Sirri Outlines SEC's Systemic Risk Role and Lessons from CSE Program

As Congress considers creating a systemic risk regulator as part of a new financial services regulation structure, noted SEC Director of Trading and Markets Erik Sirri, the Commission is focusing on how best to deploy its broker-dealer expertise in the new regulatory paradigm. In testimony before the Senate Securities Subcommittee, he asked that the SEC’s regulatory expertise be recognized and deployed efficiently. He also listed some important lessons learned from the SEC’s supervision of investment banks under the Consolidated Supervised Entity (CSE) program.

For a set of large broker-dealer holding companies that are not affiliated with banks, he noted, the SEC supports a program that would permit the Commission to also set capital standards at the holding company level, perhaps, in consultation with a holding company regulator, if any. In addition, the director envisions that the SEC will obtain financial information about and examine the holding company and material affiliates.

These broker-dealer holding companies may also have an emergency liquidity provider, which would not be the SEC. But the SEC would determine the universe of broker-dealer holding companies that would be subject to parent company capital standards. The remaining broker-dealer holding companies not affiliated with banks would be subject to material affiliate reporting requirements, similar to the reporting regime under Section 17(h) of the Exchange Act.

Given the recent dialogue about systemic regulation, the director noted that the SEC’s experience with the bankruptcy filing of a foreign affiliate of Lehman Brothers demonstrated the innate difficulties of any multi jurisdictional approach to regulation. While cross border coordination is important, he said, jurisdictions nonetheless have unique bankruptcy and financial regulatory regimes. In addition, creditors wherever they are located will always act in their own interest during a crisis. Thus, a U.S. liquidity provider might be faced with the difficult choice of guaranteeing the assets of the holding company globally, or else risk creditors exercising their rights against foreign affiliates or foreign supervisors acting to protect the regulated subsidiaries in their jurisdictions, either of which could trigger bankruptcy of the holding company. The official described these as ``thorny issues’’ that Congress should consider carefully

He also testified that the Bear Stearns and Lehman Brothers' experience challenged a number of assumptions held by the SEC. Long before the CSE program existed, the SEC's supervision of investment banks recognized that capital is not synonymous with liquidity. A firm could be highly capitalized, that is, it can have far more assets than liabilities, while also having liquidity problems. While the ability of a securities firm to withstand market, credit, and other types of stress events is linked to the amount of its capital, he reasoned, the firm also needs sufficient liquid assets, such as cash and U.S. Treasury securities, that can be used as collateral to meet its financial obligations as they arise.

The CSE program built on this concept and required stress testing and substantial liquidity pools at the holding company to allow firms to continue to operate normally in stressed market environments. But what neither the CSE regulatory approach nor most existing regulatory models have taken into account was the possibility that secured funding, even that backed by U.S. Treasury securities, could become unavailable. The existing models for both commercial and investment banks are premised on the expectation that secured funding would be available in any market environment, albeit perhaps on less favorable terms than normal.

Thus, he pointed out that one lesson from the SEC's oversight of CSEs is that no parent company liquidity pool can withstand a run on the bank. Supervisors simply did not anticipate that a run-on-the-bank was indeed a real possibility for a well-capitalized securities firm with high quality assets to fund. Given that the liquidity pool was sized for the loss of unsecured funding for a year, such a liquidity pool would not suffice in an extended financial crisis of the magnitude now being experienced, he emphasized, where firms are taking significant write downs on what have become illiquid assets over several quarters while the economy contracts.

These liquidity constraints are exacerbated when clearing agencies seize sizable amounts of collateral or clearing deposits to protect themselves against intraday exposures to the firm. Thus, he said that, for financial institutions that rely on secured and unsecured funding for their business model, some modification, such as government backstop emergency liquidity support, may well be necessary to plug a liquidity gap on an interim basis, to guarantee assets over the longer term, or to provide a capital infusion.

Another lesson relates to the need for supervisory focus on the concentration of illiquid assets held by financial firms, particularly in entities other than a U.S. registered broker-dealer. Such monitoring is relatively straightforward with U.S. registered broker-dealers, which must disclose illiquid assets on a monthly basis in financial reports filed with their regulators. Also, registered U.S. broker-dealers must take capital charges on illiquid assets when computing net capital. As a result, illiquid assets often are held outside the registered U.S. broker-dealer in other legal entities within the consolidated entity. So, for the consolidated entity, supervisors must be well acquainted with the quality of assets on a group wide basis, monitor the amount of illiquid assets, and drill down on the relative quality of such illiquid assets.