Transcript: Harry Cross Visiting Professor Lecture
Professor Roberta Karmel
January 29, 2009
Thank you everyone for coming this afternoon. My name is Lisa Kelly,
and I am one of the Associate Deans here at the Law School, together
with Associate Dean Peter Nicholas. And we want to welcome you here
today for our first Harry M. Cross Visiting Public Lecture this
Cross Professorship holds a particularly warm place in my heart because
actually it was the thing that first brought me here to Seattle about
eight years ago. So, I feel really excited about being able to be on
the other side of this podium today. So, I'm very happy today to say a
few words about the Harry M. Cross Professorship as well as about our
distinguished lecturer today, Roberta Karmel.
The Cross Professorship was established in 1984 by Jack
MacDonald, and this was the first named professorship that was
established here at the Law School. Jack MacDonald was a classmate of
Harry Cross, who graduated here at the Law School in 1940. In 1943, he
joined the Law School, Harry Cross did. And he became a national expert
in the area of property law, particularly community property.
I also learned in doing this research that Harry Cross was an
avid athletic supporter of the Huskies. He was our faculty rep for the
NCAA, and also was president of the NCAA at one point in time. He also
was the caretaker for our mascots, and was apparently to be found at
the games with his huskies in tow.
Professor Cross also not only did all of that, but also served
as Associate Dean and acting Dean here at the Law School. And so it was
Professor Cross' vision and leadership that inspired Jack MacDonald,
his classmate, to get together with a number of other law firms here in
the Seattle community and raise the money that endows this visiting
professorship. And through this visiting professorship, we are able to
have here in the Law School national experts in various fields. And of
course, today, we have no exception to that rule. It is in fact
Professor Roberta Karmel who will be speaking to us today.
Professor Karmel is a faculty member at the Brooklyn Law School
and she is the co-director of the Dennis J Block Center for Study of
International Business Law. And she has been a member of the faculty
for 23 years. She is a Fulbright scholar, a former SEC commissioner, a
practitioner, a scholar in her own right, a teacher whose area of
expertise could not be any more relevant to our times, the times that
we currently find ourselves in.
She is the author of "Regulation by Prosecution," "The
Securities and Exchange Commission versus Corporate America." In this
era of debate over regulation of national and global markets, we are
very fortunate to have Professor Karmel here today to address the topic
of the future of the Securities and Exchange Commission (SEC). Please
join me in welcoming Professor Karmel.
Professor Roberta Karmel:
Thank you very much. I appreciate those kind words, and I appreciate
seeing all of you out here today. I am particularly gratified that some
of my students are here. After listening to me for two hours this
morning, I would think they would have had enough for one day.
am going to talk to you about the future of the Securities and Exchange
Commission, the regulator for the securities markets. It used to be
said, at least in New York, this was when Ed Koch was Mayor, it used to
be said, "A neoconservative is a liberal who got mugged."
Today, I think, it would be fair to say that a neoliberal is a
conservative who lost a large percentage of her retirement account in
the recent stock market collapse. Actually, I would not describe myself
as a former conservative, but I've always had a fair amount of respect
for the securities industry as a positive contributor to the US
economy. And I generally believe that securities regulation should not
unduly hamper the securities markets, particularly in the context of
But,like almost all Americans, I am personally outraged by Wall Street's
debacle and the government response during 2008. And, I believe that
the Obama administration and the current Congress needs to engage in
serious financial regulation reform. Unfortunately, I'm somewhat
pessimistic that such reform will be sufficiently thoughtful, far
reaching and effective in preventing future stock market volatility and
Why? My pessimism stems from years of observing how special
interests have corrupted Congressional oversight of financial
regulators so that supposedly independent federal agencies are disabled
from functioning appropriately. Moreover, since at least 1980, both the
Legislative and Executive branches, regardless of party affiliation
have been gripped by a deregulatory fever, which permitted and even
encouraged Wall Street to run amuck.
