In a speech before the Peterson Institute of International Economics, SEC Commissioner Kara M. Stein discussed several key areas where the SEC must play a critical role in addressing systemic risks.
Commissioner Stein acknowledged the seriousness of the fact that many substantive Dodd-Frank reforms have yet to be implemented, and that advancements on the systemic risk front have been generally mixed at best so far. However, she went on to point out what she saw as some successes: the FSOC is meeting regularly, the OFR is operational and has over 200 staffers monitoring and assessing threats to financial stability, the Volcker Rule is finalized, and the largest banks are submitting resolution plans.
Commissioner Stein remarked that the SEC must do better to identify and mitigate the buildup and transmission of risks that can “take down our entire financial system,” and offered the following suggestions for the SEC:
- think broadly and cooperatively with fellow regulators, both domestic and international;
- focus on improving the stability and resiliency of the short-term funding markets, including securities lending and repo agreements; and
- re-examine how the SEC evaluates capital, leverage, and liquidity within the financial institutions and funds it regulates.
As to her first recommendation, Commissioner Stein stated that the FSOC should be a starting point. She noted that the point of the FSOC was for regulators with expertise in particular areas to identify potential risks, and then enlist the help of the entire council to address them. The common purpose is to “make sure the foundation of our financial markets is strong so it can support a strong and thriving economy.” Commissioner Stein remarked that she fears the FSOC’s individual members are become bogged down in regulatory turf wars.
Regarding short-term funding markets, Commissioner Stein noted that the SEC is working hard on rules to prevent runs on money market funds, and that there have been a lot of discussions about capital, insurance, floating net asset values, redemption fees, gates, and restricting sponsor support. Commissioner Stein mentioned the SEC’s efforts to soon finish a money market fund rule, but cautioned the rule would only address part of the issues and some of the lenders. She further suggested that in order to create stability the regulators need to address the borrowers and the intermediaries.
On the subject of capital, leverage, and liquidity, Commissioner Stein urged the SEC to revisit and enhance some of its rules. The SEC, she noted, has historically had broad powers to regulate the financial responsibility of broker-dealers, but it has always viewed the regulation from the standpoint of investor or customer protection, not systemic risk. She further remarked that the goal of the SEC’s capital regime generally has been “somewhat agnostic as to the failure of the firm itself, focusing instead on ensuring the return of assets to the firm’s customers.” Given the systemic risks posed by some of the firms regulated by the SEC, Commissioner Stein urged the agency to revise its reasoning for imposing capital requirements to reflect not only its historical objective to protect a firm’s customers, but also reduce the risk to the entire financial system of a large broker-dealer’s collapse. She further encouraged the SEC to (i) reconsider what constitutes capital, (ii) require some meaningful minimum haircuts for all types of securities lending and repos, and (iii) recognize the importance of liquidity, among other things.
Commissioner Stein concluded by stating that all of these efforts “should not attempt to wring risk out of the capital markets, but [should] instead be focused on strengthening the fabric of our entire financial system.”
In this speech, Commissioner Stein establishes a position as the most vocal proponent of Dodd-Frank and, thereby, of imposing further substantial regulatory burdens on broker-dealers.
Commissioner Stein comes to the defense of the Financial Stability Oversight Council (“FSOC”), an agency that has been roundly criticized by Commissioners of both parties for overstepping its expertise. Commissioner Stein lends significant support to the notion that the FSOC might mandate capital regulation of private investment funds, saying: “We must also keep a close eye on other market participants that can cause . . . systemic shocks. In particular, we should closely monitor investment funds, such as large hedge funds, that may be highly levered and interconnected to other players in our financial markets.”
As to broker-dealers, Commissioner Stein expresses conservative views as to the way in which regulatory capital should be computed. She challenges the notion that “subordinated debt” should be considered “good” capital for regulatory purposes, describing it as “supposedly ‘sticky’ funding”. She also criticizes the SEC’s 2004 net capital rule changes that reduced capital haircuts for certain positions held by broker-dealers, and then goes on to say that these reduced “regulatory costs [were] ultimately accomplished at great cost to broker-dealers, investors, our economy, and American taxpayers.” This is an interesting conclusion, as there is no obvious link between the 2004 rule changes and the financial crisis, and the Commissioner does not draw one. If the goal of regulators is to force securities derivatives out of banks, then the 2004 capital changes (and more like them) are absolutely essential. Without them, it would be impossible to book derivatives into broker-dealers as well as into banks (essentially forcing U.S. financial institutions out of the business of being dealers). Lastly, Commissioner Stein advocates higher capital charges on broker-dealer financing businesses, such as margin lending, repurchase agreements, and securities lending.
The types of changes advocated by Commissioner Stein would significantly impede the ability of U.S. broker-dealers to act as intermediaries in credit and financing transactions, or would at least materially raise the costs imposed on broker-dealers engaged in such transactions.
If the Commissioner’s comments reflect the direction of future SEC regulation, financial market customers will face an altered landscape. Financial market customers, looking to the long term, will be forced to consider whether the securities financing markets can even continue in their current form or whether some substitution will be necessary, perhaps in the form of customer-to-customer financing or accessing overseas credit markets.