Thank you, Larry Uhlick, for your kind introduction. I am honored to be speaking again to the Institute of International Bankers. Many of the ideas and initiatives that have been put in motion in the international banking community over the past 42 years can be credited to the IIB and its work. I appreciate the work that Larry and his colleagues have done in Washington on your behalf. And of course, we in the U.S. are grateful for the billions of dollars that Institute member banks contribute to the economy through direct employment of more than 100,000 people in the U.S., as well as through other operation and capital expenditures.
But before I begin, I must say that the views that I express here are my own and not necessarily those of the Securities and Exchange Commission or my fellow Commissioners.
Credit Rating Agencies
I cannot understate the importance of international banking to the capital markets. In fact, you may feel the heat of the spotlight in the public debate about the current market situation. As we come out of the winter into March and April, let's hope that the spring rains will also bring back the liquidity in our capital markets. It is about time that we leave the liquidity drought, and the volatility in the capital markets, behind us.
The current situation is still essentially a liquidity event. The reasons for the liquidity drought are readily apparent. Market participants began to question the value of a variety of financial products, especially those with complex structures and the assumptions underlying their valuation models. Consequently, liquidity in these products fell sharply. The lack of liquidity complicates the task of valuing complex instruments. In many cases, mark-to-market accounting rules resulted in the taking of additional reserves or recognition of lower book values by financial institutions in respect of these instruments.
We, as regulators, must not stand in the way of investors' and market participants' sorting this situation out. It would be most unfortunate for the economy — investors, workers, consumers — if regulators were to contribute to market uncertainty through interfering with contracts, judging the merit of products or business strategies (especially with the benefit of 20/20 hindsight), or setting arbitrary rules based not on economics but on conjecture. Uncertainty breeds aversion to risk. Aversion to risk hinders liquidity and thus has the potential to slow down our economy.
These kinds of market situations — uncertainty regarding valuation, integrity of counterparties, or looming regulatory action — have happened before, and our current experience is mild in comparison. In past situations, especially in the early 1990s in the United States, we saw the amount of bank commercial and industrial loans decline steadily and bank holdings of government or other highly rated securities increase proportionately. Some of this reaction could be attributed to boards' and credit committees' being more risk averse. But, unfortunately some of it also could be attributed to the cumulative actions of thousands of bank examiners sharpening their pencils, tightening their reviews, increasing their questioning, and substituting their judgment for that of banks. I am certainly not advocating forbearance when action is warranted. In some cases additional scrutiny may be needed, especially where banks may have lax risk management or credit review systems. But, examiners should proceed with an understanding of the scope of their role so as not to aggravate unintentionally a situation that the markets are in the process of solving.
The SEC and the bank regulatory agencies issued a joint statement last year regarding business and lending practices in the complex structured finance transaction area. I hope and expect that banks have adhered to this guidance. But, we must be concerned about the potential distortions to the credit marketplace and the effect on entrepreneurs and smaller companies (which are usually the weaker credits) of regulatory overreaction. The pendulum can swing too far in either direction. Fortunately, unlike in the past, the sources of capital today are much more diverse, with private funds taking a larger role in lending and stepping in as lenders when regulated entities do not.
The liquidity concerns also have resulted in the recent focus on the credit rating agencies. The SEC has jurisdiction over credit rating agencies, which are known officially as "nationally-recognized statistical rating organizations." Given the importance of credit rating agencies to both U.S. and foreign investors, I will touch upon some initiatives underway.
It was only beginning in 1975 that the SEC began to make explicit reference to credit ratings in its rules, thereby creating a legal and regulatory effect for obtaining certain ratings. Initially, the SEC used the term "NRSRO" solely to determine capital charges under the net capital rule for broker-dealers. Subsequently, NRSRO ratings were incorporated into additional SEC regulations, gaining momentum with Rule 2a-7, which governs what assets may be held in a money-market mutual fund. Rule 2a-7 was promulgated in the early 1990s when some funds came close to breaking a dollar of net asset value because of declining values of certain riskier securities that they held in their portfolios. The new rule looked to high-rated debt instruments as suitable investments for money-market funds. After that, the use of the NRSRO designation continued to expand as a convenience. Congress, state legislatures, and regulators other than the SEC also began to make reference to NRSRO ratings.
