Remarks From the ACLI Annual Conference

Thank you, Bill, and good morning, everyone. It's great to be here with you.

The insurance industry plays an important role in securing the financial future of millions of Americans. Your products can help consumers achieve the retirement that they seek and the insurance protection they need. Insurance products are increasingly important to the financial well-being of many Americans.

This morning I will talk to you about something that I am sure is on your mind—our financial crisis.

The events of the past few months are unprecedented. Never before have so many important financial companies been liquidated or consolidated out of business. For the first time in recent memory, banks around the world refused to lend to each other—except at exorbitant rates. Commercial paper markets are nearly frozen.

One measure of this crisis is the so-called "TED spread," the difference between the 3-month LIBOR and the 3-month Treasury yield. A higher spread means that banks are more reluctant to lend to one another. On August 29th, the spread was about 1 percent. Six weeks later, the spread was almost 4.5 percent. This enormous increase in the spread illustrates the extent to which interbank lending has slowed and the credit markets have frozen. Businesses can't borrow and expand.

And entire nations face insolvency.

This crisis is affecting Main Street, too. Most economists believe that we are in a recession. In September, we experienced the biggest payroll reduction in five years. The unemployment rate is about 6.1 percent, an increase from 5 percent as recently as April. Retail sales fell 1.2 percent in September, extending their decline to a third consecutive month, the longest slump in at least 16 years.

This is a very difficult time for our economy, for business, for consumers and for investors. Many investors may have lost confidence in the financial markets and in the competence of their financial advisers. Many of your customers may doubt the ability of insurance companies to meet their contractual guarantees.

We are still very much in the middle of this period of uncertainty. However, I can offer two predictions. First, our nation will recover. We, and our markets, are resilient. Second, policymakers in Washington will inquire in detail and at length about the causes of this crisis, and how we can ensure that it never happens again.

Congress will hold hearings and will spend many months exploring these issues. The new Administration will, too. Indeed, the financial bailout plan directs the Treasury Secretary to report to Congress by April on the regulatory environment.

Congress, the new President and other policy makers will consider a range of issues. Should we limit the securitization of mortgages and other debt obligations? How can firms improve their analysis and management of risk? And how can regulators have confidence in that risk management? Are international capital standards adequate? They will ask many questions about the credit default swap market and its effect on liquidity and market volatility. They will inquire about the role of credit rating agencies as gatekeepers to the financial markets, and how oversight of these agencies can be improved. There will be more hearings on the housing market, on Fannie Mae and Freddie Mac, and on the regulation of mortgage originators.

And, perhaps most significant for this conference, Congress and the new Administration will consider how we can finally make our system of regulation more rational and make the protection of consumers more consistent across functional lines.

I believe that one of the strengths of our system—with all its flaws—is our willingness to look clear-eyed at what has gone wrong and how we can fix it. More than a year ago, we began to consider how we can improve our regulatory system, how we can provide investors in different types of financial products with a similar level of protection, how we can regulate the capital adequacy of firms according to the systemic risk that they present, not according to whether they happen to be a commercial bank, an investment bank or an insurance company.

This process of reevaluation began more than one year ago, as a way to ensure our continued global competitiveness. Now we are compelled to move ahead by a graver threat—the sustenance of our financial institutions and a need to rebuild investor confidence.

It is my hope that financial services regulatory reform will be guided by the following five principles:

First, we must manage systemic risk and protect investors. For too long, these two objectives have operated independently, and perhaps even at odds with one another.

Historically, banking and insurance regulators have focused more on systemic risks. They have sought to maintain the solvency of large institutions, and prevent financial failures that could lead to larger market or even macroeconomic crises. They have prohibited excessive risk-taking and required firms to preserve their own capital.

Securities regulators have focused more on investor protection and on the preservation of customer assets, separate and apart from the assets of the broker dealer or investment adviser. They have required issuers and intermediaries to disclose the facts about their products and services. They have required intermediaries to recommend products and services only if they are suitable based on an individual investor's needs and circumstances.

I think we can all agree that both the management of systemic risk and the protection of individual investors are essential to the smooth operation of our financial markets and the financial health of our citizens. But are they really at odds with one another? In my view, they represent two sides of the same coin.

