By James Hamilton, J.D., LL.M.
SEC Commissioner Annette Nazareth recently described the Commission’s approach to prudential regulation, which in her view means meeting regulatory obligations without one-size-fits-all requirements. It means more efficient regulation, she said, not less effective regulation. In remarks at a recent SIFMA compliance and legal conference in Phoenix, Nazareth explained that a prudential approach to regulation can serve more complex business models well, but rules-based regulations may be more effective for smaller firms.
The SEC has had to adopt a more prudential approach to regulating certain broker-dealers and their holding companies, according to Nazareth. She said the events involving Drexel Burnham helped lead the SEC to a more prudential approach for broker-dealer entities that are part of a complex financial conglomerate.
One initiative that followed the Drexel Burnham experience was the formation of the Derivatives Policy Group. This initiative was important because it gave the SEC its first comprehensive look at the securities firms’ off-balance sheet exposures, she said. It was also one of the first times the SEC responded to a topical issue in a manner other than rulemaking.
Nazareth said the best example to date of a prudential regulatory approach is the SEC’s Consolidated Supervised Entity program. She believes the success of the program is a preview of the direction that regulation should take in the future. The SEC has benefited from the program by gaining insights about subprime lending problems, energy trading operations, hedge fund derivative innovations and other evolving issues, she said.
The question is whether this approach could be applied more broadly throughout the SEC’s regulatory program, especially where it would benefit certain business models. Nazareth suggested one area in which it may apply is portfolio margining. She said that progress has been made to permit firms that can demonstrate that they have adequate procedures to manage the credit risk associated with portfolio margining to use self-regulatory organization models to calculate margin on a portfolio basis. One day, firms may be able to use their own proprietary models for portfolio margining, she said.
One-size-fits-all regulatory approaches are becoming outmoded, according to Nazareth. However, smaller firms with more traditional broker-dealer businesses may find rules-based regulations more efficient and effective than creating unique proprietary models. A prudential approach would require a large investment in internal controls and infrastructure that may be too burdensome for some firms, she said.