– At the 21st Symposium on Building the Financial System of the 21st Century: An Agenda for Europe and the United States
Securities markets and banking sector regulatory approaches
Recent events, such as the failure of confidence in certain US regional banks, rising inflation and its economic effects, and the lingering effects of the pandemic, raise important considerations for policymakers that can reverberate around the world. The securities markets and the banking sector are key pillars to our economies. Yet, the appropriate roles of securities regulation and prudential regulation, while highly complementary, serve very different purposes and are intended to achieve different outcomes. These considerations expose different views of regulation and expose pressure points worth exploring.
The securities markets serve important functions in global economies: they provide liquidity and price discovery, they permit participants to raise capital and to allocate risk in an efficient way to meet their various tolerances, and they enable investors with opportunities create wealth to fund retirement and other goals.
At the SEC, regulation generally focuses on requiring full disclosure of material information in order to protect investors and the integrity of the capital raising process. Exchanges, trading activities, and asset management are regulated from a market conduct perspective to prevent fraud, protect against market manipulation, and facilitate capital formation.
Fair, orderly, and efficient markets can be facilitated through rules requiring prompt and accurate clearance and settlement of transactions and the safeguarding of securities and funds. Through price transparency, conduct regulation, and appropriate disclosure requirements, the securities markets create economic growth and opportunities. Finally, and perhaps most importantly, it is expected that some issuers of securities will fail and the markets will help to discern which ones thrive.
On the other hand, banking regulation serves an important purpose by maintaining the safety and soundness of depository institutions and payment systems. Prudential regulation is appropriately focused on ensuring that bank capital positions are adequate, such as through leverage and risk-based capital requirements, and supervising banks through exams and other means. Generally, banking regulation is intended to prevent banks from failing and providing confidence to depositors that their deposits are protected and withdrawals will be satisfied.
In contrast to the securities markets, depositors do not generally engage in risk-taking or require disclosure about how to allocate their capital; they rely on prudential regulation to provide them with assurances that their deposits, and the banks in which they are held, will be safe and sound.
Since the 2008 financial crisis, there has been significant focus by regulators on financial stability. However, it is important to recognize that attempts to prudentially regulate the securities markets can undermine the very purpose of those markets – the efficient allocation of risk and return. Examples of prudential regulation in the asset management sector include imposing capital requirements on asset managers and investment funds, designating non-bank firms as “systemically important” and subjecting them to heightened requirements, and instituting liquidity ratios and capital requirements for investment funds and managers. Thus, for the securities markets, the failure of some enterprises is a very real, and anticipated, outcome.
SEC regulatory agenda
While much attention has been focused on financial stability, there has been less discussion on regulatory stability. To be effective, the regulatory framework should address clearly identified problems and be supported by appropriate economic analysis. In the aftermath of the 2008 global financial crisis, it was appropriate to take a hard look at our regulations. However, there are understandable concerns that the SEC’s current regulatory agenda lacks a coherent vision and that the current path may create significant disruptions in the financial markets without obtaining commensurate benefits.
In the absence of Congressional mandates, investor protection concerns, or market crises, the SEC’s rulemaking agenda is largely discretionary. In such cases, I am reminded of the Hippocratic oath for medical professionals – “First: do no harm.” Change for change’s sake rarely leads to good outcomes, particularly when market participants and investors look to regulation as a source of stability and predictability.
One significant concern relates to the potential for the SEC to adopt final complex rules with compliance dates in close proximity to each other. In addition, the SEC reviews each proposal’s costs and benefits singularly, but generally does not review related proposals holistically or how they might interact with each other. Yet, engaging in such analysis is vital where proposed rules are likely to have interrelated impacts and overlapping compliance dates. Otherwise, there is a concern as to whether the SEC can demonstrate a reasoned basis in exercising its rulemaking authority.
For example, the SEC issued four market structure proposals, including new “Regulation Best Execution,” a new “Order Competition Rule,” amendments to Exchange Act Rule 605 enhancing broker order execution disclosures, and amendments to minimum pricing increments and exchange access fee caps – in December 2022. These four proposals are in addition to other market structure proposals, including re-defining which entities are “exchanges” and are “dealers.”
The SEC also proposed two new cybersecurity-related rules and amendments to Regulation S-P in March 2023. These proposals could affect many of the market participants affected by the other market structure proposals. Each rulemaking has overlapping costs, complexities, and unintended consequences that the SEC has not thoroughly analyzed, but is asking the public to address and respond. The SEC has also failed to examine how any potential implementation of rules should be sequenced. For instance, the SEC has already finalized a rule that accelerates the settlement date for equity securities from two business days to one business day. This change will take effect in May 2024 and require extensive changes and testing for a successful transition. Should the SEC create additional risks by implementing these other changes around the same time?
