The Practical Implications of SEC Regulation outside the United States
Marriott Hotel, London
17 February 2004
Speech by John Tiner
First I would like to thank the organisers of this conference for inviting me to give the keynote address at today's conference. I have been asked today to say a few words on the subject of the practical implications of SEC regulation outside the United States. This is a wide subject and I only have a few minutes so I will confine my comments to only a few main areas.
The US and EU capital markets are the largest and most successful in the world. Together the US and EU equity markets alone comprise more than two thirds of worldwide capitalisation. In terms of volume of traded shares the ratio is even higher. The US capital market is both internally integrated and relatively open to those from outside the US who wish either to invest capital or to raise it. The EU capital markets are also becoming more integrated and more open and so more like the US markets. The aim of the EU's legislative programme under its Financial Services Action Plan is to create a single and efficient capital market within the EU. Similarly within the US the SEC is undertaking important reforms of regulatory structures especially in the areas of capital standards and consolidated supervision for broker-dealers and accounting, auditing and disclosure standards.
The growing similarities of the US and EU, especially the UK, capital markets makes it increasingly of practical importance that regulatory authorities on both sides of the Atlantic work to reduce unnecessary differences in standards that might create barriers to entry and hinder the growing inter-dependence of the two markets. Key to this, among other things, are the capital adequacy standards that apply to the large investment banking groups containing broker-dealers, especially at a group-wide or consolidated level and the accounting, auditing and disclosure standards that apply to those who are seeking to raise capital.
Turning to the first of these, capital adequacy standards for investment banking groups, I note that both the SEC and EU have important and parallel initiatives for reform. Within the EU there are the Financial Groups Directive ("FGD"), also called the Financial Conglomerates Directive, which is due to come into force from 2005 and the draft EU Commission proposal for the Risk Based Capital Directive which at present is drafted to come into force at the end of 2006. The FGD strengthens the regime for consolidated supervision for financial groups within the EU including groups that contain broker-dealers. The draft Risk Based Capital Directive proposes applying the standards set out in the draft New (Basle 2) Accord not only to the banking sector but also to the other financial sectors (other than insurance) but including broker dealers. Similarly the SEC is proposing "Alternative Net Capital Requirements" for broker dealers that both introduce consolidated supervision and apply capital adequacy standards that are consistent with Basle.
Within the banking sector consolidated supervision has of course been in place in both the EU and US for many years now. It rests on the idea that membership of a group by a regulated bank is both a potential source of strength and of risk to the bank's financial stability and credit standing. This is equally true whether the entities making up the group in question engage principally in 'conventional' banking activities or provide a wide range of disparate financial services. A strong group is a potential source of both capital and liquidity if the bank were to experience difficulties. However the reverse is also true. In times of financial stress for the group, the bank may come under pressure from its owners to transfer funds to the group thus potentially weakening its own financial strength. Perhaps even more seriously, publicity arising from the financial stress to which the group is subject may damage confidence in the bank leading to difficulty in attracting or retaining deposits and other sources of finance. Consolidated supervision which takes the form of group-wide quantitative and qualitative standards relating to internal controls, capital adequacy, intra-group transactions and risk concentration is the means by which supervisors aim to identify group wide risks and ensure that these are properly addressed.
Outside of the banking sector the application of consolidated supervision is more recent and more controversial. We believe, however, it is fundamental to the modern and appropriate supervision of large financial groups that undertake financial activities as principals such as taking deposits, significant own account trading or underwriting insurance risks. Put at its simplest, the risks facing financial groups are not the same as the sum of the risks facing its constituent parts. And it is the job of the group's management and supervisors alike to identify and address risk at the group-wide level.
The EU first introduced consolidated supervision for financial groups including broker-dealer groups from 1996. However, this only applied to EU groups. Where an EU investment firm was a subsidiary of a group with its head office outside of the EU, consolidated supervision did not apply or only applied to the EU sub-group, if any. Early last year the EU enacted its Directive on Financial Groups with the aim of closing this gap in the scope of consolidated supervision. The directive imposes consolidated supervision at the level of the ultimate holding company even where this is situated outside the EU, except where the home jurisdiction of that holding company itself imposes an "equivalent" regime for consolidated supervision. It thus has the potential to apply to the large US broker-dealer groups which have broker-dealer subsidiaries in the UK or elsewhere in the EU. At present the SEC does not apply consolidated supervision to broker-dealer groups but, as I have already mentioned, it is in the process of consulting on introducing them in its paper on "Alternative Net Capital Requirements".
