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Turmoil in the credit markets

Examining the Regulation of Investment Banks by the U.S. Securities and Exchange Commission

Securities, Insurance and Investment Subcommittee of the Senate Banking Committee

May 7, 2008

Comments of Cate Long, Multiple-Markets

I appreciate an opportunity to forward comments to the Subcommittee on the regulation of investment banks by the Securities and Exchange Commission.

Like members of Congress and other market participants I have been concerned that our regulatory framework may have gaps which developed as our capital markets have evolved and accelerated.

The draining of liquidity from Bear Stearns which lead to its near failure on March 16 demonstrated the high level of interconnectedness that exists between our largest broker dealers.

The concentrated reliance of our largest investment banks on each other for funding and liquidity lead to the need for the New York Federal Reserve to mediate and fund the acquisition of Bear Stearns by JP Morgan Chase.

This extraordinary action by the New York Federal Reserve has lead some market commentators to suggest that the oversight of our largest investment banks (who are the Federal Reserve’s primary dealers) should be transferred to the Federal Reserve.

I believe that this is a direction that Congress should pursue with great caution and deliberation.

The Exchange Acts of 1933 and 1934 have generally created an effective framework for securities regulation. Recent events suggest that additional authority for the SEC, beyond the scope of the ’33 and ’34 Acts might be necessary to enhance America’s role of having the freest, most transparent and deep capital markets.

Recent proposals for reform put forward by the Presidents Working Group enshrine “market stability” as a prime regulatory function.

The elevation of “market stability” as a central regulatory premise would represent a landmark shift in our approach to regulating the securities markets.

The ’33 and ’34 Acts embody the principles of disclosure, transparency and the varied responsibilities that parties operating in the markets have towards each other.

Granting a regulatory entity the responsibility for “market stability” was not the focus of lawmaking in the aftermath of the Great Depression.

We can assume that Congress and the Roosevelt administration believed that financial markets would inherently regulate their own stability if they operated in an open and transparent manner.

If markets are going to regulate their own stability the truth is that some firms will fail through difficult parts of a credit cycle.

If we believe that markets naturally create successful and unsuccessful firms then the failure of Bear Stearns was an ordinary market event.

Bear’s counterparties and creditors acted on their belief that the firm was over-leveraged and unstable.

These counterparties sought additional compensation for the risk of transacting with Bear or in many instances “backed away” from lending and trading which they had formerly engaged in.

Bear’s counterparties, who trade and lend to the firm on a daily basis, were in the best position to judge the stability of Bear.

Bear’s counterparties were in a much closer relationship to judge creditworthiness and stability than a regulator who operates on secondary and delayed information.

SEC Chairman Cox made the following statement in his testimony to the Senate Banking Committee on April 3, 2008 (page 2)

~~~~ “…In the cauldron of these events, the actions that the Federal Reserve took – in particular, extending access to the discount window not only to Bear Stearns, but also to the major investment banks – were addressed to preventing future occurrences of the run-on-the-bank phenomenon that Bear endured.

It remains, however, for regulators and Congress to consider what other steps, if any, are necessary to harmonize this significant new safeguard with other aspects of the existing legislative scheme, and the regulatory structure that resulted from the enactment of the Gramm-Leach-Bliley Act.

The SEC, of course, does not have the function of extending credit or liquidity facilities to investment banks or to any regulated entity.

Instead, through our consolidated supervised entities (CSE) program, the Commission exercises oversight of the financial and operational condition of Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley at both the holding company and regulated entity levels.

Our oversight of the CSEs includes monitoring for firm-wide financial and other risks that might threaten the regulated entities within the CSE, especially the U.S. regulated broker-dealer and their customers and other regulated entities, here and abroad.

In particular, the SEC requires that firms maintain an overall Basel capital ratio at the consolidated holding company level of not less than the Federal Reserve’s 10% “well-capitalized” standard for bank holding companies. CSEs provide monthly Basel capital computations to the SEC.

The CSE rules also provide that an “early warning” notice must be filed with the SEC in the event that certain minimum thresholds, including the 10% capital ratio, are breached or are likely to be breached.

At all times during the week of March 10 – 17, up to and including the time of its agreement to be acquired by JPMorgan Chase, Bear Stearns had a capital cushion well above what is required to meet the Basel standards….” ~~~~

The markets knew that Bear Stearns was failing. Bear was the first and most significant broker-dealer casualty of the credit crisis of ’07-’08.

The failure of Bear has clearly raised the specter that broker dealers operating with leverage ratios of 30-1 risk collapse in unsteady market conditions. Hopefully this event has spurred other large broker dealers to delever. Markets have absorbed this lesson and investment banks are supplementing their balance sheets accordingly.

I believe that the Committee has several useful paths for information gathering and review.

1. What signals and methods of information gathering is the SEC utilizing to assess the soundness and liquidity of the CSE participants? (How is the Commission working with the Federal Reserve and international regulators? Is the Commission utilizing publicly available market data such as subscribing to various credit default swaps pricing services?)

2. Is the oversight broad enough in scope? Should it encompass all the major broker dealers?

3. Is additional lawmaking necessary to give the SEC the required authority in this area?

4. What authority does the SEC require to ensure the orderly dissolution or sale of an unsound CSE participant?

5. Does the SEC require additional resources to fund this program?

Also it might be useful for the purposes of the Subcommittee to request that the SEC and various trade groups such as SIFMA, ISDA, and FIX Protocol prepare backgrounding information on the current state of the financial markets.

This backgrounder could include the following types of information:

1. Trade volume and product mix of the registered exchanges

2. Size and member mix of the self regulatory organizations (SROs)

3. The levels of leverage and asset quality of the major broker dealers (i.e. levels of Level 1, 2 and 3 assets)

4. The size and ownership of the various ATS (alternative trading systems)

5. Information on the tiered pricing used by broker dealers to various types of buyside clients and other counterparties

6. The volumes of trading conducted over-the-counter for various products (for example who are the dominant dealers)

7. The condition of the interdealer market for various products

8. The extent of reliance of the major broker dealers on each other for liquidity and funding and the levels of borrowing they have done at the Federal Reserve (liquidity concentration)

9. Any feedback from the trade groups on areas of regulatory weaknesses

10. Any feedback concerning lack of transparency and competition in the financial markets 

I laud the efforts of the Subcommittee in this vital area of inquiry.

I thank the Subcommittee and Chairman Reed for an opportunity to forward these comments.

Please advise if I may provide additional information.