Thank you for that warm welcome. It is a pleasure to be speaking this morning at the Corporate Directors Forum. As some of you may know, I grew up in Southern California, not too far from here in San Bernardino. San Diego has long been a favorite vacation spot for my family, and so it is especially nice to join you here today.
Before I begin my remarks, I must let you know that the views I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
We have been persevering through a period of financial and economic strain unlike anything since the Great Depression. The turmoil already has evoked a historic expansion of the federal government's role in the economy, and the government's involvement in the economy is expected to expand even more.
Today, now that the financial system has stabilized, attention is focused on revamping the financial regulatory framework for the future. Although we will be studying the financial crisis for decades to understand its causes and consequences - indeed, economists continue to study and learn from the Great Depression - regulatory change already is underway. Last month, in June, the Obama Administration offered its plan for what would be the most far-sweeping overhaul of financial regulation since President Roosevelt's New Deal.1 The SEC has been active, advancing a number of initiatives concerning matters such as credit rating agencies;2 short selling;3 the election of board members;4 public company compensation and governance disclosures;5 and money market funds.6 More is likely to follow. As always, I look forward to considering the comments we receive on these proposals.
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A motivating force behind regulatory reform is the goal of reducing risk. As the argument goes, in recent years, financial institutions took too much risk; investors took too much risk; homeowners took too much risk; and even regulators took too much risk, at least insofar as some claim that the regulatory regime became too permissive. My goal this morning is not to slice and dice these claims. Instead, I want to offer some general thoughts on the business of regulating risk. My basic point is this: Even in times of crisis and hardship, when the benefits of regulation seem apparent and there is pressure to "do something," we cannot overlook the risk of overregulating. It is essential for the government to retain a healthy respect for the role of markets; and we must appreciate that there are limits to what we can and should expect from regulation.
Without question, the government, including the SEC, must be adaptive and nimble. We have to learn from our mistakes and take appropriate steps to ensure that we have a state-of-the-art regulatory regime that fits our increasingly interconnected and complex global financial system. However, while regulatory change is needed, we need to be cautious. We need to evaluate carefully the costs and benefits of each reform, as well as assess the cumulative impact of the entire package of new regulatory demands to determine the overall effect.
Regulating to avoid excessive risk is not costless, whatever the benefits may be of securing the financial system and protecting investors and others from misfortune. Some risks simply are worth it if avoiding them is too costly because legitimate, wealth-creating enterprises and transactions are stifled. In other instances, efforts to clamp down on certain practices and activities may have unintended adverse effects, some of which could exacerbate the concern the regulation targets. This includes the prospect that government action may foster moral hazard. When properly framed, then, the regulatory objective should be to achieve the optimal degree of risk, not necessarily to minimize risk. Achieving the optimal degree of risk involves making tough tradeoffs, netting costs against benefits.
A handful of concrete considerations suggest the kind of balancing that prudent risk regulation involves. Is restricting short selling worth the potential cost of disrupting markets at the expense of liquidity, price discovery, and capital formation? Will greater shareholder involvement in corporate governance put more pressure on management and the board to focus on short-term earnings and stock price performance? Given that venture capital (VC) funds have not been identified as a potential cause of the financial crisis, do the benefits of requiring VC managers to register with the SEC justify the burden registration might impose on capital formation to the detriment of businesses, particularly small businesses, that rely on VC funding? How, if at all, should any fiduciary obligation imposed on broker-dealers be modulated to ensure that investors can continue to receive the range of products and services they desire? If so-called "Tier 2" commercial paper did not contribute to the stresses straining money market funds last year, is it worth prohibiting money market funds from holding Tier 2 paper if, as a result, businesses lose a valuable source of financing? To what extent should any enhanced regulation of over-the-counter derivatives accommodate the need for customized contracts that allow enterprises to allocate risk efficiently when standardization is required for central clearing, let alone on-exchange transactions?
All of this is to say that, even during times of severe hardship, it remains possible for regulation to go too far. Our dynamic economy - marked by a constant stream of cutting-edge goods and services and an ever-expanding set of opportunities - depends on the willingness of individuals to take risks. Undue emphasis on mitigating downside risk can be unduly costly if it chills the kind of prudent risk taking that drives innovation, entrepreneurism, and competition and thus economic growth. Just as there can be excessive risk taking, there can be excessive conservatism.
