Last week, SEC Chairman Mary L. Schapiro, testified before the Financial Crisis Inquiry Commission about the causes of the recent financial crisis. Schapiro stated that, in her opinion, the crisis was a result of several different, but interconnected factors, including:
- The rise of mortgage securitization (a process originally viewed as a risk reduction mechanism) and its unintended facilitation of weaker underwriting standards by originators and excessive reliance on credit ratings by investors;
- A wide-spread view that markets were almost always self-correcting and an inadequate appreciation of the risks of deregulation that, in some areas, resulted in weaker standards and regulatory gaps;
- The proliferation of complex financial products, including derivatives, with illiquidity and other risk characteristics that were not fully transparent or understood;
- Perverse incentives and asymmetric compensation arrangements that encouraged significant risk-taking;
- Insufficient risk management and risk oversight by companies involved in marketing and purchasing complex financial products; and
- A siloed financial regulatory framework that lacked the ability to monitor and reduce risks flowing across regulated entities and markets.
These factors combined and reinforced one another resulting in the unprecedented global market downturn. Chairman Schapiro stated that, as a result of the crisis, the SEC has learned a number of lessons that the Commission will bear in mind as it works to address the weaknesses leading to the financial melt down. Schapiro organized the bulk of her testimony outlining the lessons learned and her plans for moving forward with those lessons in mind.
- Consistent and Vigorous Enforcement Is a Vital Part of Risk Management and Crisis Avoidance — Particularly in Times and Areas of Substantial Financial Innovation.
- Transparent Disclosure of Risk and Other Material Information is Essential.
- Regulators Must Remain Vigilant Against Fraud.
- Consistent Accounting Practices are Essential to Investor Confidence and Fair Competition.
- Enforcement Agencies Should Continue to Work Together to Address Financial Crimes.
- Internal [agency] Changes Can Strengthen and Speed Enforcement.
Regulation of Complex Financial Institutions:
- Capital Adequacy Rules Were Flawed and Assumptions Regarding Liquidity Risk Proved Overly Optimistic.
- Consolidated Supervision is Necessary but Not a Panacea.
- Systemic Risk Management Requires Meaningful Functional Regulation, Active Enforcement & Transparent Markets.
- Regulators Should Constantly Review and Update Their Tools and Approaches to Regulation.
Regulation of Financial Products:
- Money Market Funds Are Not Risk-Free and Can Be Subject to Runs.
- Asset-Backed Securities Requirements must be strengthened.
Transparency and Investor Information:
- Too Many Investors and Regulators Over-Relied on Credit Ratings, Especially for Complicated Financial Products.
- Policymakers Should Consider the Constraints and Tradeoffs Associated with Programs that Involve "Voluntary" Oversight and Regulation.
- Short-term Compensation Incentives Can Drive Long-Term Risk.
- Management and Boards of Directors Should be More Accountable.
- Markets and Market Regulation Should Promote Long-Term Investor Confidence, Not Undermine It.
- Rethink the culture of securities regulation, recognizing the causes and missed opportunities leading up to the financial crisis.
- Reduce regulatory arbitrage by closing the regulatory gaps between markets and ensure that similar products are regulated similarly.
- Too-Big-to-Fail Problem Should be Addressed.
- Over-the-Counter Derivatives Should be Regulated.
- Private Fund Managers Should be Included Within the Regulatory Framework.
- Broker-Dealers and Investment Advisers Should be Subject to the Same Fiduciary Standard of Conduct and Heightened Regulatory Regime When Providing the Same or Substantially Similar Services.
- Regulators Need to Work More Closely Together So That We Can Better Understand Regulated Entities and Market Risks.
- Properly funding the SEC and other financial oversight agencies is key to an effective and independent regulatory scheme.
Schapiro closed her remarks by stating that, rather than merely laying blame, determining the causes of the crisis and seriously considering the lessons learned must lay the foundations for a solid recovery.
We cannot hesitate to admit mistakes, learn from them and make the changes needed to address the identified shortcomings and reduce the likelihood that such crises reoccur. More vigorous regulation and a new culture or approach are essential.
The full text of Chairman Schapiro's January 14, 2010 testimony is available at: http://sec.gov/news/testimony/2010/ts011410mls.htm