The Securities and Exchange Commission has been criticized by
both the left and the right for regulatory failures leading to the
financial meltdown. John McCain said, "If I become President, I'm going
to fire Chris Cox."
A number of the SEC's critics and the SEC's own Inspector
General blame the agency for missing red flags at Bear Sterns and
failing to reign in risk taking by investment bankers. The SEC's
failure to uncover Bernie Madoff's Ponzi scheme, the biggest such
scheme ever to have occurred, has also been highlighted. Some of this
criticism is fair, but in my view the SEC was considerably less
culpable than other government actors for the financial meltdown.
Congress, the Federal Reserve Board and the Executive branch
all fostered an economic climate of easy money, insufficient personal
and governmental savings, excessive leverage, reckless credit practices
by mortgagors, and lax regulation of financial institutions and the
Moreover, the failure of the private and public sectors deal
with the compensation structures of financial executives, which
encouraged excessive risk taking, created an accident waiting to
happen. Fannie Mae and Freddie Mac, despite questionable financial
practices and a lack of adequate internal controls, were allowed to
remain loosely regulated under a quasi governmental guarantee and grew
until they were too big to fail.
The Federal Reserve Board presided over a technology bubble in
the 1990's and an asset bubble thereafter without raising margin
requirements or interest rates, and was firmly committed to both the
continuation and growth of the derivatives market and a deregulatory
There were plenty of warning signs of an overly leveraged
financial system based on the use of derivatives. For example, the
stock market crash of 1987. I was the public director of the New York
Stock Exchange when that event occurred. It was very frightening. Then
there was the long term capital management implosion. There was the
stock market bubble of the 1990s. Yet, after each of these events the
President's working group and financial markets decided no action to
curb derivatives trading should be taken.
If some of you may not know what is the President's working
group on financial markets - This is a committee composed of the
Secretary of the Treasury, the Chairman of the Federal Reserve Board,
the Chairman of the SEC, and the Chairman of the Commodities Future
Trading Commission, the CFTC.
David Router, who was then the Chairman of the SEC, dissented
from this conclusion that nothing should be done. But, he was the only
negative voice. Moreover, in 2002, the Commodities Future Trading Act
was amended so that credit derivatives, probably the most toxic of the
assets currently at the heart of the financial crisis, could be traded
over-the-counter as completely unregulated instruments.
Even before this sub-prime mortgage crisis began to royal the
financial markets, three high-powered special commissions issued
reports on the need for Financial Regulatory Reform. There was a report
by the Committee on Capital Market's Commission; this was composed of
CEOs and other high ranking officers of a number of financial
institutions and professors from Harvard, Columbia and Chicago. They
issued their final report in December 2007.
An independent bipartisan commission established by the U.S.
Chamber of Commerce issued its report in March of 2007. At the request
of New York Senator Charles Schumer and New York City Mayor Michael
Bloomberg, the McKenzie Organization issued a report in January, 2007.
So, you had these three big fat reports all coming out more or less at
the same time.
These reports addressed the migration of the capital markets
from the United States to overseas financial markets. But, each report
had a somewhat different emphasis. However, all of these reports
expressed a concern about prudential supervision and the lack of a
coordinated federal focus and systemic risk in the capital markets.
These concerns proved present when many segments of the financial
markets collapsed because of excessive leveraging.
In the meantime, the Department of the Treasury began a study
of the regulatory structure in March, 2007, and then issued its
blueprint for a modernized financial regulatory structure in March,
2008. I will refer to this simply the Blueprint. Although the Blueprint
was issued after the near collapse of Bear Sterns and in the midst of a
serious stock market and general economic turmoil, it was as much a
response to the three reports I just mentioned which all dealt with the
loss of U.S. capital market competitiveness as it was a response to the
sub-prime mortgage and rating agency problems in the markets.
