Remarks from the New York University Pollack Center for Law and Business

As prepared for delivery.

Thank you for the invitation and thank you all for coming today.

This is an important moment for financial markets in the United States, and throughout the world. Uncertainty and extreme volatility have defined the markets for a period that is now approaching two years. A byproduct has been what the OECD¹ recently described as the "deepest and most synchronized recession in our lifetimes."

Indeed, investor trust and confidence have plummeted to historic lows. Trillions of dollars in investments have evaporated – and trillions are being spent by the federal government to provide stability and liquidity to the marketplace.

But if there is a silver lining amidst these dark clouds, it is that the turmoil creates an opportunity to "fix the plumbing" of the U.S., and global, regulatory architecture – patching the leaks, but also modernizing the piping in such a way to promote market stability and investor confidence, and lay the groundwork for renewed growth and stability.

And that process is well underway. The current regulatory system is undergoing its most extensive review since it was created in the late 1930s and early 1940s. This restructuring is by its nature a complex process. But throw in the imperative of rebuilding a regulatory scheme that is comprehensive and thoughtful—yet allows the capital markets to thrive and boosts confidence among investors, and you understand how much work there is to be done.

Today, I want to focus on those regulatory reform efforts—with a look at the idea of a systemic risk regulator, and how FINRA fits into that idea, while also exploring the critical need to address the many gaps in U.S. financial regulation.

Going forward, FINRA has a critical role to play, and after many years of working in the regulatory system, I was proud to recently join such a respected organization. As you may know, it was created in 2007 through the consolidation of NASD and the member regulation, enforcement and arbitration divisions of the New York Stock Exchange. With a staff of 2,800, FINRA regulates the practices of nearly 4,900 firms, about 174,000 branch offices and more than 650,000 registered securities representatives, and acts as the primary examiner and rule enforcer for those firms and their employees, under the oversight of the SEC. We strive to be a trusted advocate for investors, dedicated to keeping the markets fair, ensuring investor choice and proactively addressing emerging regulatory issues before they harm investors or the markets.

Our work has assumed renewed importance during this period of market volatility. Indeed, the breadth and depth of the downturn exceeds anything I have witnessed over the course of my career in the securities industry. One of the benefits of reaching my age is that I have been around long enough to have observed my share of financial crises, both in the U.S. and throughout the world. The most notable include the banking and economic turmoil that infected Latin America throughout the 1980s; the Dow's 22 percent slide on a single day in October 1987; the savings & loan crisis; the Russian debt default in August 1998; the meltdown at Long-Term Capital Management one month later; and the bursting of the technology bubble and the corporate scandals of 2001 - 2002.

While every crisis has a unique set of circumstances, there also tend to be some common denominators, and that's true for the current crisis as well. The pre-crisis period is generally marked by strong asset appreciation and high levels of liquidity. Together, these foster the perception of new market paradigms—as well as new approaches to risk management, which often amounts to "more risk and less management."

But the music eventually stops, sometimes very abruptly, and the excessive optimism that fed the market rise gives way to a deep pessimism, causing liquidity to dry up and opportunities to evaporate. As one banker wryly observed a few years ago, whereas credit grows arithmetically, it shrinks geometrically.

Exploring the cause or causes of a crisis is a useful exercise, as it can provide a guidepost for what needs to be fixed. The research arm of the U.S. Congress issued a report in January that explored the different ideas that have been put forward as possible causes of today's financial crisis. It may be a measure of the complexity of our financial system that the report cited no less than 26 different possible causes—spanning from excessive leverage and deregulation to bad computer models and so-called "Black Swans."

You'll be happy to hear that I'm not going to review each of the 26 causes. In fact, I prefer to draw on some of the conclusions that are included in a report issued a few months ago by the Chairman of Britain's Financial Services Authority—their version of the SEC. Known as the Turner Review, the report has been lauded by many commentators as a landmark assessment of the crisis and a thoughtful call-to-action to avoid future collapses.

