The following remarks were delivered by Commissioner Daniel M. Gallagher of the U.S. Securities and Exchange Commission in Washington, D.C. at the Institute of International Bankers 25th Annual Washington Conference on March 3, 2014.  A copy of the speech is also available here.

Thank you, Roger [Blissett].

Before I begin, I’d like to point out that two years ago, I spoke at this conference and discussed the Financial Stability Oversight Council, or FSOC, in great detail.  I spoke about the inherently political nature of FSOC, how it had been vested with tremendous power, and how it could threaten our capital markets.  So, given everything that has happened since then, I have to say: I told you so.[1]

Today, I’d like to share some thoughts about regulatory capital requirements.  I’ve spoken before about the significant differences between bank capital and broker-dealer capital, because I fear that these distinctions are all too often overlooked in the debates over regulatory capital.  After all, in order to come up with the right answers on how to set capital requirements, we need to ask the right questions – and that’s impossible without a proper understanding of the important differences between broker-dealer and bank capital requirements.  Those differences are fundamental, and we ignore them at our peril.

In many ways, the philosophy of bank capital is easier to understand.  In the banking sector, which features leveraged institutions operating in a principal capacity, capital requirements are designed with the goal of enhancing safety and soundness, both for individual banks and for the banking system as a whole.  Bank capital requirements serve as an important cushion against unexpected losses.  They incentivize banks to operate in a prudent manner by placing the bank owners’ equity at risk in the event of a failure.  They serve, in short, to reduce risk and protect against failure, and they reduce the potential that taxpayers will be required to backstop the bank in a time of stress.

Capital requirements for broker-dealers, however, serve a different purpose, one that, to be fair, can be somewhat counterintuitive.  The capital markets within which broker-dealers operate are premised on risk-taking – ideally, informed risks freely chosen in pursuit of a greater return on investments.  In the capital markets, there is no opportunity without risk – and that means real risk, with a real potential for losses.  Whereas bank capital requirements are based on the reduction of risk and the avoidance of failure, broker-dealer capital requirements are designed to manage risk – and the corresponding potential for failure – by providing enough of a cushion to ensure that a failed broker-dealer can liquidate in an orderly manner, allowing for the transfer of customer assets to another broker-dealer.

As I said, it’s counterintuitive, but the possibility – and the reality – of failure is part of our capital markets.  Indeed, our capital markets are too big – as well as vibrant, fluid, and resilient – not to allow for failure.  Our job as capital markets regulators is to accept the inevitability that some brokerage firms will fail and to craft a capital regime that fully protects customers in the event of such failures.  A safety-and-soundness bank-based capital regime simply doesn’t work in the context of capital markets.

To put it another way, when you deposit a dollar into a bank account, you expect to get that dollar back, plus a bit of interest.  We place our savings into bank accounts for safekeeping, and while we know that the bank makes use of our funds, we also know that we are entitled to receive all of our principal back – and bank capital requirements, along with government backstops, are designed to ensure the availability of that principal.  When you invest a dollar through a broker-dealer account, however, the market determines how much you get back.  You could break even, you could double your investment, or, of course, you could lose part or all of that initial investment.  The point is that when we make a bank deposit, we expect, at a minimum, to receive the entirety of our principal back, while when we make an investment, we expect the market to dictate what we receive in return. It stands to reason, therefore, that the capital requirements for broker-dealers must be tailored accordingly.

I’m sure you didn’t need an SEC Commissioner to explain to you the difference between a deposit and an investment.  And yet, when it comes to setting capital requirements, bank regulators seem increasingly determined to seek a one-size-fits-all regulatory construct for financial institutions.  In addition, as noted by my friend Peter Wallison in an important recent op-ed in The Hill, both the Dodd-Frank-created FSOC and the G-20-created – and bank regulator dominated – Financial Stability Board seem intent on applying the bank regulatory model to all financial institutions they deem to be systemically important.[2]

Traditionally, the Fed, as the nation’s central bank, has been known more for its role as the lender of last resort to banks than as a regulator.  By offering access to its discount window to illiquid, but not insolvent, banks offering good collateral, the Fed can provide crucial liquidity and stabilize otherwise solvent banks in times of difficulties.  During the recent financial crisis, however, the Fed went beyond offering access to the discount window to depository institutions in its capacity as the lender of last resort to serving as the investor of last resort.  The acquisition of almost 80 percent of AIG in exchange for an $85 billion loan, for example, as well as the ownership of $29 billion in former Bear Stearns assets, marked a fundamental departure from the Fed’s traditional role.  After Dodd-Frank, there is a confusion about the Fed’s lender of last resort function that is warping regulatory debates and is being used to the advantage of the Fed and central bankers around the world to increase their jurisdiction.  Policymakers today incorrectly conflate ‘lender of last resort’ with the rightly dreaded ‘bailout.’  This confusion must be addressed by policymakers before we can have a constructive discussion about capital and margin requirements for non-bank financial services firms.

