The following remarks were delivered by Commissioner Kara M. Stein of the U.S. Securities and Exchange Commission before the Peterson Institute for International Economics on June 12, 2014. A copy of the speech is also available here.
Thank you, Adam, for the kind introduction. I also would like to thank the Peterson Institute for International Economics for hosting me today.
I, like all of you in this room, believe we need to have strong, vibrant capital markets if we want to have a healthy, job-creating economy. Our capital markets must be built on a foundation that is strong enough to withstand the next storm. During the Great Recession, we started a discussion about how to help insulate us when the next crisis comes.
The next financial crisis may come from any direction. My job is to help figure out where the next crisis may come from, and how to minimize the damage it would cause. That means we must identify systemic risks and mitigate them. Today, we have convened to continue this conversation and discuss what the SEC can do to better prevent the buildup and transmission of risks that can take down our entire financial system.
I’m going to begin our discussion today with a quick reminder of how we got here. And then, I’m going to focus on the three key areas where the SEC can play a critical role in addressing systemic risks. First, we need to step outside of our silo and think broadly and cooperatively with our fellow regulators, both domestic and international. Second, we need to focus on improving the stability and resiliency of the short-term funding markets, including securities lending and repurchase agreements (repo). Third, we need to re-examine how we evaluate capital, leverage, and liquidity within the financial institutions and funds we regulate.
With the financial crisis in the rear view mirror, many forget the forces that converged in 2007. Some even deny the impact of the recession, optimistically viewing our financial markets and our economy as inoculated from a virus that spread quickly and wreaked havoc on a global economy. Yet, studies demonstrate that the Great Recession continues to affect both attitudes and behaviors. A recent survey found that the generation entering the workforce now – the Millennials, who are 21 to 36 years old – have the same fiscally conservative views as the generation that exited the Great Depression. Millennials are skeptical of the financial markets and long-term investing, yet we increasingly depend on them to invest and drive our economy.
I, too, am crisis-scarred. And I share a dream with these Millennials. I dream of never facing another financial crisis. I want to do my part to avoid ever having to face another one. The events of 2008 are indelibly etched into my memory. In 2008, while I was working for Senator Jack Reed, our country’s economic leaders began closed-door briefings with members of Congress. Concerned about the unfolding financial crisis, the Chair of the Federal Reserve and the Secretary of Treasury pleaded for help and for an unprecedented financial intervention to stave off another Great Depression. They wanted tools to protect our Nation from an invisible force that came to be known as systemic risk. A comprehensive strategy was developed to stabilize our economy and unlock the credit markets in order to save our financial system.
Those were scary days, with millions of American jobs, and billions of dollars on the line. Huge policy choices had to be made with imperfect information, with consequences that would shape the world’s economy for years to come.
Many of you, like me, were doing everything you could to help. And we accomplished a lot. The Congressional battle over the Troubled Asset Relief Program (TARP) tends to be what people remember the most. I certainly remember looking at a streamlined, three-page document authorizing the expenditure of several hundred billions of taxpayer dollars—with almost no strings attached. One doesn’t soon forget that.
And policymakers had to make monumental decisions within a matter of days.
TARP was just one small part of the picture. We also had to deal with frozen funding markets. Financial institutions were struggling to meet their daily obligations; and overnight rates jumped from one day to the next. Ultimately, it appeared that no bank wanted to do business with another. And so, the lender of last resort had to step in. The Federal Reserve eased its rules, expanding the ability of firms to tap the discount window, and created several unprecedented programs to support the largest financial institutions.
To help borrowers and investors in the credit markets – markets, that the SEC largely oversees – the Federal Reserve also created a slew of programs to support the commercial paper markets, money market mutual funds, and asset-backed securities. Trillions of dollars were pumped into our credit markets. The SEC didn’t have the authority, or the money, to do it. But the markets and the institutions we oversee were saved by these efforts.
Shortly thereafter, Congress began to work on what would ultimately become the Dodd-Frank Wall Street Reform and Consumer Protection Act. My colleagues and I spent thousands of hours researching the causes of the crisis and figuring out how to address them. Then, just after five a.m. one Friday morning, we were done. The finished product was the most comprehensive piece of financial legislation since the Great Depression. It contained several important substantive reforms to address systemic risks.