However, the Blueprint is still a viable document. It is still
being talked about. It laid out a history of the vulcanized financial
regulatory structure, which exists at the federal and state levels for
the financial markets and financial institutions, except for its
short-term, intermediate-term and long-term recommendations for reform.
The Blueprint argument for the review and reform of financial
regulations was not based on a loss of competitiveness of the U.S.
capital markets as these prior reports were. But rather, on
developments in the capital markets, particularly globalization,
improvements in information technology which led to new financial
products and trading strategies, and the growing institutionalization
of the markets.
According to this Blueprint, the current system of functional
regulation is incompatible with these market developments because
jurisdiction of disputes between regulators, slow innovation can lead
to migration to foreign markets.
In addition, there is too much regulatory duplication. The
Blueprint, therefore, made short-term and intermediate-term
recommendations for reform and then set forth an optimum regulatory
structure for the future.
Although much of the Blueprint was devoted to ideas for
regulatory consolidation and streamlining of regulatory approvals, two
new federal agencies were suggested; a Mortgage Origination Commission
and an Office of National Insurance within the Treasury Department. So
these were ideas that came a little more directly out of the financial
Among the short-term recommendations were better coordination
of the financial regulatory policy by the President's working group on
financial markets, which I just described to you, gets convened
whenever there is a crisis in the markets. The inclusion of additional
Federal Bank regulators in that bout, also onsite examinations by the
Federal Reserve Board of non-depository institutions with the focus on
liquidity and funding issues.
Those are kind of the short-term recommendations. Many of the
intermediate-term recommendations involve a rearrangement of federal
regulation of banks. Of importance to today's lecture, however, is a
recommendation that the SEC and the CFTC, the Commodities Future
Trading Commission, be merged. Further, the staff members of both
agencies were urged to begin working on convergence of their regulatory
philosophies and methods.
As I'll explain to you that is not so easy. Before President
Obama took office, the Chairman of the SEC and at least one former SEC
Chairman endorsed a merger of the SEC and the CFTC. The acting chairman
of the CFTC, however, endorsed consolidation of federal financial
regulators generally. But dismissed a merger of the SEC and the CFTC as
quote "A code for a large for a larger SEC along with its rule-based
model and culture." As I explained, the CFTC has a principle based
model and culture.
But, the United States is the only country in the world to
separately regulate securities and financial futures. Some of the key
causes of the market melt-down are due to over-the-counter derivatives;
trading regulated by neither agency, by neither the SEC nor the CFTC.
Yet, the merger of the SEC and the CFTC in the past has been
difficult to implement and will probably be difficult to implement in
the future just for political reasons. The SEC and the CFTC have
different oversight committees and the Congress and the members of
these committees receive large campaign contributions from members of
the industry. Industry concerns regulation of securities of
derivatives, ironically, some of these are the same organizations.
Each of these agencies also have active and concerned alumni
and staff who will resist change in the regulation, their regulation,
of financial markets. Further, as I said before, these agencies have
different approaches to new product approvals and regulation of
exchanges in other market places.
The blueprint favorably contrasts in the CFTC approach to new
product approvals and regulation of financial institutions to the SEC
approach. In fact the blueprint was very critical of the SEC, not for
the reasons people are criticizing the SEC today, for being too lax but
for being too tough and not allowing enough financial innovation.
In view of the disruption in the credit markets in 2007 and
2008 and the role of derivatives in causing these disruptions, I don't
know if the CFTC's principle placed approach to regulation is as
appealing to as many people as it was when the treasury blueprint was
For the longer term the blueprint recommended an optimum
regulatory structure that recognizes the convergence of the financial
services industry but also recognizes distinctions between wholesale
institutional markets and retail financial transactions.
Five basic federal regulators are suggested. One, a market
stability regulator for overall conditions of financial market
stability. Two a prudential financial regulator for institutions with
an explicit government guarantee of their business operations. Three, a
business conduct regulator.