Similarly, the SEC has proposed several ESG-related proposals that are interrelated but that do not speak to each other: the climate-related disclosure for corporate issuers, ESG-mandated disclosure for investment advisers and funds, and the use of “ESG” in a public investment fund’s name. In particular, the proposed ESG disclosures for funds and advisers rely in part on corporate climate disclosures and should be sequenced accordingly.
To further illustrate my concerns, the SEC’s agenda includes over 50 items. This is very ambitious and on a scale that rivals the rule proposals issued in the aftermath of the global financial crisis. At this pace and volume, can the public review and meaningfully comment on the proposals? For instance, many of these rule proposals affect companies and market participants in Europe. Speed and volume may be good metrics for a widget-producing factory, but not in a regulatory regime that should be built on careful analysis and deliberation.
To give a sense of the SEC’s agenda, it includes proposals on:
Public companies, including finalizing climate-related change disclosure and, beneficial ownership reporting, and shareholder proposal exclusions and introducing proposals relating to human capital and board diversity disclosures, and the accredited investor definition;
Asset management, including finalizing proposals on open-end fund liquidity, money market funds, custody, outsourcing of certain functions, private fund advisers (with respect to conflicted and prohibited transactions, preferential treatment, quarterly statements on performance and fees and expenses, fund audits, and adviser-led secondary transactions), ESG disclosures, fund names, and proposing rules on digital engagement practices for investment advisers and broker-dealers;
Rulemaking on cybersecurity, including for public companies, investment advisers, broker-dealers, exchanges, and other market participants; and
Further market structure proposals beyond the previously discussed ones, including narrowing the proprietary trader exemption from FINRA membership, risk management practices for central counterparties in the US Treasury market, central clearing of US Treasury securities and repurchase and reverse repurchase transactions, and updating the governance of clearing agencies.
The importance of robust global markets
Concerns about the SEC’s current proposals to change regulation are not limited to a domestic perspective, but also about how they might impact global markets. Rapid changes to the US securities markets regulation can have consequences throughout the world. Securities markets are global markets, and international engagement is important to ensure that regulators and market participants work together.
The globalization of capital markets can open up additional opportunities for market participants and investors, lower the cost of capital for companies, and increase competition in specific markets. These benefits, however, can only accrue through responsible regulation that is appropriate and not overly prudential. Such regulation can enhance the effectiveness of the global capital markets in establishing conduct regulations (e.g., antifraud provisions), disclosure requirements, and market efficiency (e.g., listing requirements, market making and liquidity requirements).
As in the domestic markets, carefully evaluating costs and benefits can help to avoid ineffective and costly regulations that could otherwise impose barriers to entry that reduce the diversity of companies, investment advice, and financial service providers, and inhibit competitiveness.
Appropriate ways to promote globalization could include a careful use of a regulatory regime to permit investors to directly access foreign markets, provided those markets are supervised in a foreign jurisdiction under a securities regulatory regime that provides investors with protections comparable to those of the home jurisdiction. One example includes memoranda of understanding to help facilitate the sharing of regulatory information for enforcement or other appropriate purposes. Twenty years ago at this symposium, notions of equivalence and convergence were presented as a way to facilitate cross-border activities in a responsible way.
International bodies such as IOSCO and the Financial Stability Board can also facilitate meaningful dialogue in the regulator and market participant community. These organizations have made efforts to bring together the views of investors and other market participants through roundtables, surveys, and other outreach. However, these organizations have a tendency to focus on developing prescriptive standards or launching overly ambitious work plans covering a multitude of topics.
I would encourage these organizations and others to avoid the trap to continually publish and produce: more is not necessarily better. Continually launching new workstreams and publishing new standards at breakneck speed risks having the international community pay less attention, not more. It also taxes the ability of the regulators to fully participate in these organizations given their own resource constraints and priorities.
In speaking about resource constraints, I want to make sure that I do not exhaust yours in light of the ambitious agenda for today. I will leave you with a brief summary of my overall thoughts: first, there is an appropriate role for each of prudential regulation and securities market regulation, and regulators should be careful to recognize the pitfalls and benefits of each. Second, to be effective, regulation should be carefully tailored to address a specific articulated problem, backed by data, and be subject to public comment. Third, domestic market regulation is increasingly global regulation, and regulators and market participants would be well served by an open dialogue that discusses potential impacts and seeks to address barriers to a more open and democratic market.