Moving Past the Days of Deregulation

The United States and the world as a whole must adopt a more investor-centric approach to regulating the capital markets and abandon the deregulatory thinking of the past that left too many holes of risk unfilled, officials said at Compliance Week 2009.

“If there’s a silver lining in the dark clouds, it is that turmoil creates opportunity to fix the plumbing of the U.S. regulatory architecture, patching leaks and modernizing the piping in a way that promotes market stability and investor confidence,” Richard Ketchum, chairman and CEO of the Financial Industry Regulatory Authority, or FINRA, told the more than 300 attendees.

Likewise, Securities and Exchange Commissioner Luis Aguilar said any new regulatory plan must be built around investor protection, not the preservation of any particular industry or entity. He also said policymakers should be careful to understand the causes of the current economic crisis before crafting a regulatory solution.

“We need to be careful about blindly concluding that the regulatory structure is the reason that investors have lost confidence,” he said. “We had institutions playing fast and loose with other people’s money and a deregulatory philosophy that let people get away with it.”

Aguilar

Ideally, Aguilar said, Washington should establish an integrated capital markets regulator that would combine the functions of the SEC with the Commodities Futures Trading Commission and the Department of Labor’s Employee Benefits Security Administration. He fretted that other ideas, such as dismantling the SEC and allocating its functions to other agencies, have gained currency because the SEC’s mishandling of the Bernard Madoff fraud and other recent missteps has tarnished its reputation.

“Today’s markets are so interconnected that centralized market oversight by a single independent regulator makes sense,” Aguilar said. “There are enormous areas of the securities markets that lack appropriate regulation, including over-the-counter derivatives, hedge funds, and municipal securities. These gaps need to be closed.”

Richard Ketchum, left, fields questions from Compliance Week editor Matt Kelly.

Ketchum said consensus seems to be emerging in the United States and in Europe for the creation of some type of regulator that would be charged with spotting systemic risk across all major marketplaces. It would look for risks to the stability of markets rather than risks related to any individual entity or firm, he said. He believes such a regulatory body could be formed at least conceptually by the end of 2009 or soon after.

“The stovepipe regulations that exist in this country and … in every other country simply had not evolved to deal with the risk or work with the difficulties with transparency” that led to “sickening volatility and huge challenges the economy has had to deal with,” Ketchum said.

Aguilar said the notion of regulating systemic risk has merit, if it is focused on preserving important market functions, rather than market institutions. The wrong approach would be to protect banks and other financial institutions “too big to fail,” which would position a government regulator as “picking winners and losers among companies at the expense of investors and at the expense of market certainty.”

A systemic regulator should have a comprehensive investor protection mandate for all investment products, such as securities, derivatives, and interests in retirement funds, to create a financial regulatory entity with authority over all capital market activity, he continued. It should also be an independent agency with strong and broad regulatory authority and vigorous enforcement, he said.

SEC COMMISH ON SYSTEMIC RISK

The following excerpt is from Luis Aguilar’s speech at Compliance Week 2009:

I think we need to have some clarity in our thinking about what are systemic risks—because how you define systemic risk directly influences your ideas about how the financial regulatory system should be structured. Many think that the regulation of systemic risk should be primarily focused on preserving the viability of institutions that are “too big to fail.” But this view of systemic risk can result in a financial regulatory model that focuses too much on specific institutions, not investors, and positions a government regulator to pick winners and losers among companies at the expense of investors and at the expense of market certainty.

Instead, systemic risk regulation should recognize that the various market functions exist to serve investors and other users—and that the focus needs to be on ensuring the continuation of systemically important market functions, not institutions, and should have a clear focus on investor protections. This orientation toward investors and away from a “too big too fail.” philosophy would involve identifying the systemically important market functions that an entity provides, and working to isolate these functions within the entity. The objective would be to ensure that the functions would be heavily reinforced against failure, and could be separately maintained should other parts of the entity weaken. The regulation could also provide for cross-entity relationships, or standardized market systems, to allow one or more other entities that provide similar market functions to step in and continue the functions seamlessly. For example, if the NYSE-Arca systems were to fail, the SEC has designed our market system so that NASDAQ would quickly pick up the important market functions.

Let’s turn from the objectives of a systemic risk regulator to how the systemic regulator would be organized.

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. Currently, there are two main models for a potential systemic risk regulator: they are, first, a monolithic risk regulator, and second, a council of regulators. While there are advantages and disadvantages to both of these approaches, the council of regulators seems to offer a comprehensive and effective option.

Some of the advantages of a council of regulators approach are: first, it reflects the main objective of a systemic risk regulator, which is to identify accumulation of risks. In short, the systemic risk regulator needs to spot issues. Bringing together different regulators with different techniques and expertise will provide for a diversity of perspectives that could make it more likely that a risk will be spotted. Just as a wise leader does not guard the fortress with a single sentry, but has several vigilantly scanning the horizon, so too should Congress and the administration require the appropriate regulators to form a council to monitor for systemic risk.

In addition, a council of regulators would inherently ensure that any issues and proposed solutions would be subject to scrutiny in a consultative process by regulators having different mandates, information and expertise. This diversity of perspectives would make for better decisions.

Lastly, and most significantly, a council of regulators would avoid the inherent tensions and conflicts that could arise where one regulator has combined responsibility over monetary policy, a vested interest in the safety and soundness of particular institutions, and plenary powers to address systemic risk. Any organization with a narrow focus on a particular industry and very broad powers is likely to favor that sector to the possible detriment of others.

Source

Luis Aguilar Speech: Putting Investors First (June 3, 2009).

But it also needs a sustainable self-funding mechanism to permit long-term planning, much the way banking regulators are funded and operated today. Indeed, Aguilar said, the SEC itself is a case-study in how the regulatory mission is hampered by funding constraints.

“Currently, the SEC does not have the ability to self-fund, and this has harmed the agency’s ability to perform its mission in terms of long-range planning, developing necessary technology, and maintaining appropriate staffing levels,” he said. “In fact, the SEC has had to freeze needed hiring as the budget allocations failed to keep pace with year-to-year expense increases for existing staff.”

Ketchum, too, questioned the wisdom of breaking up the SEC, potentially harming its accumulated expertise and experience in overseeing the trading markets. “It would likely make the SEC a less effective regulator,” he said. He favored the notion of a systemic regulator, but said it would require a carefully crafted mandate to assure it could close current regulatory gaps without duplicating existing regulation.

As the regulatory framework is rebuilt, Ketchum said, corporate compliance officers can take an important lesson from the exercise: Companies should strive to draw a clear line between those who develop risky strategies and those charged with reining those people back in.

“You simply can’t have a situation where people who have fallen in love with the positions, or fallen in love with the strategy, analyzing the downside scenarios,” he said. Further, he said, companies should give compliance officers a heightened role in spotting stress points before a given risk leads to catastrophe.

Whatever the ultimate shape and form of future regulation, Aguilar said the days of deregulation and relying on free market forces to foster choice and competition are over.

“One thing that I don’t think anyone can have much faith in after this economic crisis is enlightened self interest,” he said. “The desire to earn a profit—or, as some would call it, greed—is a fantastic motivator and an engine for growth. But it doesn’t check itself or act in the public interest. In fact, it must be marshaled in the public interest.”