The cost of overregulation is borne in the future by us and our posterity and for now is an intangible. The perceived benefits of regulation, on the other hand, appear concrete and seem self-evident, given the recent crisis we have been struggling through. To help guard against the risk that the government will be overly precautionary in regulating, we need to remind ourselves what the cost of excessive regulation means in real-life terms. When regulatory demands overburden the economy and constrain and chill productive endeavors and the creation of wealth, the unfortunate consequences are felt throughout society as fewer jobs are available; as investors earn lower returns on their portfolios; as fewer innovations are commercialized and brought to market; as health care becomes harder to come by; and as college tuition becomes harder to pay for. Bringing the cost of regulation to life may help balance the regulatory analysis.
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The regulation of systemic risk has been a particular focus of debate. In 2008, the federal government committed unprecedented amounts in response to concerns that the financial system faced collapse. The SEC itself took an extraordinary step, temporarily banning short selling of financial sector stocks.7
A central plank of the Obama Administration's proposed regulatory overhaul includes expanding the Federal Reserve's authority to oversee all financial firms, including non-banks, that could jeopardize the financial system. The Administration also has proposed creating a complementary Financial Services Oversight Council to "identify emerging risks" and "advise the Federal Reserve on the identification of firms whose failure could pose a threat to financial stability due to their combination of size, leverage, and interconnectedness."8
I understand the argument that some government body should have explicit responsibility for monitoring and overseeing the financial system as a whole. In making decisions, people tend to emphasize the personal costs and benefits of their actions without necessarily taking full account of the broader social impacts that may follow. For example, profit-and-loss considerations, as compared to ensuring the soundness of the financial system, primarily determine a financial firm's decisions regarding its leverage, liquidity, and trading. Accordingly, there is an important role for the government in ensuring a sound, well-functioning financial system - a "public good." The Obama Administration's plan put it this way: "In effect, our proposals would compel [the largest financial] firms to internalize the costs they could impose on society in the event of failure."9
Recent attention has centered on whether the Fed is the right body to lead the regulation of systemic risk. "Who" will serve as the systemic risk regulator is key. But I am more troubled by "how" systemic risk might be regulated. Identifying a market failure does not necessarily tell us what the appropriate government response should be. Even when there is a market breakdown, it remains possible for the government's response to do more harm than good.
My principal concern turns on the potential scope of the systemic risk regulator's authority. As a threshold matter, I still have not heard a satisfying definition of what constitutes a systemic risk. Systemic risk is easy enough to conceptualize in theory, but it is much more difficult to identify in practice. What does it mean for a firm to be "too big" or "too interconnected" to fail? A sort of "I know it when I see it" approach to regulating systemic risk is untenable. Such open-endedness accords the regulator too much discretion and is too unpredictable.
Because no two "tail events" are the same, the Federal Reserve or other systemic risk regulator needs some room to maneuver in overseeing the financial system. Regulatory flexibility is valuable because the regulatory challenge that may be faced is uncertain. That said, the regulator's authority must be circumscribed and defined in advance. It would be troubling if there were no clear guidelines and parameters to constrain the systemic risk regulator, as it would then be difficult to foresee how the regulator may act or to hold the regulator accountable in any meaningful way when it does act. I would not welcome such unbounded power, even if exercised with the best of intentions. It would inject too much uncertainty into the system and concentrate government authority to a worrisome degree.
Finally, I am concerned that the systemic risk regulator will be too precautionary - if not initially, then at least over time. Systemic risk regulation contemplates an anticipatory approach to regulation. To this point, the Obama Administration's plan talks in terms of "emerging" risks that "could" jeopardize the financial system. The systemic risk regulator is charged with spotting and responding to risks earlier to avoid infirmities that threaten the system. When given this charge, the natural tendency may be to act increasingly quickly and aggressively to minimize - as opposed to optimize - systemic risk. The regulator may overemphasize the downside - as its mission is to prevent the buildup of risk - without giving appropriate due to the potential benefits of the conduct and practices presenting the worry. Once a risk is spotted, there may be a bias to avoid it, notwithstanding the cost of doing so.
I am troubled that systemic risk regulation readily could result in a prophylactic regulatory strategy that is unnecessarily burdensome and restrictive. Risk is the price we must pay for a financial system that allows room for private-sector innovation, entrepreneurism, and competition - fundamental drivers of economic growth. Although we need to take steps to ensure that our regulatory framework addresses systemic risk, we have to avoid overreacting when doing so.
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Risk is unavoidable. When we regulate one risk, something else pops up. The responsibility we have as lawmakers is to engage in the kind of rigorous analysis that will best position us to identify and evaluate the range of consequences - both good and bad - that attend our decisions so that we can make conscious tradeoffs. Calling something a "regulatory gap," for example, should not distract from a demanding analysis of the pros and cons of a regulatory initiative.
It has been a pleasure speaking to you this morning. I am happy to take a few questions.