finra

Rick Ketchum
Chairman & CEO, FINRA

Fordham University Ethics and Regulatory Conference
October 2, 2009

Thank you, Steve [Freedman] for that introduction. And thank you to Fordham's College of Business Administration for organizing this conference and inviting me to speak. I'd like to acknowledge a good friend, John Tognino, who I know is a highly valued member of the Fordham community.

 

This conference comes at an important time, in the aftermath of a very difficult period. If we look back to the summer and fall of 2008, every time we thought conditions in the financial sector couldn't get worse, they did, and we ultimately came to the brink of a global market meltdown. Even with the enactment of stabilization measures in October, the market turmoil continued into March, at which time the S&P 500 reached a 12-year low.

 

When combined with the terrible harm to investors resulting from the Madoff and Stanford scandals, there is no question that we need to step back and take stock of the values driving our most important financial organizations, and the effectiveness of our regulatory oversight.

 

Part of the learning process involves making sense of precisely what caused the financial crisis. The volatility spawned an array of theories, and the research arm of the U.S. Congress issued a report earlier this year that cited 26 different possible causes—spanning from excessive leverage and deregulation to bad computer models and so-called "Black Swans."

 

I'm not here this morning to wade into any of those debates. But I do find it interesting that one element of the market turmoil that is often glossed over is ethics and professional responsibility. And that's why this conference is so important.

 

Because whatever we believe to be the biggest contributors to the financial crisis, we can hopefully agree that underpinning much of the turmoil were decisions made by market participants that were, at best, short sighted and ill advised, and in many cases reckless, if not illegal. At the most basic level, many market participants abdicated their professional responsibility—selling products or pursuing deals that may have offered short-term gains but which they had to know were inappropriate for the marketplace.

 

The risks associated with such behavior have been a concern of regulators for decades. In 1938, just a few years after the Securities and Exchange Commission was founded, the Commission's chairman, William Douglas, spoke to the importance of trust in the markets. He said,

 

To satisfy the demands of investors there must be in this great marketplace not only efficient service but also fair play and simple honesty. For none of us can afford to forget that this great market can survive and flourish only by the grace of investors.

 

A more contemporary observation of this phenomenon has come from someone we don't usually associate with the financial sector, and that is Pope Benedict. In the Encyclical published earlier this year, he conveyed some very timely and wise ideas related to the recent financial turmoil. "The market" he said,

 

is shaped by the cultural configurations which define it and give it direction. Economy and finance, as instruments, can be used badly when those at the helm are motivated by purely selfish ends. Instruments that are good in themselves can thereby be transformed into harmful ones. But it is man's darkened reason that produces these consequences, not the instrument per se. Therefore it is not the instrument that must be called to account, but individuals, their moral conscience and their personal and social responsibility.

 

With that passage as a jumping off point, the challenge I would like to address is one facing financial services firms, regulators and educators. And it is how to instill a deeper sense of integrity, and professional responsibility, in the financial sector, and develop a clearer science about preventing good people, who are subject to pressures and conflicting incentives, from making truly bad decisions.

 

Firms

 

I'd like to begin by talking about ethical issues as they relate to institutions, with a focus on conflicts of interest. About a decade ago, in the midst of the technology bubble, a research analyst remarked that there was nothing problematic with his role in helping to sell investment-banking services because, and I quote, "What used to be a conflict is now a synergy."

 

As we know, the "synergy" that he spoke of really was a conflict, and the research analyst settlement of 2003 now prohibits analysts from selling investment banking services. But it's still the case that conflicts of interest permeate the financial sector. These conflicts are embedded in the system so deeply that they are never going to be completely eliminated. So the goal should be for institutions and the individuals who work for them to manage these conflicts, and be fully transparent about them.

 

In 2003, in the midst of charges that mutual funds had engaged in late trading and market timing, the SEC's director of enforcement, Steve Cutler, gave an important speech. He called on every financial services firm to undertake a top-to-bottom review of their business operations, aimed at addressing all of their conflicts of interest. And, he encouraged each firm to identify business practices that could pit the interests of one set of customers over another, or could put the firm's interests ahead of its customers' interests.

 

The need to address conflicts of interest is just as important today as it was six years ago. While the profile of the financial sector has been transformed over the past two years, conflicts are still rampant—and they demand greater disclosure. Failing to disclose conflicts frequently results in exposure of conflicts. And that brings even greater scrutiny from the press, the public and regulators; it heightens reputational risk, and it contributes to an erosion of investor confidence. More fundamentally, disclosure is the right thing to do—customers should know when a firm's interests may not be aligned with their interests.

