Crisis and Conflicts
Director, Office of International Affairs
U.S. Securities and Exchange Commission
Director, Office of International Affairs
U.S. Securities and Exchange Commission
International Centre for Financial Regulation
Third Annual International Regulatory Summit
Regulation and Policy Priorities: Growth, Stability and Sustainability
25-26 September, 2012
Thank you, Barbara (Ridpath), and thanks to the International Center for Financial Regulation for inviting me here today. Before I get into any substance, I should give the SEC’s standard disclaimer that these remarks are my own views and do not necessarily represent the views of the Securities and Exchange Commission or other members of the Commission staff.
When I was first told about the topic of the conference, "Growth, Stability and Sustainability," I was intrigued by the combination of several seemingly mutually exclusive concepts; a "we can have it all" approach befitting election year campaigning in the United States, but perhaps problematic in real-life.
But upon reflection, this trinity makes sense. We are right now still recovering from the worst financial crisis since the 1920s and 30s. Financial instability has depressed economic growth around the world – just as in the 1920s and 30s. And recent labor reports in the United States and economic growth reports in Europe and Asia suggest that economic growth is not enough. It is about stable and sustainable economic growth. After several years of global economic weakness, with high and persistent unemployment, it is no comfort to the millions of unemployed workers that many countries are no longer technically in a recession. We may have growth, but if you can’t count on the source of your next paycheck, or even whether there will be a next paycheck, life is very unstable.
Growth, Sustainability and Stability and Capital Markets
Global prosperity depends of on economic growth and we know from history that financial markets are essential to that growth. This is a truism. But that doesn’t lessen the importance of the corollary that a return to economic growth depends on a strong financial market.
As for "sustainability," it is a term we hear overused quite a bit these days – calling into question its meaning. The meaning of sustainability in the context of a limited but renewable resource is clear: Don’t cut down a forest faster than new trees can grow; don’t continually plant the same crop on the same land lest you deplete the soil’s nutrients. But what "sustainability" means in the context of a market is less clear. Financial markets have seen bubbles and resulting financial crises on a periodic, very unpleasant, yet quite sustainable basis for almost 300 years now. A fan of economists such as Schumpeter or Minsky might even suggest that it is these very financial crises that correct for market over-exuberance and make financial markets sustainable.
As for "stability," for those of us involved in the financial markets, it is one of the most common terms we hear these days. Following the financial crisis, we saw the creation of the Financial Stability Board and the formation of the Financial Stability Oversight Council in the United States and the European Financial Stability Facility. The US Treasury Department even formed a new webpage, financialstability-dot-gov. The 2008 financial crisis has been defined as a crisis of instability – as if any fraud, poorly designed incentive structures, regulatory holes, and macro-economic structural problems were fundamentally problems because they introduce instability to the system, like a restaurant table with one of its legs a bit too short. And if only we could wedge a folded up supervisory napkin under that leg, in the form of better prudential controls and greater capital requirements, the system would be "stable." As you may have guessed, I don’t agree with that view.
Risk Avoidance and Risk Promotion
It’s true that the 2008 financial crisis was fundamentally a banking crisis. And the fears that keep banking supervisors up at night are fears of instability – bank runs and contagion, and the inherent maturity mismatch between banking assets and liabilities. However, the financial system is more than just the banking system. In our rush to prevent another banking crisis, the banking system has become the lens through which the entire financial system is viewed. And improving "financial stability" has come to mean porting traditional banking supervisory concepts over into other areas of the financial system, often in ways for which they are ill-suited and possibly quite harmful.
We can already see the effects on the broader economy. Banking supervision is, at its heart, about managing risk. The recent financial crisis shows what happens when banks, and entities engaging in bank-like behavior, take on excessive risk. So it’s natural that banking supervisors will want to oversee bank risk and monitor bank capital. After all, banks are often investing insured deposits, sometimes in illiquid assets. Catastrophe is always just around the corner if depositors lose faith in the banking system and collectively withdraw their assets.