It restored regulatory oversight of the derivatives markets, which had played a huge role in AIG’s collapse and provided the kindling for the brewing financial firestorm. It restricted banks’ ability to engage in proprietary trading, which had magnified banks’ losses during the crisis. And it prescribed new rules for asset-backed securities, and the mortgages that went into them, which were at the heart of the crisis.
The Dodd-Frank Act also created a council of regulators, the Financial Stability Oversight Council (or FSOC), to identify and address systemic risks. And it created a new research group, the Office of Financial Research (OFR) to help. The point was to break down regulatory silos and encourage all of our regulators to engage in some lateral thinking.
Next month will mark four years since the enactment of the Dodd-Frank Act, and I think it’s fair to ask how we’re doing on the systemic risk front. To put it charitably, I’ll say the answer is mixed.
We have made some headway. The FSOC is meeting regularly, and the OFR is up and running, with over 200 staffers monitoring and assessing threats to financial stability. The Volcker Rule is now final – a critical step forward in improving financial stability. And the largest banks are submitting resolution plans to ensure that they don’t collapse in a disorderly mess.
Unfortunately, however, far too many of the substantive reforms mandated by the Dodd-Frank Act are not yet implemented. Derivatives reforms, for example, are in legal limbo at the CFTC, and the SEC still has a long way to go. Credit rating agency reforms remain to be done. The controversial swaps “push out” provision hasn’t gotten off the ground. The mortgage rules on risk retention aren’t finished. And rules to ensure that bank executives don’t have pay packages that encourage excessive risk-taking haven’t been completed. Many of the most important systemic risk reforms of the Dodd-Frank Act just aren’t done. We need to finish these rules now; we cannot afford to wait.
However, finishing our Dodd-Frank Act rules, which largely address the last financial crisis, won’t extinguish our responsibility to address new and emerging systemic risks. We need to continue to work with our fellow regulators around the world to identify and address systemic risks in whatever form they arise.
Within the United States, this discussion should start with the FSOC. I’ve been pleased to see the hard work and dedication of this Council, including their must-read annual reports. I’m disappointed, however, to see that the FSOC suffers from much more squabbling among regulators than it should. 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 intention was to get each regulator to become more resourceful and start thinking in new and different ways. While some of that may be happening, in other cases, members of the FSOC are merely trying to dictate to, or control, regulators with primary jurisdiction over certain areas. The FSOC needs to come together as a team to focus and provide mutual support. And, I fear that individual members defending their territorial jurisdiction detracts from the FSOC’s critical mission to promote financial stability.
As a Commissioner at the Securities and Exchange Commission, I see a staff every day that has deep expertise and understanding of the capital markets. They are the best in the country at what they do. If the FSOC is going to be successful, it must take advantage of that expertise. At the same time, the Commission needs to welcome and benefit from the fresh eyes and different ways of thinking that can come from other regulators.
It is disturbing that members of Congress and reporters have been inquiring about the level of cooperation between the SEC and the OFR regarding a report on potential sources of systemic risk. We should all be above this. The FSOC’s mission is far too important to be bogged down in a regulatory turf war. We all share a common purpose: to make sure the foundation of our financial markets is strong so it can support a strong and thriving economy.
Although systemic risk has not traditionally been a focus of the SEC, it is now. And we need to embrace that mission and that responsibility. Without a doubt, firms and markets we regulate contribute to systemic risks in a number of ways. We need to do more on this front, and we need our fellow regulators’ help.
Unfortunately, at times, the dialogue has not been particularly helpful. For example, consider the term that some regulators use to describe our capital markets: “shadow banking.” It paints a picture of shady activities taking place under cover of darkness and outside of view. This is a misnomer. Banking regulators may not have focused on some of these activities much in the past, but I can assure you that the SEC and others have been paying close attention to the funding markets for decades.