Of course regulators must be ever mindful of systemic risks. As we have seen, if financial markets crumble, fear escalates and investors flee. Credit markets dry up and stock markets plummet. Our ability as an economy to allocate capital to create jobs and growth is impaired. We must develop a more coherent way to calibrate risk-taking and to monitor and correct systemic deficiencies across all financial institutions.

But protecting investors is just as important. As investors lose faith in the issuers and intermediaries with which they do business, markets shrink or fail to materialize. Without rules to protect investors, financial systems will not raise capital and the economy will not grow.

In the current crisis, the insolvency of firms has harmed their shareholders and customers. On the other hand, the marketing of inappropriate investments has undermined investor confidence and imperiled the capital of those firms. These two problems—insolvency and investor harm—can develop a symbiotic relationship, in which each one contributes to the destructive tendencies of the other. If the failure to manage risk and to protect investors are two sides of the same coin, then so is the solution. We must create a regulatory system that gives equal weight to protecting against systemic risk and to investor protection.

My second principle of regulation is the following: We must decide how to regulate institutions that are too big or too interconnected, to fail. Let us be honest that some firms, because of their size, because of the risks that they present to their counterparties, enjoy a special status that departs from traditional free market economic theory. Permit me to quote Alex Pollock of the conservative American Enterprise Institute:

"Here's as close to an empirical law of government behavior as you'll ever get: When government financial officers—like Treasury secretaries, finance ministers and central-bank chairmen—stand at the edge of the cliff of market panic and stare down into the abyss of potential financial chaos, they always decide upon government intervention. This is true of all governments in all countries in all times."

To which one might say, "thank heavens they do." This intervention in our capital markets is not surprising considering the importance of a handful of large institutions to the financial system. Given the way global markets operate today, there is simply no way we can put that genie back in the bottle.

But we can do better. We can better define the types of institutions that the government will save. We can establish criteria for intervention, and make the forms of intervention more predictable. Of course, the government will need flexibility to address different market conditions. But in recognizing that we will intervene, we should make more predictable how we will intervene.

By admitting this fact, we also will be forced to improve our capital adequacy standards, to ensure that all large institutions, regardless of sector, maintain necessary levels of capital and liquidity and do not engage in the type of risk-taking that will require intervention. These policies could dampen economic growth. But they also could contain the risks that large institutions present to the financial system and to taxpayer money. I, for one, would be willing to make the trade-off of better capitalized, more closely supervised, but less profitable institutions for less volatility and less potential to imperil the entire financial system.

My third principle of regulation is the following—and this has been a constant theme of mine for years: Consumers of financial products and services must receive the same level of protection regardless of the product or service that they purchase. An investor in a variable annuity or an indexed annuity, a customer of an investment adviser, a mortgage broker, a securities broker or an insurance agent, should receive similar levels of protection.

Today, more than ever, we place upon the shoulders of the average consumer the burden of planning for his future. Largely gone are the days when workers hope to live off employer-sponsored pensions, or to when they deposit their assets in savings accounts. We expect our citizens to plan for their retirement, and to figure out how to live on a combination of their own savings and investments and the threatened programs of Social Security and Medicare. Defined contribution plans and individual investments have become the basis for the financial future of many of our citizens.

We cannot expect consumers to wade through a labyrinth of regulators or to decipher which product or service will afford the greatest protection.

Let me provide an example that will be familiar: If an investor buys a variable annuity, FINRA will have reviewed the product's sales material to ensure that it is fair and balanced. The salesperson will have passed a qualification exam and kept up with industry trends through continuing education and training programs. The customer will receive information about the general features of the annuity, including potential surrender charges and periods, tax penalties, and fees and expenses. A registered principal will have ensured that the recommendation to purchase the product, to invest in particular sub-accounts and to choose particular riders and features are suitable based on the customer's individual needs.

If an investor buys an indexed annuity, the level of protection he receives will depend upon the state where he lives. In some states, he may receive detailed information about fees and expenses. In other states, he may not. There may be some kind of suitability requirements depending upon the state. FINRA normally will not review the sales material. In some cases, the investor will be deprived of the same quality of disclosure that he would have received with a variable annuity.

