the risk that a broker-dealer may fail due to the insolvency of its holding company or an affiliate. This risk, as broker-dealers have become affiliated with more and more complex holding company structures, was exemplified by the bankruptcy of the Drexel Burnham Lambert Group and the consequent liquidation of its broker-dealer affiliate in 1990. Post-Drexel, the Commission and its staff undertook a number of initiatives to conduct group-wide risk assessments of financial institutions with significant broker-dealer subsidiaries. The initiatives included (1) Commission risk assessment rulemaking using authority granted by the Market Reform Act of 1990 requiring larger broker-dealers to provide certain information about material affiliates, (2) creation of the Derivatives Policy Group consisting of firms active in OTC derivatives that agreed to voluntarily provide information to Commission staff about their OTC derivatives activities, and (3) the Commission's program for supervision of broker-dealers that register as OTC derivatives dealers. These initiatives assisted the Commission in understanding how financial institutions with large broker-dealer subsidiaries manage risk globally at the group-wide level, and have over time allowed the Commission to develop a unique capacity to regulate securities firms.
Motivated in part by the need for group-wide risk monitoring, and in part by requirements of the European Union's Financial Conglomerates Directive, which essentially requires non-EU financial institutions doing business in Europe to be supervised on a consolidated basis, the Commission in 2004 crafted a new comprehensive consolidated supervision regime that was intended to protect all regulated entities within a group including broker-dealers. The rule was designed to restrict eligibility to those groups with a large and well-capitalized broker-dealer. In other words, the Commission believed that it should only supervise on a consolidated basis those firms engaged primarily in the securities business, and not holding companies affiliated with a broker-dealer incidental to its primary business activity. As a result, the rule effectively requires that the principal broker-dealer have tentative net capital, measured as equity plus subordinated debt less illiquid assets, of at least $5 billion.
The CSE program has five principal components: First, CSE holding companies are required to maintain and document a system of internal controls that must be approved by the Commission at the time of initial application. Second, before approval and on an ongoing basis, the Commission examines the implementation of these controls. Third, CSEs are also monitored continuously for financial and operational weakness that might place regulated entities within the group or the broader financial system at risk. Fourth, CSEs are required to compute a capital adequacy measure at the holding company that is consistent with the Basel Standard. Finally, CSEs are required to maintain significant pools of liquidity at the holding company, where these are available for use in any regulated or unregulated entity within the group without regulatory restriction.
Before I expand on each of these in turn, I would like to point out that these five principal program components are implemented in conjunction with the authority to protect regulated entities within the groups. When potential weaknesses are identified, the Commission has broad discretion under our rules to respond, for example by mandating changes to a firm's risk management policies and procedures, by effectively requiring an increase in the amount of regulatory capital maintained at the holding company, or by requiring an expansion of the pool of highly liquid assets held at the parent. These powers are not theoretical abstractions. All three of the steps that I just cited, namely requiring changes to risk management systems, requiring more capital, and requiring more liquidity have been taken at various firms over the past two years.
I have described this morning a system of consolidated supervision that has thus far demonstrated its effectiveness during the current credit market difficulties. It appears to be effectively achieving the goal of reducing the likelihood that weakness within the holding company or an unregulated affiliate will place a regulated entity, including an ILC, or the broader financial system, at risk. I have described the means by which we monitor on an ongoing basis the financial and operational condition of the CSE holding companies, leveraging our many years of experience in overseeing broker-dealers and their affiliated holding companies. And I have described our broad authority under the CSE rules to take action in the event of a weakness or potential weakness. Further, while the program is similar to other consolidated supervision regimes, notably the Federal Reserve's oversight of Bank Holding Companies, the CSE regime is tailored to reflect the reliance of securities firms on mark-to-market accounting as a critical risk and governance control, as well as the need for such firms to maintain adequate internal liquidity sources to withstand market stress events. The CSE program is recognized internationally as providing consolidated supervisory oversight of our largest U.S. securities firms that is equivalent to that of well recognized federal banking regulators. And finally, we are constantly learning from our experience in supervising these firms and we are continually evaluating the CSE regime for any potential improvements.
In conclusion, while we generally support the goals of consolidated supervision of holding companies affiliated with industrial loan companies, any legislation should ensure that CSEs, which are highly regulated under the Commission's consolidated supervision program, are not subjected to an additional layer of duplicative and burdensome holding company oversight. Any legislation should recognize the unique ability of the Commission to comprehensively supervise the consolidated groups that are overwhelmingly in the securities business, especially given the heightened focus on these issues in an era of increased global competitiveness. And any legislation should respect the careful deference accorded by the Gramm-Leach-Bliley Act to functional regulators in overseeing the activities of functionally regulated members of financial holding companies.
Thank you again for the opportunity to speak on behalf of the Commission. I would be happy to answer any questions that you may have.