The SEC would continue as an agency separate from these three
agencies and would responsible for corporate finance regulation, kind
of the one part of the SEC's work that Secretary Paulson liked.
Separate Federal Insurance Guarantee Corporation would be an insurer
for institutions regulated by the prudential financial regulator.
Former SEC commissioner, Annette Nazareth endorsed the idea of
a regulatory body charged with business conduct and investor protection
but asked, "Well, why wouldn't this body be the SEC?"
In my view, it is more important to reform financial regulation
than to assess how much blame each regulator had for the current
financial crisis, but some of the examinations of the causes of the
meltdown are necessary to propose reforms.
To what extent was the SEC responsible for the meltdown? I'm
going to discuss three areas very briefly where the SEC had some
responsibility. Although for the most part the SEC's powers were
limited. These were the SEC's role as a consolidated regulator of
holding companies of brokered dealers. I should say as a regulator for
holding companies of brokered dealers. The SEC's role as overseer of
disclosures by Freddie Mae and Fannie Mac and the SEC's role with
regard to short sale rules.
In 1975, the SEC became responsible for administering the net
capital or capital adequacy rule for all broker dealers. Prior to that,
this rule had actually been administered by the New York Stock Exchange
and the NASD. The New York Stock Exchange failed to prevent wholesale
bankruptcies of brokered dealers in the late 1960's and early 1970's.
Congress said, the exchange into this anymore, the SEC should
do it. I mean we're in a kind of similar position today where congress
and others are saying, "Oh the SEC failed in this area, the Federal
Reserve board should do it." That gives me a little pause for reasons
Generally, this rule, this net capital rule, required broker
dealers to retain a debt to net capital ratio of 15 to one. In other
words that was the leverage that was allowed. In April 2004, this ratio
was relaxed pursuant to a SEC rule passed by William Donaldson when he
was chairman of the SEC and the commissioners then serving. This really
predated Chairman Cox and his commission.
The background for this rule change was that when the Graham
Leach Bliley Act, which eliminated the separation of investment and
commercial banking was passed, no provision was made for the regulation
of broker dealer holding companies similar to the supervision of bank
holding companies by the Federal Reserve Board.
The European Union threatened to become the consolidated
regulator of U.S. broker dealer holding companies because in Europe
there was long a model of universal banks. You didn't have any
investment bank holding companies. You didn't have companies like
Goldman Sachs, and Lehman Brothers, and Merrill Lynch. You just had
In response to this threat from the European Union, the SEC
said, "Well we'll do this". Since nobody could decide who ought to do
it in the United States and they didn't want the European Union doing
it, the SEC did this, but it did so on a voluntary basis. This was a
voluntary program. It was never provided for in any statute.
The five largest such companies, which were - they're all gone
now or they've become banks. You had Lehman Brothers, Bear Sterns,
Goldman Sachs, Morgan Stanley, Merrill Lynch. They agreed to have the
SEC become their supervisor even though there was no statutory
authority for this. The quid pro quo for this voluntary relaxation
regulation was a relaxation of the net capital rules.
This change permitted these firms to transfer billions of
dollars of reserves against capital to their parent holding companies,
foreign investment in mortgage backed securities, credit derivatives
and other exotic instruments. As a result by the time of the Bear
Sterns collapse, the ratios of four of the five firms subjected to this
consolidated regulation regime, was in the neighborhood of 30 to one.
Chairman Cox conceded that the SEC's oversight of consolidated
broker dealers, including Bear Sterns and Lehman Brothers, contributed
to the financial crisis. He noted however, that the SEC's program of
oversight was a voluntary program and, therefore, it was - and I'm
quoting - "fundamentally flawed from the beginning."
Another voluntary program administered by the SEC, which
contributed to the current crisis was the financial statement
disclosures and filings by Fannie Mae and Freddie Mac. Unlike other
public companies, these institutions were exempt from the registration
provisions of the Securities Act of 1933 when they sold securities.
