SEC Commissioner Kara Stein Declares War on SEC Chair Mary Jo White

A relatively new SEC Commissioner, Kara Stein, has decided to depart from the usual polite behavior regulatory overseers and is making noise about SEC decisions and policies that she finds to be dubious. The word most commonly used in the media about her remarks is “blistering”.

But the press, while giving Stein’s unusually forthright speeches the attention they warrant, has either failed to notice or is pretending to miss what is really going on: Stein is taking on SEC chairman Mary Jo White on her finance-firm-friendly regulatory stance in a remarkably frontal manner.

The reason that Stein’s outspokenness is so unusual is that it is almost unheard of for a regulatory supervisor to cross swords openly with an agency head who hails from the same party.

And don’t think that Stein is merely making noise. Even though she’s only been in her post for roughly a year, she’s already having an impact. The final Volcker rule came out much tougher than the financial services industry expected, and insiders report that Stein played a significant role in those eleventh-hour improvements.

Similarly, having a strong pro-regulation, pro-enforcement voice on the commission emboldens staffers in the SEC to be more vigorous in pursuing violations (contrary to popular opinion, many career staff members are keen to stamp out bad conduct. Too often, they are curbed by the more craven politicized division heads. One has to wonder, for instance, if the SEC’s Drew Bowden would have been as direct and specific as he was in calling out widespread abuses in the private equity industry in early May if Stein hadn’t paved the way for more blunt SEC public remarks.

Stein has called out numerous SEC failures of nerve in her brief tenure as commissioner. For instance, in April she issued a withering dissent on the SEC’s waiver of having Royal Bank of Scotland lose its status as a “well-known seasoned issuer” as provided in both legislation and SEC rules, when it convicted for interest rate manipulation. This standing is valuable because, among other things, it allows securities issues to float offerings at will, rather than wait for the SEC to review and approve their offering documents. Stein also said that the SEC had recently given kid-gloves treatment to another financial institution that had also engaged in criminal abuses. In a statement to the Huffington Post, Elizabeth Warren backed Stein’s position:

When the SEC waives automatic penalties for criminal misconduct by the largest banks, it sends a dangerous signal about how weak it is in its enforcement of the law,…We are still paying the price for a financial crisis that was caused in part by regulators looking the other way while big financial institutions broke the law. Big corporations should not get special treatment when they break the law, and the SEC needs to learn from its past failures in oversight, to demonstrate no one is above the rules, and to show some backbone.

At the end of May, Stein told the securities industry self-regulatory body FINRA that investors were increasingly concerned that markets are rigged and that the use of computer-based trading strategies could make it harder to prove intent to engage in bad conduct. She argued for greater use of prohibitions and that enforcement needed to be tougher:

Your sanctions should be designed to deter misconduct and improve business standards. And recidivists should be treated more harshly.

But, I fear the results, after months or years of hard work by you, are too often financially insignificant for the wrongdoers. Your enforcement cases must be impactful, and provide strong motivation for compliance.

I would encourage you to examine your sanctions and update them. I think the Commission could be very helpful to you in that process.

This is coded, since Stein is dealing with an independent agency, but the message is clear: “Too many of your sanctions are obviously mere slaps on the wrist. Time for that to stop.” In an article applauding Stein’s speech, Larry Doyle at Benzinga pointed out that FINRA fines have been a pathetic .0.1% of industry profits.

In a speech on Thursday at the neoliberal Peterson Institute, Stein hit out at a broad menu of regulatory reform failures, including:

The large number of Dodd Frank provisions that have yet to be finalized

The resulting shortcomings in reducing systemic risk

Continuing turf battles among regulators that need to work together

The failure to take firm enough measures to curb risk in short-term funding markets

Pitfalls in the SEC’s approach to capital and liquidity

Inadequate measures to deal with the threat presented by hedge funds that use levered trading strategies

Other commentators have criticized tardy Dodd-Frank implementation and insufficient focus on the risks that large, leveraged traders pose. Stein is opening up new fronts by calling out jockeying among regulators (in this case, between the SEC and the Office of Financial Research) and questionable approaches still used by the SEC to measure capital adequacy, liquidity and risks of repo funding.

