Securities Industry Perspectives on the Regulatory Reform Plan

By W. Bernard Mason

On July 17, 2009 the House Financial Services Committee heard from representatives of the securities industry regarding the issues raised by the Administration's regulatory reform plan. Appearing before the Committee were: Richard Baker, representing the Managed Funds Association; William Brodsky, representing the Chicago Board Options Exchange; Randy Snook, representing the Securities Industry and Financial Markets Association; Paul Stevens, representing the Investment Company Institute; Douglas Lowenstein, representing the Private Equity Council; Diahann Lassus, representing the Financial Planning Coalition; and Rob Nichols, representing the Financial Services Forum.

Rep. Paul Kanjorski (D -PA) chaired the Committee and began the hearing by mentioning a recent survey of investors that cited regulatory failure as the primary reason for their lack of confidence in the financial markets. He said he had advised SEC Chair Mary Shapiro earlier this week that the Commission must take bold and assertive action to strengthen enforcement. He said the Commission must also re-write the rules governing the industry to better protect investors. Additionally, he said Congress must update our security laws. He said Chairman Shapiro and the SEC's Inspector General have submitted legislative suggestions and the Administration's "white paper" and accompanying pieces of legislative language complement these suggestions, especially in the areas of hedge fund regulation and establishing a fiduciary duty for broker/dealers providing investment advice. Rep. Kanjorski said he is now developing legislation aimed at closing loopholes and stopping unscrupulous practices. Reform of credit rating agencies has a "top spot" on his agenda, as overly optimistic ratings played a significant role in the global crash.

Rep. Brad Sherman (D - CA), in his opening statement, indicated that he would be introducing legislation requiring the SEC to select the rating agency for a particular security issuance as an attempt to deal with the perceived conflict of interest created by issuer selection. Regarding custom, over-the-counter derivatives, he said these have been justified as a way to hedge legitimate risks, but he views the majority of these transactions as just "casino bets" where someone does not have a risk to hedge. He said this is a particular concern since Secretary Geithner told the Committee that he reserves the right to bail out derivatives issuers and their counterparties, so Mr. Sherman believes the federal government has an interest in restricting these instruments. Rep. Sherman says much higher capital requirements are needed for over-the-counter derivatives, and these instruments may be restricted to use only where a market instrument is not available. He said legislation should make clear that there will be no further government bailouts for these derivatives.

Rep. Randy Neugebaurer (R - TX) noted the witnesses' general agreement with the broad principles of the Administration's proposal on securities markets but he cautioned that the Congress must not take action that will put derivatives users at a competitive disadvantage and discourage businesses from properly hedging their risks. He warned that the government cannot micromanage markets to prevent future losses. Investors need to know that the responsibility rests with them and that government bailouts are not an option.

Mr. Baker, the first witness, provided a profile of the hedge fund industry by pointing out its total assets of $1.5 trillion under management make it significantly smaller than either the mutual fund industry or the banking industry and less likely to pose systemic risk. He further pointed out that many hedge funds use little or no leverage, further limiting their contribution to systemic risk. Nevertheless, he said his members have a shared interest in restoration of investor confidence and establishing a more stable and transparent marketplace. He believes this can be attained with a carefully constructed regulatory scheme and aided by adoption of industry "sound practices". He said this will require investors to do their own due diligence. He noted that SEC registration for fund advisors is a key regulatory reform. Mr. Baker said his organization supports efforts aimed at standardization and central clearing or exchange trading of OTC derivatives. However, he believes it is important for market participants to enter into customized contracts, assuming appropriate collateral is posted and adequately separated and protected. He said there should be a systemic risk regulator with key oversight of the system and with a clear mandate to protect the integrity of the financial system, not individual market participants.

Mr. Brodsky said he applauded the Administration's proposal on regulatory reform, and he believes the Congress should not squander the opportunity to design reforms that are long overdue. He believes the SEC/CFTC jurisdictional divide is dramatically antiquated. He said this bifurcation has had consistent negative consequences that we ignore at our peril. Consolidation of these two agencies is the only rational approach, he indicated. He said he applauded the Administration's proposal to create a regulatory council to oversee systemic risk.

Mr. Snook stated that establishment of a systemic risk regulator is the most important step in regulatory reform. He supports the Administration's proposal in this regard. He mirrored Mr. Baker's views with respect to regulatory oversight of derivative products.

Mr. Stevens said his organization fully supports the Administration's reform proposals, but has one concern regarding the plan to oversee systemic risk. He said his members have long subscribed to the notion of a council to oversee such issues and believes a diverse perspective is required. However, he is concerned that the council as proposed by the Administration would have only an advisory and consultative role. Vesting the authority with the Federal Reserve would strike the wrong balance. He would urge Congress to create a strong systemic risk council.

Mr Lowenstein said it is important for Congress to enact reforms, but speed should not be the goal. He stressed that private equity presents none of the factors listed in the Administration's proposal for identifying systemically important entities.

Ms. Lassus said her group was happy to see that the Administration's plan would hold broker/dealers to the same fiduciary standard as investment advisors. She said she further supported all the Administration's key principles for strengthening consumer protection.

Mr. Nichols said reform and modernization is needed and overdue. The current framework is outdated. In his view, the main deficiency with the current regulatory structure is its stovepipe structure that has led to two major problems that created the opportunity for and may have exacerbated the current crisis: gaps in the existing silos; and, no agency is responsible for systemic risks. He believes the cornerstone of reform is creation of a systemic risk supervisor. He said perhaps no factor is more regrettable than invoking the concept of "too big to fail", and it is important to establish an acceptable resolution mechanism to provide for failure of larger entities.

Rep. Kanjorski expressed his severe doubts regarding the appropriateness of designating the Federal Reserve as the systemic risk regulator. He is also concerned that "systemic risk" has not be adequately identified and defined. Mr. Stevens agreed that no one has clearly defined what "systemic risk" is. He said the Administration's criteria make specific application very uncertain.

Rep. Judy Biggert (R - IL) asked Mr. Baker his view on the proposal to establish a separate consumer agency. Mr. Baker said it is unclear to him how any such consumer agency or activity would relate to an entity regulated by either the SEC or the CFTC, and he would have to understand how that would work before he could take a position on the issue.