Finance: What went wrong

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Muzzling the Watchdog
By WILLIAM DONALDSON, ARTHUR LEVITT Jr. and DAVID RUDER

THE downfall of Bear Stearns, the release of Treasury Secretary Henry Paulson’s sweeping blueprint for the overhaul of our financial regulatory structure, and the worsening health of the stock market and our economy has raised serious questions for the future of the Securities and Exchange Commission. As the capital-markets regulator and investor’s advocate, the S.E.C. is a natural recipient of finger-pointing during a market crisis.

Each of us led the S.E.C. during challenging times — the stock market crash of 1987, the price-fixing scandal at Nasdaq in the 1990s, and the accounting and governance failures and mutual fund scandals of this decade. We are in agreement with Secretary Paulson that the world of finance is changing rapidly, having eclipsed in many areas the regulatory structure put in place, piece by piece, over the past century. Yet we fear that the current conversation about the future of the S.E.C. is getting ahead of itself. Secretary Paulson’s proposals to change the structure and function of the S.E.C., if adopted, risk inflicting serious damage to investors and our capital markets.

The current housing and credit troubles do not present a sufficient basis for reforming the entire financial regulatory system. Instead of moving hastily, policymakers need to examine what went wrong, why it went wrong and what the best approaches are for re-establishing the unequaled reputation and performance of the American capital markets.

There is precedent for such an exercise. In 1987, a presidential task force was established to investigate the Black Monday crash. Today, we need a similar exhaustive, bipartisan and impartial examination to explore a series of possible business and regulatory failures.

This investigation should include apparent conflicts of interest on the part of the credit ratings agencies; the failure of banks and other lenders to adopt sound lending practices; the failure of investment banks to disclose that they had significant portfolios of securities backed by subprime mortgages; the sale of high-risk securities to investors for whom they were unsuited; the breakdown (or absence) of adequate risk management systems among the top financial services firms; and the failure of regulators to recognize and take early action to deal with the problems that have grown to today’s magnitude.

Any reforms undertaken after the commission completes its study should not undermine the S.E.C.’s central roles as an investor’s advocate and a law enforcement agency. But the Treasury Department proposal envisions an S.E.C. that would no longer regulate through hard-and-fast rules enforced swiftly and justly, but rather would practice “prudential” regulation, offering up principles and conceptual guidelines and working collaboratively behind closed doors with regulated entities and their self-regulatory organizations when they have violated the law.

This approach would turn the S.E.C. from a market referee into an industry coach — a regulator that is heavy on forgiveness and light on punishment. That’s not a viable way to address wrongdoing. In our experience, tough enforcement of the securities laws deters bad behavior by market participants.

The problem with the S.E.C. today is that it lacks the money, manpower and tools it needs to do its job. The commission’s 2009 enforcement budget does not keep pace with inflation, although it does provide significant increases in the risk-assessment function.

The S.E.C.’s effectiveness is not contingent just on the size of its budget. Historically, the S.E.C. has been effective in using the bully pulpit to affect the behavior of market actors. But before we merge the S.E.C. with other regulatory agencies or change its regulatory mission, we should empower it to do its current job by providing it with what it needs to be a more effective regulator.

We are not advocating a preservation of the status quo. The only thing constant in our global economy is change, and to keep pace with the capital markets and needs of investors, our regulators too must change. But before we embark on a radical restructuring of the financial regulatory system, we must understand clearly where the current problems lie, what was and was not done by regulators leading up to the current crisis, and whether new powers are needed to keep pace with financial innovation.

And above all, whatever we do, we must preserve the S.E.C.’s role as the enforcer of the markets’ rules of the road and as the government’s advocate for investors of all sizes.

William Donaldson was the chairman of the Securities and Exchange Commission from 2003 to 2005, Arthur Levitt Jr. from 1993 to 2001 and David Ruder from 1987 to 1989.
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