 

So first, institutions should be reviewing their conflicts, and disclosing them, and then they should be ensuring these reviews become part of their standard operating procedure. It is not enough to do a conflict review once every few years and put it in the drawer; it should be a continuous, evolving process, just as real-time as the changes in a firm's business and the financial products it manufactures and sells. For employees, this process will help to underscore the seriousness with which their respective employers treat conflicts of interest.

 

Quarterly earnings pressures

 

Another issue that must be confronted is the compliance and risk management issues associated with public companies and their reporting of earnings.

 

As you know, companies report the earnings every quarter, and while this provides only a snapshot of corporate performance, the impact of earnings on a company's stock price can be considerable. And there have been many examples through the years of companies manipulating their numbers to show uninterrupted quarter-to-quarter growth. A few years ago, a study found that from 1999-2004 nearly half of the companies in the Dow Jones Industrial Average always met consensus earnings estimates, or beat them by a penny. Meeting short-term earnings estimates can have short-term advantages, but it can be a poor approach to creating long-term growth, and it can lead senior officials to resort to practices that are unethical and often illegal. We should remember the words of W. Edwards Deming, the celebrated business thinker, who once wrote that, "People with targets, and jobs dependent on meeting them, will probably meet the targets—even if they have to destroy the enterprise to do it."

 

What's needed is a set of responses that can help to minimize the pressures that come from this reporting process. Let me suggest what some of those responses should be.

 

First, compliance officers need to have direct access to senior management and they must be an active participant in the process of formulating and implementing risk management strategies. The artificial border between risk management and compliance must end. The instincts of risk management officers need to be integrated into firms' everyday operations.

 

Beyond just access to senior leaders, there needs to be a genuine demonstration of compliance's importance in the way senior leaders respond to potential problems, invest in technology solutions and, most important, provide adequate staffing in the area of compliance.

 

Second, employees must not fear the decision to question a company's financial reporting, or to escalate an internal dispute. Indeed, questioning should be encouraged, and even rewarded in certain instances. We have to confront the reality that both managers and general counsel still perceive that acting as a squeaky wheel is career-limiting, if not career-ending.

 

Third, at senior management meetings, there should always be time allocated to risk and compliance issues. Theoretical access means little if there isn't a continuous message of the importance senior management attaches to these issues.

 

Corporate boards have an important role to play in helping to ensure that the implementation of these and other steps is rigorous. As pointed out recently by my predecessor at FINRA, Mary Schapiro, who is now Chairman of the SEC, in the period leading up to the financial crisis, boards of directors failed to thoroughly question the decisions of senior management to take on risks. And it seemed they often did not understand the risks being taken. No, board members will not be able to fully evaluate all of the risk analysis presented to them. But board members becoming more engaged in integrating compliance into company operations would be a step to help prevent these mistakes from being repeated.

 

Products

 

Next, I'd like to turn to how financial services firms should think about the products they offer. Today, firms typically maintain product review committees, to review what the firm is selling, how popular and profitable their products are, and to explore additional products that could potentially be offered. Having a formal committee pass judgment on financial products is a good step, but more is needed.

 

Like the reviews of conflicts of interest, product committees need to be institutionalized. And the committees need to broaden their focus to look at not just whether a product is acceptable, but also how products have evolved, who they have been sold to, and whether they have become riskier over time. That requires an in-depth understanding of the components of the products. It also demands a sophisticated analysis of which external forces could influence their behavior, and how. Firms have made some real progress in the new products process over the last few years through the creation of review committees and the incorporation of compliance earlier in the product creation process. But too often the analysis ends when the product is pushed out for the first time. This is less than optimal given that macro forces can fundamentally change how a product performs and who should be buying it.

 

The recent experience with auction rate securities highlights the need to understand the risk-reward quotient of products. That understanding must extend from the product originator to any firm marketing the product. Product review cannot be a static process and firms must understand when market forces render a change in the risks of a product at the earliest reasonable time.

 

Executive compensation

 

I would also like to say a few words about executive compensation. It is fairly well established that certain compensation schemes contribute to a dangerous short-termism—encouraging executives to pursue measures, some of them unethical, which drive up the company's stock price but do nothing for the long-term health of the company, and often undermine it. We saw this during the dot-com and technology boom, with its stock option culture. More recently, we saw it with financial institutions taking on excessive leverage, and making high-risk bets tied to the expectation of a continued rise in housing prices.