Before the implementation of the Credit Rating Agency Reform Act of 2006, the practice of the SEC had been to allow staff to designate credit rating agencies as NRSROs through the no-action letter process. If, in the staff's view, widespread acceptance of ratings issued by a particular ratings agency had been achieved, the staff would issue a no-action letter. In practice, obtaining designation as an NRSRO was a rather opaque process. Some applications would linger for more than a decade without definitive resolution. In 1997, the SEC proposed a rule regarding NRSRO applications and received significant comments on it, but never took action to adopt a rule.
The unintended consequence of the SEC's approach to credit rating agencies was to limit competition and information flowing to investors. As expected, Congress reacted to change the situation. The legislative history reflects a genuine concern that the SEC facilitated the creation of — and perpetuated — an oligopoly in the credit rating business. Indeed, today, three NRSRO-designated firms have more than 90 percent of the market share.
Since I joined the Commission in 2002, I have been a vocal proponent of increased transparency in the NRSRO designation process. We have promulgated rules to achieve that goal. My only regret is that Congress left the appellation of NRSRO as "Nationally Recognised," rather than "Nationally Registered." Congress apparently kept the name because that terminology is widely used throughout federal and state statutes and regulations. In my view, we are in the registration, not recognition, business. The government should facilitate market-based decisions, not substitute its judgment for them.
The SEC currently is examining the role played by credit rating agencies in the development of the current subprime market. Credit rating agencies have been criticized about the accuracy of their ratings, for failing to adjust timely those ratings, and for not maintaining appropriate independence from the issuers and underwriters. Our examinations will review whether the rating agencies diverged from their stated methodologies and procedures for determining credit ratings. They also will focus on whether the rating agencies followed their procedures for managing conflicts of interest inherent in the business of determining credit ratings.
In our review, we must not rush to conclusions or view matters solely through 20-20 hindsight. We must not attempt to substitute our judgment for that of the rating agencies. Instead, we must bear in mind that rating agencies may have reached an incorrect result through no fault of the process. They may have just got it wrong. A rating is an expression of opinion — one that, barring self-dealing or lack of integrity, enjoys the protection of the First Amendment. More importantly, we must remember that even the highest rating by a credit rating agency is not an insurance policy. We should not create a regulatory regime that appears to provide insurance where there is not such certainty in the capital markets.
International Financial Reporting Standards
Another significant issue for the international financial community involves the use of International Financial Reporting Standards (IFRS). Last year, the Commission adopted a rule that permits foreign private issuers who report under IFRS as adopted by the International Accounting Standards Board (IASB) to file their financial statements with the SEC without reconciliation to U.S. generally accepted accounting principles (GAAP).
Now that we have taken that step, the question is raised as to whether U.S. issuers should likewise have a choice to report in IFRS or GAAP. In August 2007, the Commission issued a concept release seeking information about the extent and nature of the public's interest in allowing U.S. issuers to do so. The comment period closed on November 13, 2007, and the SEC is in the process of reviewing the comments submitted. These comments will be helpful as we further consider the path of convergence between IFRS and GAAP.
In March 2007, we adopted new rules that significantly changed the requirements for exiting the Exchange Act reporting system by foreign private issuers. Unlike the older rules that required a foreign private issuer to have less than 300 holders resident in the United States, new Exchange Act Rule 12h-6 permits the de-registration of a class of equity securities if U.S. average daily trading volume is less than five percent of the average worldwide daily trading volume for a recent 12-month period.
A number of eligible foreign private issuers filed to withdraw immediately after effectiveness. After years of pent-up demand and the turmoil of the ill-fated and ill-conceived Audit Standard 2 of the PCAOB, we expected a large number of deregistrations. According to the Division of Corporation Finance, as of the end of last year, approximately one hundred foreign private issuers had filed the deregistration form (Form 15F) under the new criteria set forth in Rule 12h-6. This equates to just under 9% of all foreign registrants filing for deregistration, with the largest group coming from the European Union.
One of the intended effects of the new rule was that it might encourage foreign private issues to register with the Commission in the first place — because if you know you can leave, then you just might want to come to the United States in the first place to try it out. So I am happy to report that, during 2007, more than 75 new foreign private issuers registered securities with the SEC.