Actually, I gave a talk like this a couple of months ago at
Brooklyn Law School and somebody who teaches in this area said,
"Really, I didn't realize that. That Freddie Mac and Fannie Mae were
exempt from SEC disclosure regulations."
In 2002, these organizations agreed to voluntarily file annual
and periodic reports with the SEC but they misstated their financial
statements from at least 1998 through 2004. The SEC brought an
enforcement action against them. In my view, exempting categories of
issuers from the registrations provisions easily leads to fraudulent
There are other such loopholes that used to exist that have
been closed over the years after scandals and insolvencies.
Unfortunately, congress did not see fit to require Fannie Mae and
Freddie Mac to prepare and file honest and fair financial statements.
Another politicized topic is the short sale rule. A short sale,
for those of you who don't know this, is a sale of any security the
seller does not own or any sale consummated by the delivery of a
borrowed security. A former SEC rule prohibited any person from
affecting a short sale of any exchange listed security below the price
at which the last sale of that security was reported. This was known as
the "uptick rule."
This rule was rescinded in the summer of 2007 because it was
believed that with decimal pricing - in other words, a penny pricing
instead of an eighth or quarter which used to be the case - and
derivatives, the uptick rule had become really obsolete and
Nevertheless, after the current financial crisis was triggered
by the collapse of Bear Stearns and the Lehman Brothers bankruptcy,
there was a hue and cry that this was all the fault of the short
sellers. And the SEC responded by prohibiting short sales in financial
There were a number of occasions on which the SEC did this, and
it included in the financial stocks some stocks that might resonate
with this audience - CVS CareMark, IBM, General Motors, General
Electric. The short sale rules were criticized as making a volatile
market worse, a clumsy effort to buoy shares of battered financial
stocks and despite the ban stocks, including National City, Sovereign
Bancorp, Washington Mutual and Wachovia essentially failed.
Chairman Cox later stated he thought that SEC's emergency short
sale rules were a mistake. However, Mary Shapiro, the new Obama
appointed SEC commissioner who, I think, took office today or
yesterday, did say in her Senate confirmation hearings that she would
examine whether the uptick rule should be restored.
One of the most important messages of the financial meltdown is
that over-the-counter derivatives are dangerous securities and should
never have been allowed to be wholly unregulated. Battles between the
SEC and CFTC began almost as soon as the CFT was formed in 1975 because
almost immediately thereafter the Chicago Board introduced the first
futures on a security.
Distinguishing between a commodity's futures contract and a
security was always difficult, and protecting jurisdictional turf
frequently seemed more important to the SEC and CFTC and their
respective oversight committees than did protecting investors.
The competition between the SEC and CFTC was resolved to some
extent by the commodity futures modernization after 2000, which
permitted commodities exchanges to trade single stock futures.
Unfortunately, this statute also accepted the conclusion of the
president's working group that the trading of OTC financial derivatives
between sophisticated counter parties should be excluded from
regulation by the CFTC and the statute also excluded these from
regulation by the SEC or anybody else. This was justified on the ground
that OTC financial derivatives were not susceptible to manipulation.
Modernization of the financial regulatory systems was
sufficiently urgent that it became a campaign issue. I am not going to
go through what Obama said during his campaign because now he's
president, and I don't know what is going to happen.
Of interest also is the day after President Obama's
inauguration, the Government Accounting Office, which is the audit arm
of Congress, released a framework for assessing financial regulatory
reform proposals. Their proposals, like the Obama campaign proposals,
were very vague except that and to me one of the most important points
made in this document, and is that and I am quoting: Regulators should
have independence from inappropriate influence as well as prominence
and authority to carry out and enforce statutory missions.
To me, this coming from the GAO, is really astonishing because
we, what, who curtails their influence? Congress. The GAO report
sidesteps the question of whether the SEC and the CFTC should be
merged. To what extent is it likely that the Obama administration or
Congress will adopt either legislation merging the SEC and the CFTC or
any of the more detailed reform proposals advocated by the Treasury
Blueprint or any of these other fact reports that I have mentioned.
