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News June 8, 2015 Issue

Piwowar Turns the Tables on Prudential Regulation Advocates

SEC commissioner Michael Piwowar apparently knows how to play poker.

In a recent speech, Piwowar decried the efforts of bank regulators and others to expose the asset management industry to "prudential regulation," which would leave advisers, funds and others subject to the same kind of rules that cover the banking industry. But instead of just voicing the same objections to prudential regulation that others have made, he raised the ante by calling for banks to be subject to enhanced disclosure requirements, which he called "market-based prudential regulation."

"Rather than imposing prudential regulations on markets, I would argue that exposing banks to the disclosure-oriented focus of market-based regulation would provide better protection to the financial system," he said. "In other words, instead of ‘prudential market regulation,’ the financial system would be safer with ‘market-based prudential regulation.’"

Prudential regulation

Much of the debate over prudential regulation of the asset management industry goes back to the question of what – and what kind of institutions – contributed to the 2008 financial crisis. Piwowar believes that those who blame asset managers and investment companies for the crisis are mistaken. "They did not precipitate the 2008 financial crisis and, in fact, continue to flourish today."

Focusing on the Federal Reserve in particular, Piwowar said it "apparently believes that because asset managers and investment companies have been so successful, they somehow pose a systemic threat to the financial system and therefore have earned an additional layer of regulation – prudential market regulation. Of course, what they ignore is that those entities have been  subject to extensive and highly effective regulation by the Commission for 75 years."

The Fed and other banking regulators are not experts on capital markets, he said. "They do not even understand the basics."

"Capital markets and capital market actors or, as the Fed labels them, non-bank financial institutions, are not engaged in ‘shadow banking,’" Piwowar said. "Investors in the capital markets operate with the knowledge that the money they invest is subject to risks and, unlike bank deposits, is not guaranteed. Investors make a tradeoff between the risk of loss of principal and the hope of earning a higher return on their investment. The Fed may be risk averse and suspicious of those motivated by profits, but risk taking and profit seeking are the cornerstones of the capital markets."

The danger of trying to mitigate risks on a macro level is that it would result in a "narrowing of the differences in the way assets are managed," he said, which could result in all financial firms having similar investments. "If all firms are invested in the same types of assets, then during a period of market stress the entire financial system is more likely to collapse," he said. In addition, he noted that prudential regulation could force asset managers to face "the impossible task" of balancing their fiduciary duties to clients and investors against regulatory obligations to do what is best for the financial system as a whole.

The role of the SEC

Piwowar argued that those calling for prudential regulation of non-bank financial institutions not only lack an understanding of the capital markets, but show little appreciation of the SEC’s mission. "I am very concerned about the extent, fervor and momentum of those proposals."

"It is the Commission, not the banking regulators, that has the statutory authority and responsibility for regulating the capital markets. It is the Commission, not the banking regulators, that has the requisite expertise and experience with capital markets. It is the Commission, not the banking regulators, that should be regulating the capital markets," he said.

SEC commissioner Daniel Gallagher has also criticized the proposed use of prudential regulation for asset managers. Prudential regulators "and the policymakers they have captured adhere to a false narrative of the financial crisis that says capital markets regulators like the SEC failed, and the markets and market participants overseen by capital markets regulators were a major cause of the financial crisis," he said in an April 10 speech, "Bank Regulators at the Gates: The Misguided Quest for Prudential Regulation of Asset Managers" (ACA Insight, 4/20/15).

Efforts to label the asset management industry as systemically risky have also drawn criticism from other quarters. The Investment Adviser Association and the Securities Industry and Financial Markets Association, in a March 25 comment letter sent to the Financial Stability Oversight Council (FSOC), said that the risks in asset management are not systemic and, in any event, should be addressed by the SEC, not the FSOC. The letter was sent in response to a FSOC notice seeking public comment on its evaluation of potential risk in the asset management industry.

The IAA and SIFMA also sent separate letters last month to the Financial Stability Board and the International Organization of Securities Commissions on similar issues.

"The right regulator and the primary regulator (for advisers and others in the asset management industry) is the SEC," said IAA general counsel Robert Grohowski separately.

"Piwowar’s speech makes a very direct, sensible, and well-supported case for two primary points," said Ropes & Gray counsel and former IAA executive director David Tittsworth. "First, the asset management profession is fully and appropriately regulated by the SEC. Second, the banking industry should be subject to a higher level of disclosure – what he calls market-based prudential regulation."

"The asset management profession is already heavily regulated and the SEC is in the best position to serve as the primary regulator of asset management firms and activities," he said.

Tittsworth added that "pending proposals before the SEC will require additional disclosures by asset management firms and funds. The SEC and FSOC and other regulators need to work together to avoid regulatory arbitrage and duplication. Adding an additional layer of regulation and bureaucracy is unnecessary and would result in costly and burdensome requirements."

Increased bank regulation

Instead of imposing prudential regulation on markets, Piwowar called for banks to be subject to the "disclosure-oriented focus of market-based regulation," as that would provide better protection to the financial system.

"One of the most important lessons from the financial crisis is that bank investments are not adequately disclosed," he said. "There is limited public information about how banks are investing their assets, so investors have difficulty making informed investment decisions, and creditors cannot assess the true creditworthiness of banks. Moreover, the Commission and the banking regulators do not have key information that would allow them to monitor bank risk at the individual bank level and/or across the banking system."

Saying that he would "never be so bold as to call banks ‘shadow investment companies’" – a clear jibe at those who use a similar term for asset managers and investment companies – "it is worthwhile to think of banks as being similar to investment companies in that their assets are invested in a myriad of products," Piwowar said. "Investment companies are subject to the Commission’s disclosure regime, which requires extensive information about an investment company’s portfolio holdings. Banks are not."

"’Sunlight is said to be the best of disinfectants; electric light the most efficient policeman,’" Piwowar said, quoting former Supreme Court Justice Louis Brandeis. "Banks should be subject to sunlight, and in fact a direct spotlight, in much the same way as investment companies, such as through market-based prudential regulation."