What’s more, some tend to suggest that these markets are unregulated. Again, this is a misnomer. While the primary regulators of these markets, including the Commission, need to enhance oversight, and revise rules, it cannot be said that nothing has been done.
If you strip away the inflammatory language, however, and focus on the substance, there is a lot of potential for progress – which brings me to my second point: short-term funding markets.
The short-term funding markets are large and interconnected. The collapse of these markets during the crisis was profound. Money market funds experienced runs. The commercial paper markets dried up. Securitizations and conduits stopped completely in their tracks. And firms suddenly demanded more and better collateral to support securities lending and repos.
Our short-term funding markets have their benefits. Money market funds and other investors can purchase short-term funding obligations and make higher returns, and broker-dealers can fund their positions very cheaply with high-quality collateral. At the same time, short-term funding for long-term obligations can create serious problems.
What happens if I use a credit card to buy a car? Well, if I get an introductory rate of zero percent, this sounds like a good deal. But if the zero percent rate spikes after twelve months to 25 percent, then I’ve got a problem. Our short-term wholesale funding markets are not that different. Except, unlike my credit card, I don’t know when the interest rate may spike, or if my lender might demand full repayment.
Ultimately, an over reliance on short-term funding may accelerate credit supply and asset price increases in the good times, but it may also accelerate precipitous declines in asset prices and credit in the bad. The Commission is working hard on rules to prevent runs on money market funds, and I think everyone wants to get it right. There have been a lot of discussions about capital, insurance, floating net asset values, redemption fees, gates, and restricting sponsor support. Each tool has its pros and cons.
For example, if there are fees and gates, couldn’t this trigger pre-emptive runs by investors that otherwise would not have occurred? Or will fees and gates reduce run risk? We have seen arguments by very sophisticated firms and economists on both sides. In short, is it more likely (1) that fees and gates can cause, or exacerbate, a crisis; or (2) that fees and gates can actually prevent or stop one?
And what happens to the borrowers when the money fund providing their short-term financing slams its gate down? Will the money fund decline to renew their repo arrangement? Does that impact, not just that borrower, but the rest of the short-term lending market, or the entire financial system? In an industry this important to our financial system, we should be very confident in the answers to these questions before moving forward.
And while I hope we’re able to finish a rule soon, a money market fund rule would only address part of the issues. It would only address some of the lenders. We also need to address the borrowers and the intermediaries.
The Federal Reserve Bank of New York and others, including the SEC, have been making a lot of progress. For example, the clearing banks’ intra-day credit exposures in the tri-party repo market have been dramatically reduced. The Financial Stability Board’s Workstream on Securities Lending and Repos has also been putting forward some great ideas, including collecting more data, enhancing disclosures, and imposing meaningful discounts.
Borrowers who rely on short-term funding should be required to disclose to their investors the relative maturities of their obligations. If a borrower becomes too dependent on short-term funding, its lenders may demand more collateral, higher interest, or restrict their access to funding altogether. This is how efficient markets should work.
As for my last topic, capital, leverage, and liquidity, I think we need to revisit and enhance some of the Commission’s rules. But, before I talk about some of my suggestions for potential improvements, I first want to define what we’re talking about. Capital is, generally speaking, the amount of sticky funding for a firm, which can be used to absorb losses. Contrary to some commenters, capital is not a reserve of assets, like a savings account, stored for a rainy day. Capital is merely a source of funding.
The purest forms of capital are equity shareholder contributions, and retained earnings. They have the most loss-absorption capacity. Yet, over time, other supposedly “sticky” funding, such as subordinated debt from an affiliate, have been allowed as capital by some regulators, including the SEC.
Because I assume most of you are not SEC historians, let me take a moment to talk about the SEC’s historical approach to capital. Since the 1930s, the SEC has had broad powers to regulate the financial responsibility of broker-dealers, which we have always considered from the standpoint of investor or customer protection, not systemic risk.
Today, the Commission’s primary capital requirements for broker-dealers come from Securities Act Rule 15c3-1, commonly known as the “net capital” rule.  That rule generally requires broker-dealers to value their securities at market prices, and apply discounts to those values based on each security’s perceived risk. These values, after the discounts (or haircuts), are then used to compute the liquidation value of a broker-dealer’s assets.