The Turner Review suggests that the financial crisis was the result of the interplay between three factors. First, the increasing macro-imbalances during a period of sustained global growth and low inflation; second, the rapid financial innovation and market development—specifically the expansion in scale and complexity of securitized credit markets and the rising importance of non-bank entities in performing banking functions; and third, the capital buffers that failed to moderate an unsustainable credit boom and asset price inflation, and also failed to prevent a self-reinforcing cycle of deleveraging, falling asset prices and collapsing liquidity.

Whether one agrees or disagrees with these notions, what's clear is the need for comprehensive reform of financial regulation. In a moment, I'll turn to some reform ideas that have been put forward, but first I'd like to say a few words about Bernard Madoff.

Last December's arrest of Mr. Madoff, and the revelation that he had been operating a multi-billion dollar Ponzi scheme for decades, was the equivalent of a body blow to a financial system that was already severely injured. The immediate victims were, of course, his investors. But coming in the midst of a prolonged period of market turmoil, the disclosure also contributed to a broader erosion of investor confidence. For he quickly emerged as a symbol of all that was wrong in the markets—personifying for many the unethical behavior that seemed to have infected the system, and contributed to the plunge in market indices. And given his status, as a respected veteran of the securities industry, many investors were left to wonder if he was truly an outlier, or emblematic of how the industry operates.

While I know the overwhelming majority of people in the financial industry are upright, law-abiding citizens, there are nonetheless a number of lessons to learn from the Madoff episode. From my perspective, one important lesson is that his actions highlighted how someone with a comprehensive understanding of the regulatory system could cynically design his schemes to fit between the jurisdictional cracks, and thus reduce the likelihood of detection. While FINRA did not have jurisdiction over Mr. Madoff's investment adviser operations, only the broker-dealer operations. This is not to excuse the regulators' failure to detect his activities, but rather to place them in the proper context. Later in my remarks, I will touch on some reforms that I think will help to prevent this kind of regulatory arbitrage from being repeated.

Having identified some of the problems in the financial sector, let me turn now to some of the regulatory reforms that have been proposed to help modernize the nation's regulatory infrastructure, restore investor confidence and prevent these problems from recurring. I think the reforms that have been proposed reflect a recognition that the answer to this crisis is not regulation for regulation's sake, but rather more thoughtful regulation that is better targeted and enlightened by the lessons of recent events.

One objective of any reform effort is to eliminate the gaps in the nation's regulatory infrastructure—a theme I will return to shortly. A centerpiece of the other reform proposals put forth by the Obama Administration, the Federal Reserve and others is focused on curtailing the systemic risk in the U.S. financial system by creating a single regulator for firms deemed to be "systemically important." This regulator would provide tighter supervision of systemically important institutions, and seek to set higher standards for the management of risk and capital.

The potential creation of a systemic risk regulator raises the question of how a regulator like FINRA would operate vis-a-vis such a regulator. I'll explore that in a moment, while also providing a bit of context for how FINRA regulates and why I think it helps to promote the soundness and stability of the financial system.

A number of options have been put forward for the home of a systemic regulator, including the Federal Reserve, the FDIC or even a separate council of functional regulators that would have its own staff. Of course, the Fed already serves as the systemic regulator of the securities industry, given that last year the stand-alone investment banks merged, declared bankruptcy or became bank holding companies.

The key issue for any systemic regulator is the scope of responsibility. Such a regulator could address triage issues when issues of liquidation or insolvency arise. And it could help to fill regulatory gaps, while also collecting information from hedge funds and other unregulated investment vehicles.

But there's a legitimate concern that a systemic regulator would not be as well equipped to conduct the kind of day-to-day reviews needed for broad-based oversight of regulated financial firms. It follows that such oversight should continue to be carried out by functional regulators such as the SEC and FINRA.

I'd like to turn now to the role of independent regulation and how it works.

Independent regulation in the securities industry has a long and effective history, and both Congress and the SEC have periodically examined and reaffirmed its critical role. In designing the statutory scheme of securities regulation in the 1930s, Congress envisioned that most of the day-to-day responsibilities for market and broker-dealer oversight would be performed by independent regulatory organizations under the SEC's direct oversight.

