It’s legislative karma: As a congressman, Christopher Cox helped pass Gramm-Leach-Bliley—as SEC Chairman, Cox had to sort out implementation of Reg R. In an interview, Cox holds forth on the roles of the SEC and the Fed.
By Ed Blount, contributing editor, and executive director, Center for the Study of Financial Market Evolution
How financial regulation should—and shouldn’t—evolve. Talking it through with SEC Chairman Cox
Though his name is not on the law, Securities and Exchange Commission Chairman Christopher Cox served on the Senate-House Conference Committee that finalized the 1999 Gramm-Leach-Bliley Act. At the time, Cox was a Republican congressman from California with Harvard MBA and JD degrees. Gramm-Leach-Bliley, of course, repealed the Glass-Steagall Act of 1934, effectively reuniting investment and commercial banking, which put the six-term congressman in the position of overseeing what he had wrought when he was appointed SEC chairman in 2005. Cox inherited the challenge of creating a set of workable regulations—Regulation R—for the GLBA provision exempting bank broker-dealer operations from SEC oversight—a truly herculean task following seemingly endless negotiations with banks, brokers, and other regulators.
Contributing Editor Ed Blount met with Chairman Cox in his office in late August, five months after the shotgun merger of Bear Stearns and JPMorgan Chase. They addressed new directions for regulatory reform. Later, Cox updated some points in a follow-up conversation that took place after the fireworks of mid September.
Has Gramm-Leach-Bliley met all of its expectations? Would you do anything differently?
Chairman Cox Gramm-Leach-Bliley has at its core a sound concept, which is, “functional regulation.” Writing the law, however, was an exercise in elaborate compromise. As a result, we noticed that, in writing regulations under the law, there are principles honored in the breach that have to be accommodated. It is at once a principle-based and very pragmatic approach. Therefore, I would say there is still substantial room for improvement in the Gramm-Leach-Bliley approach. The most significant problem in the law was the failure to assign to any agency the authority to regulate investment bank holding companies.
Where do you now draw the dividing line between the regulation of commercial and investment banks?
Chairman Cox This is an expression of the precept of functional regulation. The SEC has three-quarters of a century of experience in regulating broker-dealers. The Fed has nearly a century of experience in regulating commercial banks. It stands to reason that, both as we extend the collaboration between the Fed the SEC under our current authorities, and as we contemplate regulatory restructuring, we use that extensive experience as the “wind at our backs.” It should matter less that, traditionally, one business or the other has been under the aegis of a particular agency, than that the agency’s core competencies extend to that particular institution.
So, for example, should the Fed regulate deposit-taking activities and the SEC regulate asset services?
Chairman Cox Well, there is a bit of terra nova here. Prior to all of the major investment banks becoming part of bank holding companies, the question for Congress was whether it wished to make investment banking a federally-sponsored activity. Now, that question has given way to the more straightforward matter of applying the concept of functional regulation. Since the SEC has statutory authority to regulate the broker-dealer subsidiaries of all bank holding companies, our newly-agreed memorandum of understanding with the Fed provides a solid basis for making functional regulation work.
Until very recently, the updated Basel Accord was used as the supervisory standard for the five largest investment banks. However, the Basel benchmarks showed that Bear Stearns, just before its collapse, had far more than adequate capital. Is there a broader lesson for the reform of bank capital adequacy rules?
Chairman Cox Yes. The past year has shown that the Basel standards came up short for both commercial and investment banks. And this was our experience using the Basel II framework in connection with the capital adequacy measures that are used in broker-dealer supervision. When the voluntary investment bank supervisory program was designed at the SEC in 2004, the year before I became chairman, it was decided that tracking commercial bank regulatory standards in use around the world made good sense. Commercial banks, however, have other backstops, including access to Fed liquidity, that render the cross-comparison invalid.
What we saw in the context of Bear Stearns was that, lacking a complete and comparable set of protections, the use of commercial bank capital measures was not well designed for the task at hand. Immediately following the week of March 10th, as a result, the SEC added substantially more rigorous tests of both capital and liquidity. We developed scenarios in consultation with the Fed that were of much shorter duration and much more severe, including denial of access to secured as well as unsecured funding.
I should also say that those more stringent scenarios, which are now in use, also presume no access to the Fed discount window—even though, of course, the largest investment banks do now have access to Fed liquidity facilities.
How you reconcile the regulatory approaches that the SEC uses with broker-dealers and large investment banks with the various banking regulations, including risk-weighted capital adequacy regulations included within the reformed Basel Accord?
Chairman Cox Neither Basel I nor Basel II is enough — each has serious need of improvement. Since March, the SEC, along with other groups in which we participate have focused on the need to improve standards for capital, liquidity, and risk management in both commercial and investment banking. Experience has shown amply that both the Basel I and II capital requirements on structured credit products were inadequate. Groups such as the Senior Supervisors Group, the Financial Stability Forum, and the Basel Committee itself have all pointed to the need for strengthened and improved standards. Rather than convergence, the current process should result in a new and enhanced set of standards for use by every institution.
We've just come through a period in which there were unprecedented supports provided to the market by the government. We also have seen sovereign wealth funds taking large positions in our commercial banks and primary dealers. What’s your current view of the role and effect of governments in financial markets?
Chairman Cox The United States capital market is the largest, most open, deepest and most liquid in the world. We unabashedly support policies consistent with a market economy. Our regulatory structure, as mature as it is, is premised on the worthiness of markets as determinants of, not only asset prices, but also the allocation of scarce capital to an endless variety of purposes throughout a complex economy. That’s a different system than is in place in many countries around the world.
The U.S. government’s recent market interventions, using substantial taxpayer resources—whether one approves of these measures or not—are very different from the state-controlled public companies and sovereign wealth funds of other nations. Our legislation provides an exit strategy; its entire purpose is to get the markets working; and its role is intentionally temporary.
But where is the “free market” going, when foreign-state-controlled primary dealers take positions in U.S. Treasuries, central banks adjust interest rates through global market operations, and sovereign regulators coordinate on a cross-border basis?
Chairman Cox Necessarily, U.S. regulators take the world as we see it. We have to work with other national regulators, because protecting investors is no longer possible if we limit ourselves to the 1934 paradigm for the Securities Acts. Too much of the fraud is accomplished by people who are more than willing to operate in multiple jurisdictions without reference to whose job it is to police that corner of the market.
We are crafting partnerships with like-minded regulators around the world at an rapid and accelerating pace. But there will always be significant differences between the U.S. market system and the approach taken by other governments. To date, our capital markets have been very creative in accommodating those differences. We simply won’t know the ultimate shape of global capital markets without a bit more experience under our belt.
In retrospect, the SEC Chairman always seems to be a lightning rod for critics. What’s a reasonable expectation for SEC Chairmen? What can you do?
Chairman Cox Rather obviously, the SEC and its chairman get undeserved credit when markets are rising and correlative criticism when markets are in turmoil or dropping. The SEC has the responsibility to make sure the information on which trading depends is as free-flowing and honest as a market cop can require. We are also responsible for ensuring that trading is orderly. The market infrastructure must function so as to minimize friction and to facilitate capital formation. Above all, through our law enforcement and in everything we do, we are the investors’ advocate.
As the SEC performs these roles, not only are the chairman and the entire agency doing their jobs, but the markets and their investors are being well served. BJ
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