The general goal is to ensure that a broker-dealer holds enough in liquid assets to pay all of its non-subordinated liabilities, while still being able to meet its obligations to customers. The focus has been on providing adequate time for the firm to liquidate in an orderly fashion without the need for a formal proceeding or financial assistance from the Securities Investor Protection Corporation (or SIPC).
By contrast, prudential regulators have long relied on capital and leverage restrictions to actually prevent a firm’s failure. That is not generally the goal of the SEC’s capital regime. Rather, the SEC’s capital regime has historically been somewhat agnostic as to the failure of the firm itself, focusing instead on ensuring the return of assets to the firm’s customers. This disparity in historical objectives may be part of the confusion. I say historical, because I believe that the SEC should consider whether it, too, should be focused on preventing the collateral impact of the collapse of a systemically significant firm. Given the systemic risks posed by some of the firms we regulate, I think it’s about time for the SEC to revise its reasoning for imposing capital requirements to reflect not only our 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.
What’s more, in 2004, the SEC amended its net capital rule to establish a new method for calculating capital for the very largest broker-dealers. The change, which was in line with Basel expectations of the time, allowed the largest firms to rely more on their own modeling, including value-at-risk (“VaR”) and scenario analyses. And the Commission, like other regulators, set up a few – and arguably not enough – requirements for those models.
So, when we let broker-dealers use their own models, what do you think happened? You guessed it. The models led to less capital. In fact, even when it adopted this alternative net capital regime ten years ago, the Commission noted that – quote – “[a] broker-dealer’s deductions for market and credit risk probably will be lower under the alternative method of computing net capital than under the standard net capital rule.” In return for exempting these large broker-dealers from the established calculation method, their holding company had to acquiesce to Commission supervision.
Why would the SEC do this after sixty years of effective capital regulation? The adopting release stated it pretty clearly: to “reduce regulatory costs for broker-dealers.” But reducing these regulatory costs was ultimately accomplished at great cost to broker-dealers, investors, our economy, and American taxpayers. While the SEC may have been agnostic as to whether its regulations should help prevent a large firm’s collapse in the past, we cannot afford to be agnostic now.
As part of our analysis, we should also think anew about what constitutes capital. While the SEC has recognized that “net capital … should be permanent capital and not merely a temporary infusion of funds from an affiliate or other sources,” we also have historically allowed subordinated debt from an affiliate to count as capital. Given the needed shift as to why we require capital, we should consider whether it is still appropriate to do so. Considering what we know now, the current treatment is quite troubling. Counterparties to a broker-dealer may cease to do business with it, or significantly alter the terms, if they learn that the broker-dealer is undercapitalized or otherwise in financial distress. Their concerns are not likely to be assuaged by debt provided by the broker-dealer’s affiliate. Why? Mainly because counterparties would likely want to avoid legal disputes over repayment priorities, particularly after the last crisis. If that’s the case, then the broker-dealer’s compliance with our net capital rule may still leave it at risk of a run. This, of course, can create a liquidity crunch that threatens not only the broker-dealer’s viability, but that, in turn, threatens the viability of others firms, creating contagion that can spread quickly to other parts of the financial markets.
In the same vein, it’s past time to require some meaningful minimum haircuts for all types of securities lending and repos in our net capital regime. It simply doesn’t make sense to argue that even high quality assets have zero risk. This defies lessons learned from the recent financial crisis and basic principles of finance. Yet, the current rules allow that. We need to address the stability and resiliency of our short-term funding markets comprehensively, and I hope you will join me in the effort.
To be clear, this is not just about capital. It is also about liquidity. If a firm doesn’t have enough liquid assets to meet its obligations to counterparties, then solvency is not the only issue. Even if a firm remains solvent, that doesn’t mean that it has adequate liquidity to weather a financial storm. To put it bluntly, the collapse of Lehman Brothers was at least as much a liquidity problem, as a capital one. And it affected many other players in the market, and around the world.