Under the system Congress designed, independent regulatory organizations raise the standard of conduct in the industry. They do this by imposing ethical requirements beyond those that the law can establish. The effect is to address dishonest and unfair practices that might not be illegal, but can compromise efficient operation of free and open markets, and undermine investor confidence.

FINRA rules augment federal securities laws in many areas that significantly contribute to investor protection, including supervision requirements, membership and licensing criteria, standards of fair dealing with customers, managing and disclosing conflicts of interest and market surveillance.

Today, FINRA's independent regulatory organization structure provides a valuable model that allows it to supplement the work and resources of federal regulators without additional cost to taxpayers. My experience has been that independent regulatory organizations can frequently be more nimble in responding to change in markets and business practices than their counterparts in the state or federal government. The processes for writing and amending rules, as well as issuing guidance to the industry, are more streamlined for private regulators. In addition, as an independent regulatory organization, FINRA is better situated than its government counterparts to devote and direct resources to large, multiyear technology development efforts that support its examinations, enforcement, transparency and licensing qualifications programs.

The volatility in the financial markets have been a catalyst for everyone operating in and around financial markets to explore what lessons we can learn from the market turmoil. At FINRA, we've been engaged in a process of reviewing our operations and determining how we can more effectively carry out our mission of serving as an advocate for investors.

That learning process led to the creation of FINRA's newly created Office of the Whistleblower. It was created to expedite the review of high-risk tips by FINRA senior staff and ensure a rapid response for tips that may have merit. It's an initial step toward breaking down the walls that have existed for too long—walls that have prevented the free flow of actionable intelligence that can mean the difference between millions of investor dollars being lost to a scam or bringing down well-dressed criminals disguised as financial professionals.

But above and beyond FINRA, another lesson of the credit crisis and scandals of the last year is, as SEC Chairman Schapiro noted recently, that financial regulators need to cooperate more closely than we have historically. We need to see the financial markets more as a community and our efforts as community policing. We need to cooperate a lot more effectively in sharing whatever intelligence we have between state and federal and self-regulatory organizations in order to make sure we have a maximum number of eyes looking at an institution or a problem at any given moment.

We've talked a lot in the past about joining hands when it comes to regulatory cooperation, but this is a call to really sign up and do something. It calls for corralling all of us into the same room—the SEC, FINRA, the Federal Reserve, Treasury, CFTC, all of us—letting go of turf concerns and simply talking about the issues we're facing.

It will require the sharing of information and the sharing of different perspectives. It means raising questions on a host of issues and opening previously closed doors to possible solutions through discussion and analysis.

It also means keeping an open mind and being receptive to cooperative efforts among regulators. Ultimately, the hope is that by approaching these complex issues in an inquisitive way and from many viewpoints, we'll begin to see not only the problem in a new light, but we'll begin to discover new solutions, as well. In this way, we can begin to clear a path toward reducing potential or emerging gaps throughout the regulatory system.

I'd like to focus now on the need for closing the gaps in the regulatory infrastructure. FINRA has long supported providing investors with a consistent level of protection no matter what type of product they purchase or financial professional they use. Yet our current system of financial regulation has created an environment in which investors are left without those consistent and effective protections. And that speaks to the task ahead for policymakers and regulators: to eliminate the regulatory gaps that put investors in jeopardy, put firms at risk and threaten confidence in the markets.

The most glaring example of a regulatory gap that needs fixing is the disparity between oversight regimes for broker-dealers and investment advisers. And a number of organizations, regulators and policymakers agree with FINRA on the need for reform.

The absence of a comprehensive examination program for investment advisers impacts the level of protection for every member of the public that entrusts funds to one of those advisers. Indeed, the Madoff episode revealed the risks in having two, separate, independent regulatory bodies to oversee investment advisers and broker-dealers, especially when these businesses may exist in the same legal entity.

The SEC and state securities regulators play vital roles in overseeing both broker-dealers and investment advisers, and they should continue to do so. But it's clear that dedicating more resources to a regular and vigorous examination program and day-to-day oversight for the investment advisers could improve investor protection for their customers, just as it has for customers of broker-dealers.

