Reforming the SEC: Dodging A Legislative Bullet

The SEC did not cause the current financial crisis.  Nonetheless, there was some sense that the SEC was fiddling while Rome burned. 

The five large investment banking firms that were at the heart of the crisis -- Morgan, Goldman, Merrill, Lehman and Bear Stearns -- were subject to the oversight of the SEC.  A report issued by the Inspector General at the Commission on Bear Stearns suggested that the staff became aware of "numerous potential red flags" of the impending collapse regarding the investment bank's "concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain Basel II standards" but did not take action in response.  Ultimately the Commission was stripped of its oversight of these entities through a combination of bankruptcy (Lehman), merger (Merrill and Bear Stearns), and conversion to commercial banks (Goldman and Morgan).

During the intense weekend in March when the Fed and Treasury helped stave off the possible failure of Bear Stearns by engineering the merger with JP Morgan, press reports noted the absence of the SEC, with the Chairman instead spending some of the weekend apparently attending a birthday party.  It didn't help that in the run up to the crisis, the Chairman made public statements about the adequacy of Bear Stearn's capitalization (perhaps true, but the statements suggested that the investment banking firm could weather the buffeting financial winds, which proved untrue).  Indeed, the Report issued by Treasury mostly talked about agumenting rather than reducing SEC authority. 

The subsequent decision to ban short selling, in possible violation of the Commission's administrative authority, during the worst of the financial crisis, didn't help.  Rather than renewing confidence in an agency assigned the task of overseeing the capital markets and protecting investors, the decision seemed rushed and unsupported by the evidence. 

In the midst of all of this, the Madoff scandal broke.  Madoff, of course, was not caused by the financial crisis.  He had been operating his scheme long before the current financial woes.  It may have been the case that a 40 or 50% drop in the stock market may have made the scheme harder to maintain.  Somehow even the must gullible would have to take note of steady returns in the neighborhood of 10% during such a melt down.  Even before the report was issued by the Inspector General on the Madoff matter, there was a sense that the SEC had become almost irrelevant.

By the time the Obama Administration came to office, systematic reform was front and center.  Debates and leaks suggested that, at least initially, the SEC was in play.  There was talk of a super-regulator that would absorb the SEC's functions.  In addition, rumors surfaced about stripping away the Agency's oversight of mutual funds.  In the end, the efforts were beaten back (apparently in no small part by the behind the scenes efforts of Chairwoman Mary Schapiro) and reform proposals concentrated on changes to the banking system and the creation of a new Consumer Financial Protection Agency.  Thus, when the President gave his most recent speech on the need for systematic reform of the financial system in mid-September, there was no mention of the Securities and Exchange Commission. 

The Agency dodged a legislative bullet.  There was no serious talk about curtailing the Agency's authority or mission.  Of course, this did not amount to permanent immunity.  There was still a sense that something was seriously broken at the Commission.  Even worse was a continued sense of irrelevancy, as if the Agency had little role to play in the waive of developments taking place in the financial markets.

Perhaps as a result, the Agency has begun to restructure internally.  In particular, reforms have been proposed for the Division of Enforcement.  We will turn over the next several posts to these reforms proposed for the Division of Enforcement.