We also must keep a close eye on other market participants that can cause and transmit 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. The risks posed to our financial system by these funds are not new. But they are constantly evolving. The SEC, as the primary regulator over the advisers to these funds, should be monitoring these risks closely, along with our fellow regulators. While data contained in Form PF should help in this effort, we should also be eager to ensure that all our regulators have the data needed to identify and understand these major market participants and the roles they play. And if we determine that additional measures are necessary to mitigate systemic risks posed by the largest participants, we should adopt them.
The SEC needs to examine its capital, leverage, and liquidity requirements, and modernize them to reflect the current funding ecosystem and our post-crisis understanding of systemic risks.
I’ve been with the Commission for a little less than a year. And we’ve done quite a bit in that time. But, in my view, the SEC can, and must, play a much larger role in addressing systemic risks. We need to be working more closely and effectively with the FSOC and OFR. We need to be improving the stability and resilience of the short-term funding markets. And we need to update and enhance our approaches to capital, leverage, and liquidity for our largest firms and funds. These efforts should not attempt to wring risk out of the capital markets, but we should instead be focused on strengthening the fabric of our entire financial system.
In many respects, considering systemic risk is new territory for the Commission. But I believe we will be up to the task. And I will rely on all of you to keep us accountable. We all have a vested interest in the outcome.
 UBS Financial Services Inc., Investor Watch Q1 2014, Think you know the Next Gen investor? Think again, (2014), available at http://www.ubs.com/us/en/wealth/news/wealth-management-americas-news.html/en/2014/01/27/ubs-investor-watch-report-reveals-millennials.html.
 See, e.g., the Term Auction Facility (TAF), Primary Dealer Credit Facility (PDCF), and the Term Securities Lending Facility (TSLF). For descriptions of these programs, see, http://www.federalreserve.gov/newsevents/reform_taf.htm (reflecting $3.8 trillion in TAF loans), http://www.federalreserve.gov/newsevents/reform_pdcf.htm (for PDCF, reflecting $8.951 trillion in PDCF loans), and http://www.federalreserve.gov/newsevents/reform_tslf.htm (reflecting $2.319 trillion in TSLF loans, market value).
 See, e.g., Commercial Paper Funding Facility (CPFF), Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), Money Market Investor Funding Facility, and the Term Asset-Backed Securities Loan Facility (TALF). For descriptions of these programs, see http://www.federalreserve.gov/newsevents/reform_cpff.htm (reflecting $739 billion in CPFF loans and $738 billion in purchases of commercial paper), http://www.federalreserve.gov/newsevents/reform_amlf.htm (reflecting $217 billion in AMLF loans), http://www.federalreserve.gov/newsevents/reform_mmiff.htm (reflecting $0 in total loans as the MMIF facility was never used), and http://www.federalreserve.gov/newsevents/reform_talf.htm (reflecting $71.1 billion in TALF loans).
 Section 10B of the Federal Reserve Act provides the Reserve Banks with broad authority to extend credit to financial institutions. The Federal Reserve authorized most of the programs under its emergency authority contained in Section 13(3) of the Federal Reserve Act, which has been significantly modified by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“DFA”). See DFA § 1101, Pub. L. 111–203 (2010).
 DFA § 112, Pub. L. 111–203 (2010).
 Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 79 Fed. Reg. 5535 (Jan. 31, 2014).
 See, e.g., Title I and IDI Resolution Plans, (publishing the public portions of required plans) available at http://www.fdic.gov/regulations/reform/resplans/.
 Sec. Indus. and Fin. Mkts. Ass’n., et al. v. U.S. Commodity Futures Trading Comm’n, No. 13 Civ. 1916 (D.D.C. filed Dec. 4, 2013).