Currently, the Federal Reserve Board by default has become the
consolidated regulator of all the major investment banking holding
companies who remain in business, and the SEC has closed down its
consolidated regulatory program.
Here is a big question of whether it is salutary for a central
banker to also be a regulator. This is a serious issue. It is beyond
the scope of my talk, but it is something for Congress and the
administration and the public to think about because that situation
really undermines the ability of the Federal Reserve Board to operate
in a certain way as the central banker.
Similarly, consolidation of the banking regulators, how they
should be consolidated and the proper regulation of insurance
companies, which now is entirely by the states, are subjects beyond the
future of the SEC. As I've indicated, relevance to the future of the
SEC is whether or not the SEC and CFTC will be merged, and if so,
whether the merge regulator will be dominated by former SEC or former
CFTC commission and staffers?
President Obama nominated chairs for both agencies. It is
noteworthy that his appointee to the SEC chairmanship is Mary Shapiro
who not only is a former SEC commissioner but a former chair of the
CFTC as well as the immediate past at Fenra. So, you might think, "All
right. This is a message. These agencies are going to be merged."
On the other hand, the gentleman who has been nominated to be
head of the CFTC is also a strong individual with a good background,
and I don't think either of these people would have taken the job if
they thought their agencies were going to disappear in the near future.
In my view, however, not only should these agencies be merged, but much
more importantly, the statutory framework for both agencies with regard
to regulation of the securities and derivative markets needs to be
The provisions of the Securities Exchange Act of 1934 dealing
with the regulation of the securities market was passed in 1975 in
another financial crisis, but the purpose of that act was to unfix
commission rates, to integrate exchanges and over-the-counter markets
and inject greater competition into the trading markets.
In addition, that statute gave the SEC authority to regulate
clearing agencies, transfer agencies and other non-brokered dealer
intermediaries. The SEC administered the statute in a somewhat heavy
handed, rule-based manner, and that may well have been one of the
factors leading to the explosion of unregulated trading markets. In
other words, there were too many rules. They were too detailed. And it
was very difficult for exchanges to launch new products and move
On the other hand, the CFTC, in 2002, was instructed by
Congress to regulate according to principles rather than rules to have
a great deal of self regulation, and to leave the over the counter
derivatives market alone. Financial innovation was allowed to trump
Both agencies the SEC and CFTC directly and through there
congressional oversight committees have suffered from regulatory
capture by the securities industry. The mandates and regulatory
methodologies for these two agencies really needs to be reconciled, and
both should be made more workable and freer from industry and
These agencies are considered independent federal agencies.
That means they are independent of the executive branch. They are not
independent of congress. And neither are sufficiently large, well
funded or protected by powerful political forces, particularly, after
the financial crisis for which they are being blamed to operate as the
expert regulatory they were intended to be.
Further, the SEC needs new authority and greater funding in
order to regulate important unregulated sectors of the securities
markets such as credit derivatives and hedge funds. Regulation of other
sectors such as investment advisers and credit rating agencies needs to
be seriously strengthened. Exemptions for so called sophisticated
investors have proved chimerical and need to be re-examined.
In healthy economic times, there has always been a tension
between Main Street and Wall Street - that is between industry and
finance - which is good check and balance in a capitalist system. But,
since the 1980's, regulators have permitted and even encouraged
financial interest to overwhelm industries needs. Market or trading
interests rather than capital formation and investor protection became
the focus of financial regulators.
While the genie unleashed by the derivatives trading cannot be
put back in a magic lamp, the leverage injected into the financial
markets by derivates needs to be seriously reduced.
A significant goal of the Securities Exchange Act of 1934 and
reaction to the depression was that securities credit had to be
seriously limited - that is, securities credit as compared to other
kinds of credit in the economy. But, the importance of limiting such
credit was forgotten or ignored by financial regulators.
