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Senate Committee Tells SEC to Ramp Up Supervision of Investment Banks

Following an admission by the Securities and Exchange Commission’s Erik Sirri that the near-collapse of Bear Stearns took his agency by surprise, Senate Banking Committee member Charles Schumer said today that a “stronger, more unified regulator” is needed to police investment banks.

At a hearing on the SEC’s oversight of investment banks in light of the recent turmoil in the credit markets, Sirri, director of the SEC’s division of market regulation, told the committee that the Bear Stearns implosion in March “was unprecedented. Secured funding fell apart in a way we never anticipated in our scenarios for risk management.”

Bear Stearns is the smallest of five companies--the others are Goldman Sachs, Lehman Brothers, Merrill Lynch & Co. and Morgan Stanley--currently supervised as consolidated supervised entities (CSEs) under the SEC’s program for investment bank holding companies. The CSE program is consistent with controls in place at the holding company level in Europe and the U.S., Sirri said. But given the current environment, the commission is revisiting its risk controls. “Valuation of securities is critical in the risk management process,” he said. “Regulators are thinking very carefully about the issue of liquidity.”

Schumer, D-N.Y., told Sirri that while calls for abolishing the CSE program are irresponsible, “it is weak regulation by nature. The SEC has never been a good ‘safety and soundness’ regulator.” Added Schumer, “The weakness of the CSE is because of the technological and global changes in the system. A regulator should have gone in last summer and said to Bear Stearns, ‘You’ve got to raise capital.’”

According to Sirri, the CSE program was never intended to be a disclosure program or an investor protection program. Its authority derives from rules rather than statutes, he said, and it is staffed differently than any other SEC program. Instead of relying mainly on attorneys, many of the 25 professionals it employs are PhDs.

SEC chairman Christopher Cox has already requested strengthened oversight of CSEs, noted Sirri, including examination of possible conflicts of interest with credit-rating agencies. “There have never been examinations of credit-rating agencies, he said. “We need people who are ‘tech-ed up’ to understand their model and ensure that it is not being tilted for a favored client.”

The SEC was caught off guard, said Sirri, by the rapid deterioration of liquidity at Bear Stearns. The collapse “challenged a number of assumptions of our supervision of investment banks,” he said, and has already caused the commission to strengthen liquidity requirements for CSEs.

Sirri suggested that he would welcome legislation to strengthen the SEC’s hand. “The focus of the program is on preserving the safety of securities and cash,” he explained. “The CSE program deals with the holding company that surrounds the larger broker-dealers. Legislation could provide clarity that would allow us to have examination authority and restrictions around risk controls. It would provide needed clarity. We are revising the way we have supervised these firms.”

During a second morning panel, two former SEC chairmen provided additional recommendations. Arthur Levitt Jr., SEC chairman from 1993 to 2001, said that a presidential-level task force should be convened to explore regulatory failures that led to the collapse. He also said that the SEC’s enforcement division has been “hamstrung” in negotiating corporate penalties.

David Ruder, chairman from 1987 to 1989, was critical of the principles-based approach favored in the Treasury Department’s blueprint for an overhaul of the U.S. regulatory system. “The SEC should not be required to substitute principles-based regulation of investment banks for enforcement-based regulation,” he said. “The SEC needs to engage in prudential regulation of investment banks.”

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