Faith in the system is also critical to our capital markets, but it is always a very different sort of faith. For financial markets, some degree of instability has to be assumed. After all, economic growth is predicated on risk-taking, of some sort or another. A new company founded, a new product line launched, a new factory built always involves risk. And to paraphrase the guys on an American TV show called "Mythbusters," risk implies that failure is always an option.
Of course, banks and banking supervisors know that risk implies potential failure. They also recognize the risks this poses to the financial system – the "instability" it produces. But the effects of risk are quite different where capital markets are concerned. Capital markets qua markets – and by this I mean real capital markets, not banking activity masquerading as capital market activity – assume this risk and distribute it according to risk tolerance. While we all know that a run on a money market fund may look very much like a bank run, investor panic, by itself, does not necessarily affect the viability of, say, a mutual fund or a broker-dealer the way it would a bank. Where properly regulated, segregated investor assets are liquidated, and investors assume their losses. Capital may become dearer as a result, but there is no systemic contagion the way there is with a bank run. Investor assets may be insured against broker-dealer operational risk, but investors bear the market risk of their investments themselves – a fact of which they are aware.
Market Integrity, Information Asymmetry and Conflicts of Interest
As a consequence, capital markets play a very different role in our financial markets. Capital markets – and by this I mean both the public and private markets – are places where the large risks are financed. Failure is commonplace and accounted for in the cost of raising capital. Consequently, the issue that keeps securities regulators up at night isn’t necessarily contagion in the banking sense – where concerns about the solvency of one firm leads to a run on otherwise solvent firms everyone, creating a self-fulfilling prophecy of bank failures. It’s not concern about faith in the stability of the system, where stability means solvency and capital adequacy. Rather, what keeps us securities regulators up at night are fears about a widespread loss of faith in the integrity of the market – that is, a loss of investor confidence. Investor confidence in a market’s integrity is central to the integrity of the overarching financial system, but integrity and investor confidence mean very different things to a securities regulator than financial market integrity might mean for a banking supervisory. Risk, itself, is not necessarily a problem. It’s not so much that investors might fear that a particular issuer isn’t as healthy as they previously thought. It’s not so much that investors don’t happen to be winning. That occurs every day. No, the problems arise when investors begin to think that the market is a rigged game that they cannot win.
For securities regulators, this is systemic risk, and it’s a type of system risk that the normal tools of banking supervision do not address. The problems that we have seen in our capital markets as a result of the financial crisis fall squarely into this category. Many banks around the world were certainly under-capitalized and making risky investments without acknowledging or perhaps even understanding the risks they were taking. But investor losses were different. In many cases, investors either weren’t informed about critical information regarding securities they were investing in, or they were not aware of – and in some cases could not be aware of – underlying conflicts of interest that would have an impact on the performance of their investments.
Regulators need to refocus on conflicts of interest and information asymmetries facing all market participants, rather than imposing a banking supervisory approach to regulation of markets and market intermediaries ill-suited to such a model. In doing so, we will rebuild investor confidence, to the benefit of issuers and investors alike. Fortunately, securities regulators have tools at their disposal to address information asymmetry. Indeed, where problems potentially might arise from a lack of critical information, securities regulators have nearly 80 years of experience in devising disclosure requirements to address them. Not only are the disclosure requirements in a major market such as the United States’ extensive, but there exists an overarching regulatory principle in the form of something like the SEC’s Rule 10b-5 that acts as a catchall to cover contingencies that investors and regulators might not yet imagine.
Rule 10b-5 plays a critical component in the vast majority of SEC enforcement cases and is at the heart of the SEC’s oversight of issuers and markets. As regulators go, it is a model of simplicity. It says – and I am paraphrasing the entire rule minimally:
Rule 10b-5 applies in the US to both the public and private markets. And when you combine it with the SEC’s mandatory initial and ongoing disclosure requirements for publicly traded securities, and the sophistication requirements for actors involved in the US private markets, "information asymmetries" between buyers and sellers is not so great today as to pose a serious risk to market integrity. This does not mean that fraud doesn’t exist – and, as we saw with Enron, Bernie Madoff and others, information asymmetries as a result of fraud are a serious threat to the integrity of any market. But this is fraud, and a violation of existing laws and rules. These threats have to be addressed with better detection and deterrence.