Further, the SEC of the future, whatever its amended statutory
authority and mandates, needs to refocus on capital formation in the
stock and bond markets and the protection of investors retirement
Thank you very much. I will be happy to take questions.
Do you see any role for states to play in regulation? I know there is a
tension between... you see it in New York all the time? Can you comment
Yes, well, that is a very controversial area. I think that many
securities lawyers, like myself, and the securities industry have
always argued for extensive preemption of state regulation. But that's
not politically feasible or politically popular.
in certain areas, I would criticize state regulation. New York is
special case. The present New York Attorney General and the last New
York Attorney General decided to reform the securities markets in their
own way. The problem is they did this by threatening firms with
criminal prosecution. New York is one of only five or six states where
the Attorney General can bring criminal cases. I mean, to me, there is
just a basic problem with that.
Other states who's got Commissioners to operate in a different
fashion, they don't get the headlines that the New York Attorney
General does, and they also aren't in the middle of the securities
Some people have said "Well, the New York Attorney General
attacked problems that the SEC wasn't attacking." That's a little
unfair. The problem of the research analyst for example was starting to
be dealt with by the SEC and the predecessor of FINRA the SRO for the
securities industry. But, this was being done by passing new rules.
New rules are much harder to pass than prosecutions.
Prosecutions, you just sue. But, this is a whole other topic. The other
area where there are questions about the role of the states are in bank
regulation and insurance regulation, because almost everybody agrees
that banking regulation has to be consolidated. But, some people argue
that, well, community banks, smaller banks, don't need to be regulated
by the federal government. They should still be regulated by the
states. They are not part of the systemic problem that we are
experiencing. Only the bigger banks need to be regulated by the federal
regulators. And those federal regulators should be consolidated.
Another area is insurance regulation. From my personal
experiences, including having been on the board of an insurance
company, which went into runoff, I don't think state insurance
regulation is very good. And I think they are should be federal
insurance regulation, again, of at least the big insurance companies. I
mean, so much of this stock money was spent on AIG, which wasn't
regulated by any federal regulator. There is something wrong with that
It's [inaudible] of speech. Your question, yes.
Excuse me. I can't hear you.
I think the rescission of the Glass-Steagall Act is not working out. I
mean, the Glass-Steagall Act in the end was rescinded by
Graham-Leach-Bliley because of Citicorp. And now that Citicorp is
dismantling the... But, on the other hand, in every other country,
there is universal banking, which means you don't have anything like a
separation of investment banking and commercial banking.
think this an area where... It would be nice if we could go back to a
simpler financial model. But, I don't think that's possible at this
point. I mean, I just don't think it's feasible when we are in a global
market and all of the competitors to the U.S. banks are all universal
banks - which means no Glass-Steagall.
It's a difficult issue. The other related difficult issue is
whether banking and commerce should continue to be separated. And
what's happened - it's going to tee this up because Goldman Sachs, for
example, was a merchant bank that was involved in commerce. And now,
it's a bank holding company. So, what's going to happen there? I don't
The decision to relax the net capital funds in terms of long.... How
far up in Congress did that decision...? To what extent did Congress
become involved in that decision making?