The recent FSOC intervention in the money market mutual fund space shined a spotlight on this newly expansive vision of the role of banking regulators.  The money market mutual fund reform debates that raged through 2012 focused in large part on the concept of a “NAV buffer,” which effectively is a capital requirement for money market funds.  This debate culminated in the November 2012 issuance of a report by FSOC which incorporated the concept of a so-called “NAV buffer.”[3]

The reasoning behind capital buffer requirements for money market funds is that they would serve to mitigate the risk of investor panic leading to a run on a fund.  The figures under discussion, however, were far too low to promise any serious effect on panic, while the imposition of real, bank- or even broker-dealer-like capital requirements in this space, on the other hand, would simply kill the market for money market mutual funds.  A 50 basis point buffer, to be phased in over a several year period, would hardly stem investor panic, unless one believes that investors would be comforted by the knowledge that for every dollar they had on deposit, the money market fund had set aside half a penny as a capital buffer.

Crucially, as I’ve noted before, there is no limiting principle to the application of this bank-based view of capital – indeed, last September, Treasury’s Office of Financial Research issued a fatally-flawed “Asset Management and Financial Stability” report featuring similar reasoning, as reflected in its implied support for “liquidity buffers” for asset managers.[4]

It remains unclear as to whether the Fed is indeed seeking to impose bank-based capital charges on non-bank entities in conjunction with granting them access to the discount window – at the cost of submitting to prudential regulation – or whether it is instead proposing those additional capital charges in order to prevent non-prudentially regulated financial entities from ever relying upon the “government safety net” provided by the discount window.[5]

Dodd-Frank Act’s grants of authority and mandates to the Fed further expand its traditional role.  Section 165 of the Dodd-Frank Act requires, among other things, that the Fed’s Board of Governors establish enhanced prudential standards for bank holding companies with consolidated assets of greater than $50 billion.  Although Section 165 nowhere mentions broker-dealers or asset management firms, last month, the Fed issued a final rule under Section 165 that could have a profound impact on the SEC-regulated subsidiaries of large foreign banks, one that would ripple through our capital markets as a whole.[6]

The Fed’s new rule will require foreign banking organizations with U.S. non-branch assets of $50 billion or more to establish a U.S. intermediate holding company over their U.S. subsidiaries.  These new holding companies will be subject to the same risk-based and leverage capital standards that the Fed applies to U.S. bank holding companies. As such, they will be subject to the Fed’s rules requiring regular capital plans and stress tests and will be required to establish a U.S. risk committee and employ a U.S. chief risk officer.  The new holding companies will be required to meet enhanced liquidity risk-management standards, conduct liquidity stress tests, and hold a buffer of highly liquid assets based on projected funding needs during a 30-day stress event.  They will, in short, be subject to the same Fed requirements as domestic banks with assets totaling $50 billion or more.

Now, I should take a moment to make clear that I support stringent capital requirements for all financial institutions that pose risks to our financial system.  Furthermore, it’s certainly not unreasonable in theory to subject foreign bank holding companies operating in the U.S. to the same requirements as domestic ones.  That’s not, however, all that the Fed’s new rules do.  They also require a foreign entity operating non-bank subsidiaries in the U.S. to superimpose an entirely new organizational structure for those non-bank U.S. holdings – one that artificially brings those holdings under the jurisdiction of the Fed and subjects them to regulations crafted to ensure the safety and stability of banking entities.

There’s an old joke about a physicist, a chemist, and an economist finding themselves stranded on a desert island with a supply of canned food.  The physicist says, “Let’s drop the cans from the top of that tree over there – it will hit the rocks below and break open.”  The chemist counters, “No, that would spill too much of the food.  Let’s build a fire and place them in the flames until they burst open.”  As the physicist and chemist argue, the economist silently scratches out equations in the sand.  Finally, he looks up and exclaims, “I’ve got it! First, assume we have a can opener…”  Apologies to all of my economist friends!

The Fed’s new rules come a little too close to turning this joke into reality.  Broker-dealers, of course, are regulated by the SEC, as they have been for almost eight decades now.  The Fed, on the other hand, regulates banks, or more specifically, bank holding companies.  The Fed’s Section 165 rulemaking, in essence, forces a foreign bank organization to impose a bank holding company into existence over its non-bank holdings, thus subjecting those entities’ broker-dealer subsidiaries to regulation by the Fed.  In essence, by requiring a foreign bank to create a wholly new structure for its U.S. operations subject to new regulatory requirements that will have a direct impact on the liquidity available to those operations, including broker-dealers, the Fed in fact assumes a can into which the foreign bank’s U.S. operations must be packed.  Only then can the Fed employ its can opener of regulation to oversee those operations.