The Crisis, Conflicts and Controls
By contrast, what we have seen arising out of the recent financial crisis often had less to do with lack of disclosure about critical information regarding a given security or issuer, and more to do with conflicts of interest among key market participants. We saw accusations of just these kinds of conflicts of interest with credit rating agencies and asset-backed security originators "rating shopping" to get higher credit ratings; with mortgage brokers, who got paid by the number of mortgages they arranged, regardless of the credit quality of those taking out the mortgages. We saw these accusations with banks and ABS originators themselves, who lent money for mortgages which were then packaged into asset-backed securities in such a way that the banks and originators had no incentive to police the quality of those mortgages. And we have seen accusations of such conflicts of interest in the way employees of banks are compensated, where big, highly leveraged bets that pay off in the short term are heavily rewarded, regardless of the risks they pose to the firm over the medium and long-term.
Of course, these types of conflicts of interest are hardly new – even if the exact form of the conflict of interest may be. Given that conflicts of interest are endemic to any market, disclosure itself has often proven to be the best tool to combat the problems created by these conflicts. But disclosure itself is not always enough. We have seen lots of new conflicts of interest over the past decade or so – the use of special purpose entities with pernicious effects on the incentives management of an issuer face, interlocking chains of market participants involved in designing, marketing and selling a particular security; the increasing reliance by retail investors on institutional investors when participating in the market, etc. They all have translated into a landscape of conflicts of interest that evolves too fast and involves so many permutations that, in order to address them, disclosure requirements alone would either have to be so extensive that even professional investors could not read through and understand them all, or else so broad that they would lose their usefulness.
We all recognize the problem in one form or another, and we can see how regulators have tried to grapple with this problem over the past decade. After Enron, we required new disclosures and new checks on the auditing system. We prohibited some kinds of clearly conflicted relationships, such as public audit firms providing consulting services to their audit clients. Following the recent crisis, we have developed a raft of new requirements for market participants, designed to limit or manage the conflicts of interest that led to the financial meltdown.
But, to some degree, all of these efforts are an attempt to close the barn doors after the horses have fled. As the old saying goes, it’s tough to make predictions, especially about the future. But I will offer one up here – the next financial crisis will not involve the same conflicts of interest as this last one, anymore than this last one.
Because we are always going to be playing catch-up, I suggest we change tack and approach conflicts of interest with the simplicity that we approach the disclosure of material information. And by that, I mean through a principle similar to Rule 10b-5. In other words, rather than trying, to nail down every potential conflict of interest and develop a formal policy towards it – prohibit it, disclose it, or manage it in some way – we shift the onus into the relevant market participants themselves. If a market participant involved in selling, buying, underwriting, or arranging securities on behalf of others, should have an obligation to identify conflicts of interest that might affect their relationship with clients or customers, and address them in an adequate manner.
This might be through disclosure. It might be through other means. But the obligation would be the market participant’s. Because this would be a principle-based rule like 10b-5 rather than a check-the-box style rule, if a conflict later appears that the market participant should have recognized and should have addressed, the regulator can take appropriate action. And it could take this action without necessarily having to identify the conflict before the conflict becomes a problem, in much the same way that a regulator such as the SEC doesn’t necessarily have to identify every form of mistruth before bringing an enforcement action under Rule 10b-5.
Of course, Rule 10b-5, in some cases, already captures some common conflicts of interest, since issuers, in particular, must disclose material information about the securities they are selling and known conflicts of interest clearly fall under these disclosure requirements. But issuers are not the only market participants facing dangerous conflicts of interest. As the past few decades have shown, such conflicts are rife throughout the market – and arguably, some cases unavoidable. But even where unavoidable, they need to be identified and addressed, in one form or another.
As part of the Commission’s Technical Assistance Program, my office works with a range of different governments. We advise them that their capital markets are necessary for sustainable economic growth and that these markets are distinct from credit markets. The formula for success in designing a capital market requires attention to information asymmetry and conflicts of interest. We also warn them against regulating capital markets in the interest of banks – to the detriment of market finance for the benefit of operating companies. Developed economics would do well to heed the same advice.