The SEC in its consultation paper notes that a broker-dealer may incur many types of risk through its affiliates. For example, a broker-dealer's access to short-term funding may be affected by the insolvency of an affiliate. Management at holding company level may seek to divert capital from the broker-dealer making it more likely that the firm would fail during volatile market conditions. We would share this analysis and add the observation that, in order to be effective in addressing risks such as these, it is imperative that capital is available to whatever part of the group is in need of it. This means that capital needs to be adequate at all times at both the group-wide and solo entity level. As the SEC's consultation paper notes this risk was recognised within the US over a decade ago when Congress enacted legislation to give the SEC rights to obtain information from holding companies and affiliates of broker-dealers. The SEC's latest proposals take a further important step by introducing consolidated supervision for large broker-dealers who fall under the proposed Alternative Net Capital Requirements.
In their consultation document the SEC express the expectation that the supervision contemplated by their proposal would meet the "equivalence" standard set out in the EU directive. This is our hope also, but neither we nor the supervisory authorities in other EU states have yet to form a definite view on this. Now is not the time or place to offer a definitive analysis of these proposals or of the areas where further clarification or refinement might be needed, but I would draw attention to one central feature of the proposals. The SEC consultation paper states that its aim is to apply standards to broker-dealer groups that are consistent with those that apply to the trading book activities of banking groups under the Basle accord. This application of standards that are "consistent" with Basle is key to any finding of equivalence under the EU Directive at least as regards quantitative standards. The Basle standards define how to calculate both capital requirements and the actual capital available to meet those requirements. SEC standards that are "consistent" with the Basle rules does not of course mean that they need to be in all respects identical. And it is clearly unsatisfactory that the banking regulators alone should set standards for capital adequacy that then need to be adopted by securities regulators – this is a theme to which I shall return in a few moments. However, consistent or equivalent application of standards does require that there should not be substantial differences. For example, on the calculation of available capital we note that the SEC consultation document draws attention to the suggestion by some industry participants that long-term non-subordinated debt might count as capital. If permitted this would clearly set a substantially lower standard for available capital than applies under Basle.
I alluded a few moments ago to the need for securities regulators to work together with banking regulators in setting capital adequacy standards for trading book activities. You will be aware that the Basle Committee announced last month that the Committee plans to undertake a review of counterparty credit risk and trading book issues in coordination with the International Organisation of Securities Commissions (IOSCO). Both the SEC and the FSA will pay a leading part in this work. The exact scope of the work has yet to be agreed, but the broad aim is clear. Within the EU the same capital adequacy standards are applied to the trading book activities of broker-dealers as to those of banks. From end 2006 these standards will be upgraded from Basle 1 to the New (Basle 2) Accord. However during the course of the consultations within the EU, both banks and broker-dealers have raised concerns that some aspects of the New Accord might not be as well adapted to trading book, as opposed to the banking book, commercial realities as they would wish to see. Similarly within the US, although at present Basle standards do not apply to broker-dealers, I have already referred to the consultation which the SEC is undertaking to apply consolidated supervision of the US investment banks to a Basel standard. It is thus as relevant to the US as to the EU that solutions are found to the trading book issues which banks and broker-dealers have raised.
Given the complexities of the trading book issues to be discussed, the Basle Committee does not foresee that the results of these efforts can be incorporated in the text of the New Accord to be produced by mid-year 2004. However, it does believe that it and IOSCO should start working promptly and work efficiently and constructively, so that we can find good solutions soon, preferably before the implementation of the New Accord.
I will now say a few words about accounting and auditing issues, subjects which are highly topical. Again parallels between the EU and US markets are evident. On both sides of the Atlantic several high profile cases in the post market-boom period have shown up the inadequacies of previous accounting and auditing standards and techniques. There is increasing recognition that neither the US nor Europe have a monopoly of wisdom or of problems.