I know some of you strongly object to the SEC's recent proposal to treat many indexed annuities as securities under federal law. Many of these objections are based on the desire to avoid federal regulation.

But this view begs the question: Why should a purchaser of an indexed annuity receive less protection than a purchaser of a variable annuity? How are investors, the financial industry or we as a society better off by maintaining this regulatory inequality?

I do not mean to pick only on indexed annuities. We can raise the same question for many other products and services. Investment advisers are subject to a different regulatory system than broker-dealers. Insurance agents are subject to different regulation than either one. The suitability analysis required for a $100 mutual fund investment is a lot more than for a $1 million mortgage.

It will not come as a surprise to you that I believe private-sector regulation has an essential role to play. At a time of shrinking federal budgets and scarce government resources, independent, non-governmental regulators such as FINRA can dedicate enormous resources to investor protection. And, working with our fellow regulators, we can help ensure that consumers of different financial products receive a comparable level of protection.

My fourth principle of regulation is the following: We must strike the right balance between innovation and the need to protect investors. Innovation is the hallmark of the American financial markets. In the past few years, many new products and services have helped investors meet their retirement goals. However, the current crisis has revealed the risks that come with innovation.

For example, the securitization of mortgages and other debt obligations facilitated the financing of home purchases and commercial enterprises. Yet securitization also has separated the interests of the lender from those of the borrower. It has encouraged mortgage companies and other loan originators to compromise their underwriting standards, since their loans will be sold away.

Securitization has encouraged reliance by banks and insurance companies on quantitative risk models that do not account for low-probability outcomes. The pools of securitized debt are not always transparent and it may be difficult to analyze even the high-probability risks that they present. The securitization of debt obligations therefore obscured the risks in our system, even as it encouraged lenders to assume a greater degree of hazard.

Reverse mortgages exemplify another innovative product that presented an opportunity for misuse. Reverse mortgages were intended to give aging homeowners access to liquidity to meet their daily living needs, without having to give up their homes. This purpose may have been a worthy one. However, some market participants have abused this innovative product. Some of them convinced homeowners to take out a reverse mortgage in order to fund a lavish lifestyle. Others convinced homeowners to use the liquidity to invest in other products—products that presented their own risks but generated more fees for the firm.

Of course, variable annuities have been the subject of remarkable innovation in recent years. The introduction of guaranteed lifetime benefits has been a boon to your industry, but it also has permitted some investors to stay fully invested during times of volatility. It is important for investors to understand how these guarantees work, and the fees associated with the guarantees, so that they can make an informed decision about whether the guarantees are best for them.

As you know, FINRA has been concerned about the marketing of variable products for several years. We are pleased that the industry has improved its systems of compliance and supervision. We know that many firms have dedicated a great deal of resources to compliance in the past few years. We continue to encourage the industry to consider the specific compliance issues that are presented by the introduction of innovative guarantees and other features. Of course, we are very willing to work with the industry to help it meet its compliance responsibilities.

My final principle of regulation is the following: We must bring large, systemically important, yet unregulated segments of the financial industry into the regulatory system, and we must develop centralized clearing houses and exchange trading facilities for instruments that can affect the capital of our large institutions. Of course, I am principally speaking of the credit default swap market. I have been advocating a centralized clearinghouse to eliminate counterparty risk for nearly 15 years. Credit default swaps (CDS) and other over-the-counter derivatives are being traded in volumes that could not have been foreseen even a few years ago. A turn in the CDS market can threaten the capital adequacy of a large firm. At the same time, a firm with a large CDS position, with many counterparties around the world, may be a firm that the federal government feels compelled to support with taxpayer money. At a minimum, this market needs a centralized clearinghouse so that the participants are known, adequate margin or collateral supports positions and the risks from counterparty failure are minimized.

The financial crisis will require a lot of soul-searching in Washington. It will provide an opportunity to improve our regulatory system and to take the steps necessary to ensure that this crisis does not happen again.

Thank you again for the opportunity to speak to you today.