Having utilized relative U.S. average daily trading volume as a measure to exit the SEC registration system, we now are looking to use a similar measurement to determine when U.S. registration would be appropriate. Last month, we proposed revisions in our current exemption under Rule 12g3-2(b). Under the new proposal, a foreign private issuer would be exempt from registration so long as its relative U.S. average daily trading volume was less than 20% and the issuer electronically publishes its disclosure documents in English.
Of course, there are issues of enforceability and extraterritorial application of our laws. And, it is U.S. investors who have gone abroad in the first place to buy those unregistered offshore securities in the first place. But, issuers with a high percentage of trading in the U.S. likely would know about and sanction that trading. Thus, we are seeking comment on this proposed rule to fulfill our statutory obligations.
A related proposal that we approved last month was to change the annual report filing deadline for foreign private issuers. Under our current rules, foreign private issuers may file their Form 20-F up to six months after the end of their fiscal year. This deadline is the same as it was when first adopted in the 1970s. That is when it took about two weeks just to send a package to London — longer elsewhere. In today's investment world, six months is an eternity, especially when, in many cases, investors are only waiting for the reconciliation to GAAP. The six-month filing deadline makes even less sense for IFRS filers, since they now can avoid the GAAP reconciliation requirement entirely.
I look forward to hearing the comments about the appropriate time for annual reports on Form 20-F to be filed as well as the other proposed changes to disclosure by foreign private issuers.
Sovereign Wealth Funds
Now shifting from issuers to investors, one group of foreign investors has been getting a lot of press lately. You cannot open a newspaper today without reading something on sovereign wealth funds. Five years ago, you would be hard pressed to find someone outside of the investment banking community who gave any thought to these funds. Today, virtually every American has heard of sovereign wealth funds, and opinions are forming quickly, often without the benefit of deliberation and careful study.
It is rather appropriate that we talk today about sovereign wealth funds, since it was on this date 70 years ago that oil was discovered in Saudi Arabia.
Sovereign wealth funds are estimated at $2.5 trillion and expected to grow to $12.5 trillion over the next five years.1 One fund, Abu Dhabi's, which recently invested in Citigroup, is estimated to be close to $1 trillion of assets under management.2 The size of the funds, the fact that they are controlled by foreign governments, and the recent investments in troubled sectors of the U.S. economy have caused some to call for additional regulations and oversight. We in the government must ensure that these calls do not fuel protectionist pressures that could result in the implementation of ill-considered policies.
Foreign investment of large amounts of sovereign capital does not affect only the United States. As a result, the issues should be addressed with, and among, the nations. The U.S. Treasury Department, along with the President's Working Group on Financial Markets, of which the SEC chairman is a member, is discussing the implications of the growth of these funds. Treasury officials, as I am sure you heard today, have been meeting with other G-20 countries to discuss a comprehensive approach, and the IMF is working to develop best practices for sovereign wealth funds. The Organization for Economic Cooperation and Development (OECD) also has been working on formal guidance for countries receiving investments from sovereign wealth funds.
In the United States, there is already a mechanism in place to evaluate concerns with respect to national security. The Committee on Foreign Investment in the United States (CFIUS), chaired by the Treasury Department, reviews foreign direct investment that results in foreign control of U.S. business and that may raise national security considerations. Congress only last year strengthened the CFIUS review process to address concerns. If a transaction poses a risk to national security, CFIUS can respond in a fair and proportional way to that risk.
There are, of course, issues relating to sovereign wealth funds that ultimately may be unique to the SEC. The SEC is responsible for overseeing U.S. federal securities laws, which include anti-fraud provisions. It is important that we not treat sovereign wealth funds any differently than we do other investors merely because the principals are not Americans.
The current market conditions will continue to evolve, and we will certainly weather the storm. Our economy is strong, our workplace is filled with talented and dedicated men and women, and our capital markets continue to be the envy of the world. Nevertheless, the U.S. should welcome the vote of confidence that foreign capital investment represents, particularly during the current time.