At present within the EU, accounting requirements are set at a national level within the framework of the 4th and 7th Company law directives. The Directives have served the EU well, but are now over 20 years old, and are supported in member states by standards that are of varying quality and are not all comprehensive. This necessarily causes some fragmentation of the EU capital market. However, as I am sure you know, from 2005 the EU will adopt International Financial Reporting Standards for listed companies. International Financial Reporting Standards are of high quality and set by an open and transparent process by an independent standard setter. Their adoption within the EU promises to help bring together the different national capital markets, improving transparency and comparability in financial reporting and so creating greater depth and liquidity in markets within the EU for both investors in and issuers of listed securities. This is another example of how the EU capital markets might become more integrated and more open; along the lines of the US markets. As regulators, I believe we have an important responsibility to reduce to a minimum the scope for regulatory arbitrage, including arbitraging accounting rules – as these arbitrates bring no economic X to the market and, arguably, are to the retirement of the longer term investor.
Both the International Accounting Standards Board and the US Financial Accounting Standards Board recognise the need to modernise their accounting standards. It is sometimes said that the IASB's standards rest on a principles-based approach and the FASB's on a rules-based approach, but that is an over-simplification. All high quality accounting standards are based on principles, but the FASB standards have more supporting guidance and rules than the IASB's. The SEC has of course encouraged the FASB to move towards a principles-based financial accounting standards regime. It issued an SEC staff report last year that argued for the use of broad clear principles with succinct implementation rules. Even more importantly the substantive content of the two sets of accounting standards is converging as a result of the Norwalk Agreement between the two Boards, and the IASB is taking into account the SEC's staff report in developing its new standards. This holds out the tantalising prospect – at least in terms of substance, if not yet form – of a single set of accounting requirements that apply throughout the world.
Securities regulators in both the US and EU need to decide how they respond to these important accounting developments. Within the EU I lead on this as Chair the Committee of European Securities Regulators' standing committee on financial reporting (known as CESRfin). The SEC of course leads the response in the US. And both the members of CESRfin and the SEC play an important role together in the International Organisation of Securities Commissions (IOSCO). There are many common strands in the response of all three organisations to the recent accounting developments. For the sake of brevity I shall focus my remarks on the key areas of how accounting standards are set and how they are audited and enforced.
Both the SEC and the FSA played a leading role in the formation of the IASB and support the idea that accounting standards should be set following an open, transparent process by an independent accounting standards board. Both take the view that they should focus on the needs of investors and reflect the economic substance of transactions. Other users of financial statements such as, banking or insurance prudential regulators or tax authorities may use their special legal powers to obtain extra or different information if required to meet their needs.
A major factor in the development of the IASB was the IOSCO endorsement in Sydney in 2000 of International Accounting Standards for use in cross-border offerings. I am aware of the SEC's support of the IASB's work and the objective of allowing incoming issuers to use IASs in US offerings without reconciliation to US GAAP. As I have noted, the convergence of IASB and FASB will help to resolve the issues, and I hope that the growing international co-ordination on enforcement that I shall come to will also influence the SEC to allow IASs to be used by European issuers without a formal reconciliation.
[In the immediate short term, you may be aware that there are continuing difficulties in the EU with endorsing the IASB's accounting standards on measurement and disclosure of financial instruments (IAS 32 and 39).]
[The implications of the Enron collapse have been well covered and rehearsed, and we have seen the response of the US authorities. More recently we have witnessed major reporting problems here in our own back yard … Ahold, Adecco and, of course, Parmalat. Investors are reasonably asking themselves – can we trust the integrity of the capital markets. Part of the package of measures to address this issue must, in my view, include European endorsement of a single framework of accounting and reporting standards based on principles and which forges convergence with standards in other major capital markets notably, the US. The proposed standards which have proved by far the most controversial are those related to financial instruments - IAS32 and 39. Standard setters have struggled for years to find an answer to how to measure, account for and report financial instruments, although of course the US adopted FRS 133 in June 2000. The difficulties seem to turn on a number of questions: is the accounting consistent with the economic consequences of the risk management decisions made by firms? Can systems be developed at an acceptable cost to support the accounting treatment, especially where hedging is involved; does the accounting reduce significantly or eliminate the risk of firms massaging their earnings; will investors, and the capital markets more generally, understand fully the effects of the accounting treatment on a firm's value… and I am sure there are others. These are difficult issues where there may be conflicting outcomes. I do not think anyone would argue that IAS39 is perfect, but I do not believe it is plausible if the package of standards is to have credibility, for there not to be a standard on financial instruments. Derivatives are no longer an esoteric trading activity in the worlds' financial markets. They are a multi-trillion €/$ business which go to the heart of risk management in financial institutions and in many non-financial institutions. I believe there has been progress both in identifying the major outstanding issues and in working towards a resolution which might prove acceptable, in time for 2005. The IASB Board, banks, insurers, regulators, central banks and the Commission are talking in a spirit of reaching resolution and it must be hoped that compromises can be found which balance the technical arguments on one hand and the fear of unintended consequences on the other.