As the SEC has noted, the population of registered investment adviser firms has increased by more than 30 percent since 2005. Investment advisers now number 11,300—more than twice the number of broker-dealers.

Consider the contrast: FINRA oversees 4,900 firms and conducts over 2,500 regular exams each year. The SEC oversees more than 11,000 investment advisers, but in 2007 conducted fewer than 1,500 exams of those firms. The SEC has said recently that in some cases, a decade could pass without an examination of an investment adviser firm.

Regulators need to develop a system that is tailored to fit the investment advisers, and not simply export in wholesale fashion our existing rulebook or governance structure. We believe, however, that enhanced regulatory consistency is in the best interest of investors.

One of the primary issues raised about investor protection differences between the two channels is the difference between the fiduciary standard for investment advisers and the rule requirements, including suitability, for broker-dealers. This is the kind of issue that should and will be on the table as we all look at how best to reform our regulatory system and strengthen investor protections.

In the simplest terms, let's explore seriously whether a properly designed fiduciary standard can effectively be applied to broker-dealer selling activities and, if there are problems raised, make a strong effort to resolve those problems. It is time we make an honest effort to break this logjam—two different standards is simply untenable in this world.

We believe that the kind of additional protections provided to investors through the FINRA model are essential. The question of whether FINRA should be vested with the authority to regulate investment advisers is ultimately for Congress and the SEC to answer. But from my perspective, FINRA is uniquely positioned to build an oversight program for investment advisers quickly and efficiently.

I want to touch on one other topic related to regulatory gaps, and that is hedge funds. While they play a significant role in the financial system, with assets under management totaling $1.3 trillion—down from $2 trillion—they are also an unregulated part of it. And the lack of transparency about hedge funds and their investment positions is cause for concern, for three primary reasons.

First, they have a significant ability to move markets—both up and down—as we have seen from the recent redemptions by fund investors and the de-leveraging of funds in response. Second, hedge funds are heavy traders of over-the-counter derivative products that are also unregulated—creating a major void in what regulators know about the financial system and undermining our efforts to identify vulnerabilities. Third, there is broader public exposure to hedge funds than is commonly understood. While they are generally marketed only to investors deemed sophisticated, public pension funds, endowments and other fiduciary-type funds are invested in hedge funds. Absent some level of regulation, we cannot gain comfort that only investors with the appropriate risk tolerances and sophistication are invested in these unregulated vehicles.

For these reasons, some consideration must be given to regulatory oversight of the positions held by these unregulated entities, the manner in which they reach trading decisions and the nature of investors finding their way into hedge fund investments.

William Douglas, the former Supreme Court justice, and before that a Chairman of the SEC, said in 1938 that, "The point where self-determination should cease, and direct regulation by government should commence, must usually be determined not by arbitrary action but by neatly balanced judgment and discretion on both sides."

Given what we've seen unfold over the past 18 months, I think the "neatly balanced judgment and discretion" described by then-Chairman Douglas exists today, with a wide consensus supporting remedies for a regulatory structure weakened by gaps and inconsistencies. The current system has failed in a number of ways—not least in providing adequate protections to individual investors, who are the most important actors in the financial markets. The best way to earn back confidence, and restore trust in our markets, is by closing the gaps in our current system and strengthening oversight.

We should also remember that regulation, while critically important, is not going to prevent every instance of fraud or deception. What's most important of all is for market participants—from senior executives to individual investors—to possess a commitment to ethics and integrity. A market defined by a low level of trust will discourage investment, drive away reputable companies and stifle economic growth. As one financial journalist observed recently, "If there's one thing worse than too much confidence it's not enough. Fraud impoverishes a few; fear impoverishes the many." Ralph Waldo Emerson put it more concisely. "Distrust," he said, "is very expensive."

Conversely, a marketplace defined by a high level of trust and confidence will be one where capital can flow efficiently to those who use it wisely and productively. And that trust and confidence will, in the long run, help to deliver the greatest economic dividends of all.

Thank you for listening. I'd be happy to try to answer your questions.

1 Organisation for Economic Co-Operation and Development