Friday, June 20, 2008

SEC Official Defends Regulation of Investment Banks; But Says Legislation Needed

In the wake of the collapse of Bear Stearns and in the face of calls for a market stability regulator, the SEC Director of Market Regulation Erik Sirri noted changes that the Commission has made to its consolidated supervised entity (CSE) regime for investment banks. In testimony before the Senate Securities Subcommittee, he said it was imperative that Congress legislate how and by whom large investment banks should be regulated and supervised. The testimony comes in a week in which Treasury Secretary Henry Paulson called on Congress to empower the Fed as the broad market stability regulator for investment banks.

Under the CSE program, the Commission supervises global securities firms on a group-wide basis. For such firms, the Commission oversees not only the U.S-registered broker-dealer, but also the consolidated entity, which may include foreign-registered broker-dealers and banks, as well as unregulated entities, such as derivatives dealers and the holding company itself. All of the CSEs are of potentially systemic importance since they trade a wide range of financial products, connected through counterparty relationships to other large institutions.

For example, the primary concern of the CSE program with regard to hedge funds revolves around the risks they potentially pose to the firms specifically and, through the CSEs, to the financial system. In his testimony, Mr. Sirri said that, in light of the Bear Stearns affair, the SEC has revised its analysis of the adequacy of capital and liquidity and is currently directing investment banks to do more stress testing at the holding company level. The SEC has also engaged both international and domestic regulators in a cooperative manner to provide information and to discuss the broader policy implications of these events.

The SEC has also enhanced liquidity requirements for CSE firms. In particular, the Commission is closely scrutinizing the secured funding activities of each CSE firm, with a view to encouraging the establishment of additional term funding arrangements and a reduction of dependency on open transactions, which must be renewed as often as daily.

The Commission is also focusing on the so-called matched book, a significant locus of secured funding activities within investment banks. The agency is closely monitoring potential mismatches between the asset side, where positions are financed for customers, and the liability side of the matched book, where positions are financed by other financial institutions and investors. Moreover, funding and liquidity information for all CSEs is being obtained on a daily basis.

Further, together with the Fed, the SEC has developed stress scenarios focused on shorter duration but more extreme events that entail a substantial loss of secured funding, which will be layered on top of the existing scenarios as a basis for sizing liquidity pool requirements. The Commission has also discussed with CSE senior management their longer-term funding plans, including plans for raising new capital by accessing the equity and long-term debt markets.
The senior official also pledged to continue to improve the SEC’s prudential oversight of capital, liquidity, and risk management at all CSEs in response to what was learned during the subprime crisis. The SEC staff will focus on practices related to valuation, stress testing, and accumulation of concentrated positions.

The director acknowledged that the Bear Stearns' experience has challenged a number of the SEC’s assumptions relating to the supervision of large and complex securities firms. The SEC is working with other regulators to ensure that the proper lessons are derived from these experiences, he said, and that changes are made to the relevant regulatory processes to reflect those lessons.

For example, the Fed is now a very key player since, after Bear Stearns, the investment banks have temporary access to the primary dealer's credit facility as a back-stop liquidity provider should circumstances require. Thus, the SEC is in frequent discussions with the Federal Reserve Bank of New York about the financial and liquidity positions of the investment banks and issues related to the use and potential use of the credit facility.

Moreover, the director noted that the SEC and the Fed are nearing completion of a formal Memorandum of Understanding providing an agreed-upon scope and mechanism for information sharing related to the credit facility, as well as other areas of overlapping regulation. Under the current statutory framework, he observed, no agency is charged with the stability of the financial system broadly. The MOU will provide one mechanism for two of the critical agencies with responsibilities in this area to gain a broader and continuous perspective on key financial institutions and markets that could impact the stability of the financial system.

The MOU will also provide a framework for bridging the period of time until Congress can address through legislation fundamental questions about the future of investment bank supervision, including which agency should have supervisory responsibility, what standards should apply to investment banks compared to other financial institutions, and whether investment banks should have access to an external liquidity provider under exigent conditions.