The Congress was not involved in that decision at all. I am not sure of
the extent to which the SEC even understood what it was doing, because
I had a conversation with one of the commissioners who was a
commissioner when this happened more recently, he was no longer a
Commissioner. He said to me, "We did that?" I said, "Yes." This
commissioner's recollection, "I don't even remember a discussion about
was remembered is that the European Union said, "We are going to
regulate the holding companies of broker/dealers." The Financial
Regulators said politically said, "We don't want Europe regulating our
financial firms. Who's going to do this?" Congress did nothing. It was
kind of a sense, "Well, the Federal Reserve Board shouldn't do this,
because they regulate banks." So, the SEC said, "OK, we'll do it," but
I don't think it was a very thought-through idea, it was a voluntary
In terms of the leverage - let me say this. In the past the
Securities Regulatory System, unlike the Bank Regulatory System, was
that if a securities firm becomes over leveraged, makes bad business
decisions, there is a system similar to FDIC Insurance called "SIPC
Insurance" to protect the funds and securities of customers being held
by broker/dealers, and the broker/dealers should go bankrupt. When
Drexel Burnham got into trouble that's what happened, they went
This time around bankruptcy just didn't seem to be an option
anymore, because there was too much interactivity between all of the
financial firms. The Financial Regulators did allow Lehman Brothers to
go bankrupt, and many people say "This is what really caused the
meltdown." So then, the Federal Reserve Board and the Secretary of the
Treasury were afraid to let anybody else go bankrupt. Even with Bear
Stearns, the Fed opened the discount window in order for Bear Stearns
to be taken over.
I mean, the rules of the game got changed. So, if you're not
going to allow certain firms to go bankrupt, then you have to change
their regulation; then you can't have this kind of leverage. Some
people say, "OK, broker/dealers now are going to become more like
utilities. They're not going to be able to be as leveraged and make as
much money, or be allowed to go bankrupt. Should that be true for every
broker dealer? Probably not; probably only really the big ones.
Professor, you mentioned somewhat tangentially that the executive
compensation [inaudible] people running corporations did in a way that
ultimately wasn't good for the system. I wonder what kind of reform or
regulatory scheme you might impose to bring that into check.
I don't know. The last few years, I asked students in an exam the
question - why is it that the law is so ineffectual in regulating
executive compensation? I can say that I don't ever get answers that
are satisfactory. But, State law, the Delaware courts haven't done any
kind of a job here. Personally I think a lot of the problem is the Tax
Code, that the better way to attack this is through the Tax Code.
the other hand, when Congress rather ineffectually did this by passing
IRS Code Section 161M, which limits corporations from paying executives
more than $1 million a year except under circumstances where there's
some kind of a formula, and a third party could figure it out, and this
led to everybody getting a lot of options and a lot of stock, and these
obscene, really, compensation packages.
So, that wasn't a very good check, but it seems to me if you
simply say, "Compensation over a certain amount, however you figure it
out, is not going to be deductible by the corporation," that's one way
Higher taxes on the rich, that's another way to go. A lot of
people now say, "Well, that's redistribution, we don't believe in
that." We've had redistribution now for the past eight years; money has
gone from the middle class to the rich, because we've changed the Tax
So, I mean there are things that can be done. The question is whether
Congress will have the backbone to do it, but they are not jobs for the
Financial Regulators. On the other hand, should these financial firms
be taking all of this bailout money, TARP money, whatever you want to
call it, and paying high salaries with it? I mean that really I think
is a ...
guess, some paper I read in the last day or two said, "These leaders of
the banks have a tin ear when it comes to what the public is thinking
about them right now." I don't know how they've been so insensitive,
But, all of the compensation packages did encourage risk
taking, and it's not just the top people, it's all of the middle
managers and the whole Wall Street bonus system.
A lot. I mean I've thought that in many contexts that one of the
problems in the markets today, and the way those markets are regulated,
is that short term investors have been given an awful lot of power and
there is much less emphasis on long term investors. This I think is one
of the problems, but it's easier to say that's a problem then figure
out how to solve it.
Oh, mark-to-market accounting. Well, I view the problem of
mark-to-market accounting the same way that I view all of these
criticisms of elimination of the uptick rule and short sales. I mean,
this is shooting the messenger. Mark-to-marketing accounting has
demonstrated the dire financial condition that financial firms are in
because they have various derivatives that have no market, that are
problem with mark-to-marketing accounting is that once financial firms
are forced to value these securities they're holding at their fair
market value, these firms are probably insolvent. So I say, I think is
shooting the messenger really.