Stein described one pre-crisis rule change that some readers may remember, namely, that the SEC changed its net capital rule in 2004 to let dealers use their own models, including dubious but still widely used Value-at-Risk models. Stein stresses that at the time, the SEC knew full well that this change would let firms get away with carrying less capital. Indeed, the wink-and-nod was that that was the point: the objective was to “reduce regulatory costs for broker-dealers.” Part of why the SEC took such a narrow view of risk was that historically, the agency was concerned only that the customers of a broker-dealer would come out whole if a firm fails, and not to make sure the firm can survive market upheaval. We all know how that movie turned out. The biggest US securities firms did indeed lever up and either failed, were rescued or merged into banks.

Here is how Stein throws down the gauntlet:

… prudential regulators have long relied on capital and leverage restrictions to actually prevent a firm’s failure. That is not generally the goal of the SEC’s capital regime. Rather, the SEC’s capital regime has historically been somewhat agnostic as to the failure of the firm itself, focusing instead on ensuring the return of assets to the firm’s customers. This disparity in historical objectives may be part of the confusion. I say historical, because I believe that the SEC should consider whether it, too, should be focused on preventing the collateral impact of the collapse of a systemically significant firm. Given the systemic risks posed by some of the firms we regulate, I think it’s about time for the SEC to revise its reasoning for imposing capital requirements to reflect not only our historical objective to protect a firm’s customers, but also reduce the risk to the entire financial system of a large broker-dealer’s collapse…

While the SEC has recognized that “net capital … should be permanent capital and not merely a temporary infusion of funds from an affiliate or other sources,” we also have historically allowed subordinated debt from an affiliate to count as capital. Given the needed shift as to why we require capital, we should consider whether it is still appropriate to do so. Considering what we know now, the current treatment is quite troubling. Counterparties to a broker-dealer may cease to do business with it, or significantly alter the terms, if they learn that the broker-dealer is undercapitalized or otherwise in financial distress. Their concerns are not likely to be assuaged by debt provided by the broker-dealer’s affiliate. Why? Mainly because counterparties would likely want to avoid legal disputes over repayment priorities, particularly after the last crisis. If that’s the case, then the broker-dealer’s compliance with our net capital rule may still leave it at risk of a run. This, of course, can create a liquidity crunch that threatens not only the broker-dealer’s viability, but that, in turn, threatens the viability of others firms, creating contagion that can spread quickly to other parts of the financial markets.

Stein also argues that it’s outdated not to haircut all repo:

…it’s past time to require some meaningful minimum haircuts for all types of securities lending and repos in our net capital regime. It simply doesn’t make sense to argue that even high quality assets have zero risk. This defies lessons learned from the recent financial crisis and basic principles of finance.

Stein is not exaggerating. In the worst of the crisis, counterparties were so concerned about exposures to each other that it was impossible even to repo Treasuries.

Banks and trading firms are sure to howl at one of Stein’s proposals on short-term liquidity risk:

Borrowers who rely on short-term funding should be required to disclose to their investors the relative maturities of their obligations. If a borrower becomes too dependent on short-term funding, its lenders may demand more collateral, higher interest, or restrict their access to funding altogether. This is how efficient markets should work.

Traders do not like information about their positions being exposed to other parties in the markets, since that enables them to be picked off. A noteworthy recent example was the London Whale. Some might take issue with that comparison, since the JP Morgan CIO took an overly large position in a fairly illiquid derivative. But too-big positions in any market can lead to liquidity risk, since the player can’t get out quickly without depressing prices. Remember, Long Term Capital Management had to be wound down because it took an outsize bet in a highly liquid market, interest rate swaps, and other traders got wind of LTCM’s wager and started betting against it.

Despite industry protests, I would imagine that it’s not all that hard to describe bank and security firm funding profiles in a way that gives an idea of maturity/rollover risk without giving information about particular exposures.

It’s important to take note of and support Stein’s efforts at the SEC. There is a lot of well-deserved cynicism about regulators and regulatory processes. But it is also critical to remember that well-placed individuals can make a difference. Even as one commissioner out of five, Stein has already made a mark on the final Volcker rule and is throwing a lot of sand in the gears of Mary Jo White’s game plan of going easy on the financial services industry on the regulator front. So if you have a minute, send a note to your Congressman and/or Senator (particularly if they are on any of the banking or financial services committees) praising her latest speech. The more notice Stein gets, the more effective she will be in her reform efforts.