Among the other requirements to which these new intermediate holding companies will be subject is the Fed’s leverage ratio.  The Fed has proposed that the largest bank holding companies be subject to an additional 2% leverage buffer on top of the 3% mandated by Basel III.[7]  This will incentivize broker-dealers within bank holding companies to reduce the size of their balance sheets.  Specifically, it could induce broker-dealers to reduce the amount of seemingly highly leveraged but low risk and thin margin transactions in which they engage – most importantly, repo and stock loan activity.  In addition, Basel III contains a so-called net stable funding ratio, which, by favoring long term, “stable” assets, would further constrain the ability of broker-dealers to fund their day-to-day operations through the short-term wholesale funding markets.

The Fed has also proposed a new liquidity coverage ratio that would require a bank holding company to maintain a sufficient amount of high quality liquid assets that could immediately be converted into cash to meet liquidity needs in times of stress.  This could affect broker-dealer subsidiaries of large financial institutions organized as bank holding companies, in that the broker-dealers’ holdings would be taken into account when determining the parent holding company’s ratio.  The same reasoning applies to potential enhanced market risk standards under Basel 2.5 and Basel III, which could also affect the capital holdings of bank-affiliated broker-dealers.

Now, let’s be clear about one thing: whether or not you agree with these proposals and initiatives, their net effect will be a reduction in the amount of liquidity in the securities markets.  This, like the bailouts that led to this regulatory frenzy, is hardly something that Americans would vote for if they had the chance.  From the central banker’s perspective, however, this may be an acceptable cost to bring under its control the short-term wholesale funding markets I just referenced, which have long been a cause of concern for regulators.

Bank regulators and their wide-eyed admirers have spoken at length about the risks of “shadow banking,” which they define broadly to include the types of “securities funding transactions,” such as repo and reverse repo, securities lending and borrowing, and securities margin lending, used by both banks and broker-dealers for short-term funding.[8]  The loaded term “shadow banking” isn’t exactly used as an honorific, and I find it concerning that so many bank regulators routinely use the term to describe the day-to-day transactions so crucial to ensuring the ongoing operations of our capital markets.

To me, this onslaught of bank regulator rulemaking impacting non-bank markets is the result of a central, albeit unannounced, pillar of Dodd-Frank: the institutionalization of “too big to fail.”  The continued focus on “going concern” capital for institutions like broker-dealers that should fail when they take on undue risk can mean only one thing – despite the lessons learned from the financial crisis, despite the rightful disgust the American people directed at the bailouts, the U.S. government is focused on propping up institutions instead of refining the processes by which their failures will be handled.  This betrays the tenets of Title II of Dodd-Frank and reflects the absurdity of that portion of the legislation.  Why, after the failure of Lehman, we aren’t focusing on bankruptcy code amendments and related regulatory refinements, as many experts have called for,[9] is beyond me.

To be clear, I respect the Fed’s concerns about capital requirements for bank affiliated non-bank financial institutions, notwithstanding my fears as to the steps the Fed might take to address those concerns.  Our financial institutions are interconnected as never before, increasing the importance of taking a holistic view of those institutions, subsidiaries and all.  In doing so, however, it is crucial that we bring to bear the specialized experience and expertise of the regulators with primary oversight responsibility over the constituent parts of those institutions.  In the case of broker-dealers, this means the Commission, with its nearly eight decades of experiences in this regulatory space.  Since taking the reins of the agency, Chair White has strived to return the SEC to the center of the policy debates taking place with respect to large, interconnected financial institutions, and I commend her for doing so.  For example, we’ve started the process of updating our broker-dealer capital rules, which I believe is particularly important for bank-affiliated broker-dealers.

It’s my hope that the bank regulators constructively participate in this dialogue as well.  The last thing anyone wants is the old Washington cliché of a “turf war.”  For one thing, we’d lose – the SEC will never have the resources of the banking agencies – after all, it’s hard to outspend agencies that can print their own money.  More to the point, however, we’d never want to “win” – not only are we busy enough as it is, with approximately sixty Dodd-Frank mandated rules yet to be completed along with the day-to-day, blocking-and-tackling work that’s so critical to the agency’s mission, but we recognize that the banking regulators are best situated to regulate banks.  When it comes to the broker-dealer subsidiaries of banks, however, we stand ready to work with the Fed and other banking regulators to ensure that any new rules applicable to those entities are enhancements to our existing regime, not duplicative, contradictory or counterproductive regulations inspired by a regulatory paradigm designed for wholly different entities.

Thank you all for your attention this afternoon.  I hope the conference is rewarding for all of you, and I’d be happy to take questions.