The recent public comments in support of IAS 39 from the SEC were a very helpful contribution to the debate.
Good accounting standards alone are not, of course, sufficient to ensure good financial statements. Both the SEC and the FSA also focus on audit and enforcement issues. In IOSCO and CESRfin, securities regulators comment on the IASB's exposure drafts and our prime objective is to drive the IASB towards developing standards that are capable of consistent application interpretation and enforcement. The UK view is that principles based accoutring standards can only be made to work if they are applied in the context of a system of corporate governance that fosters preparers who want to comply with the principles; high quality, professionally sceptical auditors who support the principles; and independent audit committees who monitor the relationship between the auditors and management. That approach, I believe, is consistent with the SEC's and the PCAOB's objectives.
Internationally, it is more difficult to see standards of corporate governance as a key driver to consistent application of accounting standards, and the focus is on the work done by external auditors, and the approach taken by enforcement agencies. Both the SEC and the FSA have recently played leading roles in the reform of the process whereby international auditing standards are set, as they had done a few years earlier in respect of the process for setting international accounting standards. We expect that the result will be a more transparent and accountable process for setting international standards on auditing and auditor independence.
Within the UK, the FSA is not itself the enforcement body for accounting standards. This role falls to a separate body, the Financial Reporting Review Panel, which in line with enforcement bodies elsewhere in the world has recently increased its resources. This is also an area in which approaches either side of the Atlantic are becoming more similar. It is also an area in which there has been growing dialogue and increased understanding between us. At CESRfin, we have published a first standard on enforcement of accounting standards and a second is under development on coordination of enforcement approaches. We are grateful for the interest and advice that the SEC has offered on these developments. The intention is to develop a consistent framework for enforcement in the EU coupled with a forum in which issues of interpretation and enforcement can be discussed by regulators with front line responsibility for making the standards work. This approach needs to be applied globally if we are to make progress on the long term objective of a single set of international accounting standards, and it is heartening to see the CESRfin proposals being used as a basis for IOSCO's work on the same issues
Finally I want to say a few words about exchange screens access. Here in the UK we have long held the view that mutual recognition of overseas regulatory regimes is worthwhile. This is why we have a policy of recognising overseas exchanges and clearing houses where we can see that home regulation is broadly comparable to ours, with the result that we allow them to carry on business in the UK with the minimum of fuss and with proportionate regulation attached to that. I note that several US exchanges have taken advantage of this facility. The same concept – applied on a transatlantic basis – has been around for a few years now, driven historically by derivatives business, but more recently for equities by research indicating potential advantages of such a structure for building liquidity and driving down trading costs.
It seems to me that one of the results of the EU's Financial Services Action Plan will be a far more homogeneous approach to regulation Europe-wide. For instance, in due course we will have Directives setting down a common European approach to primary and secondary market trading, financial disclosure and combating market abuse. This bodes well for integration of the European markets. But it also provides a credible backdrop for Europe and the US to come together to build closer contacts, and explore ways of working together that do not involve duplication of effort – and hence cost. On securities markets issues CESR and the SEC have already laid the foundations for a joint work programme. I believe we should use this opportunity to build links at a working level so that we have the best chance of ironing out any conceptual differences and making progress towards the integrated capital market that I think electronic markets are driving us towards.
At the start of my talk I remarked on the growing similarities of the US and EU, and especially the UK, capital markets and on the importance of regulatory authorities on both sides of the Atlantic working to reduce unnecessary differences in standards that might hinder the growing inter-dependence of the two markets. This is theme on which I also wish to close. It is important we build on the progress we have already made especially in the areas of the regulation of broker-dealers and accounting, auditing and enforcement standards for issuers of securities and on the many other important issues for securities regulators that I have not had time to mention.
Thank you.