One only needs to look to the infamous Smoot-Hawley Tariff Act of 1930 to see the blunders of protectionism. The United States, in response to fear of overcapacity in the U.S. and the influx of foreign goods, raised tariffs to record levels on over 20,000 imported goods in 1930.3 Other countries swiftly retaliated with their own increased tariffs, and American exports plunged by more than 50%.4 Many economists believe the Smoot-Hawley Tariff precipitated the Great Depression.5
Aside from economic repercussions, there are other potential dangers of adopting a protectionist philosophy. Undoubtedly, protectionism has been a cause of misunderstanding and strife between nations throughout history. Many point to the two great wars of the last century, World War I and II, as examples of conflicts exacerbated by protectionism. And, who can quarrel with the argument that British tariffs and taxes sparked the American Revolution? The 19th century French economist Frédéric Bastiat insightfully remarked, "When goods cannot cross borders, armies will."6
I know that you did not bring me here today to speculate on historic geopolitics, and by no means am I suggesting that regulation of sovereign wealth funds will trigger armed conflict. But we must not let our fears of foreign capital re-ignite calls for protectionism. Protectionism breeds mistrust. Trade among free nations has united our world and brought us all together whether it be Japanese consumer electronics on U.S. store shelves, American hamburgers in Moscow, U.S. private equity investment in Asia, or foreign investment in U.S. corporations in need of capital. The United States and indeed the world have come too far to be pushed back into the failed protectionist views of last century.
Mutual Recognition
A notable trend counter to the calls for increased protectionism is the discussion about mutual recognition of foreign securities regulatory regimes. Mutual recognition is a process by which the SEC would allow foreign exchanges or broker-dealers to participate more freely in U.S. markets, provided that they are subject to a satisfactory foreign regulatory regime.
I have long been a proponent of more flexible treatment of foreign firms in the U.S. markets. Increased access by foreign and U.S. securities exchanges to each others' markets should produce great benefits. Investors will be the ultimate beneficiaries through lower costs and more choice, if restrictions are eased.
Last year, the SEC hosted a public meeting on this subject, focused primarily on the issue of whether to allow mutual recognition of foreign regulatory regimes that are substantially equivalent to the U.S. rules. However, we need to be very careful about proceeding in this manner.
Mutual recognition does not mean consolidation or reconciliation of the regulations of two jurisdictions. The process should not be analogous to the process of reconciling conflicting bills from the U.S. House of Representatives, on the one hand, and the U.S. Senate, on the other hand. In other words, mutual recognition must not be an attempt at harmonizing regulations from the U.S. and a foreign jurisdiction through a side-by-side, rule-by-rule comparison. Such a bottom-up approach would result in a completely unworkable and potentially never-ending process. Would the slightest statutory, judicial, or regulatory change cast doubt upon another country's regime? How would those changes be monitored and addressed? Imagine the effort and personnel that would be needed to monitor and respond to regulatory changes in a dozen or more jurisdictions. Would the SEC find itself with effective veto power over other countries' regulations? It might be good material for a law review article, but it would not work in the dynamic, resource-constricted real world.
A better framework would be a top-down approach, similar to one employed by other U.S. regulators, such as the Commodity Futures Trading Commission and the Federal Reserve. Under this approach, the SEC would first identify the important elements that a compatible regulatory jurisdiction should embody. This might include investor protection standards, such as protection against misappropriation of customer assets, fraudulent sales practices, financial responsibility of registered entities, and effective examination, licensing and qualification of brokers. Instead of examining each rule of the foreign jurisdiction, we would generally assess the adequacy of that jurisdiction's oversight. If the foreign jurisdiction's regulatory regime is deemed adequate, a firm could be eligible for exemption.
A workable mutual recognition regime would go far within the context of the transatlantic framework towards fostering cooperation and reducing regulatory burdens. We should work diligently to craft a practicable top-down approach, and recognize that the alternative bottom-up approach will never work.
My main concern with this high-level discussion is that we not be diverted from achievable, near-term goals. We certainly have enough of those, such as the much-needed modernization of Rule 15a-6, which governs the activities of foreign broker-dealers in the U.S. This rule started out as a reform of previous rules, but has caused consternation and increased costs for brokers and investors alike. A rule that recognizes the reality of the modern markets, including the different needs of institutional investors, is long overdue.
Thank you for your attention. I am happy to answer any questions.