 Over the nearly four years since the enactment of Title VII, the SEC has proposed a number of implementing rules. See, e.g., Conflicts of Interest Involving Security-Based Swaps, proposed 75 FR 65882 (Oct. 26, 2010); Prohibition Against Fraud, Manipulation, and Deception in Connection with Security-Based Swaps, proposed 75 FR 68560 (Nov. 8, 2010); Security-Based Swap Reporting and Dissemination and Obligations of Security-Based Swap Repositories, proposed 75 FR 75208 (Dec. 2, 2010); Mandatory Clearing of Security-Based Swaps, proposed 75 FR 82490 (Dec. 30, 2010); End-User Exception to Mandatory Clearing of Security-Based Swaps, proposed 75 FR 79992 (Dec. 21, 2010); Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants, proposed 76 FR 42396 (July 18, 2011); Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, proposed 76 FR 65784 (Oct. 24, 2011); Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants, proposed 77 FR 70214 (Nov. 23, 2012); Application of Title VII in the Cross Border Context, proposed 78 FR 30968 (May 23, 2013); and Recordkeeping, reporting and notification requirements for Security-based Swap Dealers and Major Security-Based Swap Participants, proposed 79 FR 25194 (May 2, 2014). However, the SEC has not yet finalized the vast majority of the Title VII provisions. Further, the SEC has delayed the application of most of the provisions of the federal securities laws to security-based swaps until February 11, 2017. See Extension of Exemptions for Security-Based Swaps, 79 Fed. Reg. 7570 (Feb. 10, 2014). Given the nature and extent of the remaining Title VII rulemakings, the timeline for finalizing these rules is unclear.
 See Title IX, Subtitle C of DFA, Pub. L. 111–203 (2010) (notice of proposed rulemaking published in Federal Register on June 8, 2011).
 See 15 USC 8305 (added by DFA § 716, Pub. L. 111–203 (2010).
 See 15 U.S.C. § 78o-11 (added by DFA § 941, Pub. L. 111–203 (2010)) (joint notice of proposed rulemaking published in Federal Register on April 29, 2011).
 See 12 U.S.C. § 5641 (added by DFA § 956, Pub. L. 111-203 (2010)) (joint notice of proposed rulemaking published in Federal Register on April 14, 2011).
 See, e.g., Financial Stability Board, Strengthening Oversight and Regulation of Shadow Banking: Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, ii (2013) (“But whereas banks are subject to a well-developed system of prudential regulation and other safeguards, the shadow banking system is typically subject to less stringent, or no, oversight arrangements.”) available at http://www.financialstabilityboard.org/publications/r_130829b.pdf.
 See Id.
 See, e.g., Basel Committee on Banking Supervision, Bank for International Settlements, Instruments Eligible for Inclusion in Tier 1 Capital, (1998) (“[T]he Committee reaffirms that common shareholders’ funds, i.e. common stock and disclosed reserves or retained earnings, are the key element of capital. Common shareholders’ funds allow a bank to absorb losses on an ongoing basis and are permanently available for this purpose. Further, this element of capital best allows banks to conserve resources when they are under stress because it provides a bank with full discretion as to the amount and timing of distributions. Consequently, common shareholders’ funds are the basis on which most market judgments of capital adequacy are made. The voting rights attached to common stock also provide an important source of market discipline over a bank’s management. For these reasons, voting common shareholders’ equity and the disclosed reserves or retained earnings that accrue to the shareholders’ benefit should be the predominant form of a bank’s Tier 1 capital.”), available at http://www.bis.org/press/p981027.htm.
 17 CFR 240.15c3-1, Net capital requirements for brokers or dealers.
 Final Rule: Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities, 17 CFR 240.15c3-1 (2004).
 Id. (emphasis added).
 Net Capital Rule, Exchange Act Rel. No. 28927 (Feb. 28, 1991).
 Net Capital Requirements for Brokers and Dealers, 47 Fed. Reg. 3512 (Jan. 25, 1982).
 See Reint Gropp, Federal Reserve Bank of San Francisco, Economic Letter: How Important Are Hedge Funds in a Crisis 2014-11 (2014), available at http://www.frbsf.org/economic-research/publications/economic-letter/2014/april/hedge-fund-risk-measurement-spillover-economic-crisis/el2014-11.pdf.
 See Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management, (Random House 2000) (detailing the catastrophic collapse and economic ramifications of a private investment partnership run out of Greenwich, Connecticut).