The SEC, Bear Stearns and the Failure of Regulatory Oversight (Part 1)

There has been considerable discussion over the role played by the SEC in the current turmoil.  Some, including presidential candidate John McCain, have tried to pin blame on the Chairman but have had a hard time specifying exactly how the agency could have prevented the current problems.  Much of the criticism has focused on a reduced emphasis on enforcement (particularly the decision to tie the staff's hands with respect to penalties imposed on companies), which has been a problem but is hard to relate back to the current market turmoil.

Evidence of a Commission role, however, has come from an unexpected source.  The SEC Office of the Inspector General has published a report on the consolidated supervised entity program.  This was the "voluntary program" designed to increase the inspection of investment banks ("was" because, since there are no more independent investment banks, the program has been terminated).  As the report described:

• The CSE program is a voluntary program that was created in 2004 by the Commission pursuant to rule amendments under the Securities Exchange Act of 1934.  This program allows the Commission to supervise these broker-dealer holding companies on a consolidated basis. In this capacity, Commission supervision extends beyond the registered broker-dealer to the unregulated affiliates of the broker-dealer to the holding company itself. The CSE program was designed to allow the·Commission to monitor for financial or operational weakness in a CSE holding company or its unregulated affiliates that might place United States regulated broker-dealers and other regulated entities at risk.  A broker-dealer becomes a CSE by applying to the Commission for an exemption from computing capital using the Commission's standard net capital rule, and the broker-dealer's ultimate holding company consenting to group-wide Commission supervision (if it does not already have a principal regulator). By obtaining an exemption from the standard net capital rule, the CSE firms' broker-dealers are permitted to compute net capital using an alternative method. The Commission designed the CSE program to be broadly consistent with the Federal Reserve's oversight of bank holding companies.
  

So, the Commission put itself in a position to inspect investment banks and specifically to try to duplicate the oversight of the Federal Reserve Board.  Things didn't work out, however, and the report is fairly damning in its conclusions about Commission oversight.   Much of the criticism was aimed at the staff's approach to inspections.  Standards were inadequate.  See Report ("Overall, we found that there are significant questions about the adequacy of a number of CSE program requirements, as Bear Steams was compliant with several of these requirements, but nonetheless collapsed."). 

In other instances, the staff failed to follow their own procedures. See Report, at ix ("In addition, the audit found that procedures and processes were not strictly adhered to, as for example, the Commission issued an order approving Bear Stearns to become a CSE prior to the completion of the inspection process.").   

Finally, even when the staff uncovered problems it didn't always take steps to correct them.

• In addition, the audit found that TM [Trading and Markets] became aware of numerous potential red flags prior to Bear Stearns' collapse, regarding its 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 actions to limit these risk factors.
  

Perhaps worst of all, with respect to Bear Stearns, the staff became aware of the excessive concentration of mortgage securities but took no steps to correct the problem.

• Although TM [Trading and Markets] was aware, prior to Bear Stearns becoming a CSE firm, that Bear Stearns' concentration of mortgage securities was increasing for several years and was beyond its internal limits, and that a portion of Bear Stearns' mortgage securities (e.g., adjustable rate mortgages) represented a significant concentration of market risk, TM did not make any efforts to limit Bear Stearns' mortgage securities concentration;
  

It is possible that these problems, even had they not occurred, would not have prevented the current crisis.  The discovery that Bear Stearns had engaged in excessive risk taking with respect to mortgage securities may have come too late.  Nonetheless one cannot help but wonder whether, had the staff done a better job at inspection, there still might be independent investment banks today.