 

My view on executive compensation is fairly simple: I favor rewarding people in accordance with their ability to create true, long-term value for their company. But as we know, much executive compensation has been structured thoughtlessly, and without the kind of controls that will encourage long-term thinking. Compensation is often tied to annual performance, even though bad decisions may only show up years later. So performance measures need to change. I support so-called clawback provisions, whereby executives would forfeit a portion of their compensation if it is determined that they were rewarded for taking risks that proved to be reckless. Along the same lines, I favor compensation in deferred equity, and—for senior managers in particular—companies should consider requiring them to hold on to a large portion of their equity until they retire, or at least for a number of years.

 

I have no illusion that there are simple, one-size-fits-all solutions to improper incentives imposed by today's compensation programs. But a board that cannot demonstrate that it has wrestled with these issues and sent the right messages "from the top" has not done its job.

 

I see the need for public-policy reforms focused on executive compensation. But I am not of the view such reforms will be a cure-all. We know from experience that limiting one form of compensation often just leads companies to devise another form of compensation to evade the rules. So more important than public-policy reforms is for executives and their boards to exercise greater discretion in how they structure compensation—recognizing the risks to their company, and the broader economy, in compensation packages that contribute to short-termism.

 

Retail Sales Responses

 

I'd like to turn now to the retail side of our markets, where there's more direct interaction with individual investors.

 

For entirely too long, this segment of U.S. markets has been marked by a struggle with regulators, as retail firms have pushed the proverbial envelope with regulators to see what products they can sell, what incentives they can offer, and what information needs to be disclosed. While they are seeking to comply with the letter of the laws, it seems that some are looking to evade the spirit of the laws.

 

There is a clear need for a shift in culture at these retail firms—focused on serving customers' long-term interests, providing greater transparency about the risks and rewards of financial products, and living up to a higher standard of professional responsibility.

 

There is also a clear need for a shift in regulation, and let me offer a specific example. Individual investors interface with both investment advisers and broker-dealers. These are distinct entities, but the everyday reality is, as the Rand Institute said in a study last year, that "trends in the financial service market since the early 1990s have blurred the boundaries between them."

 

Indeed, most investors cannot distinguish between the investment advisory service they receive and their brokerage service. But broker-dealers are regulated one way—they operate under a standard of selling their clients "suitable" products. Investment advisers are regulated another way—they must meet a fiduciary standard that puts their clients' interests before their own.

 

This distinction is far from an ideal regulatory arrangement, and we agree with the Obama Administration's view that a fiduciary standard should be established for broker-dealers when they are offering investment advice. Simply put, broker-dealers should always ask whether certain products or services are in the customer's best interest.

 

Regulators

 

I'd like to turn now to the role of regulators in promoting an ethical marketplace.

 

Regulators play a critical role in policing our markets and striving to ensure that regulation evolves to keep pace with market dynamics. But regulations are only as good as the people vested with the authority to enforce them. And one of the lessons from the past two years is that regulators—and I include FINRA here—need to rethink how to respond to issues of fraud, but also how to more effectively prevent it.

 

A critical ingredient in those preventative efforts is ensuring regulatory organizations are staffed by the right people, with the right backgrounds. At FINRA and other organizations with which I've been involved, I've had the privilege of working with a select corps of professionals—people with a commitment to strengthening investor protections and promoting greater market transparencies. But as markets have evolved, I have seen a need for more regulators with different skill sets, and with a refined understanding of some of the complex financial instruments that get deployed in the never-ending search for comparative advantage. We need regulators to know where to go for information, and to know how to collect it, so they have a comprehensive picture of market developments. We also need regulators to network outside their regulatory organizations—and to be able to hear the concerns of industry representatives.

 

Of course, as part of this outreach process, regulators need to be able to separate the wheat from the chaff, and make the crucial determinations about necessary reforms. Regulators must take care not to stifle what Alexis de Tocqueville called "the boldness of enterprise" that he said was the "foremost cause of [America's] rapid progress, its strength, and its greatness." By the same token, for markets to function as efficient allocators of capital, they need rules, and need these rules to be firmly enforced.

 

It's also critically important for regulators to identify gaps in regulation and then work to close them. The disparate treatment of investment advisers and broker-dealers is an example of a gap that needs to be addressed.

 

One way of thinking about regulatory gaps is to consider the law of fluid dynamics. I won't pretend to fully understand the many nuances of this law, but I know the basic principle underpinning it is that water will always flow toward the point where it encounters the least resistance. This is not so different from the financial system. Capital, like water, will flow to where it seems most welcome, which is to say, where it is least regulated.

 

But the effect of regulatory gaps is to create an unlevel playing field, diverting capital to instruments or industries not because they offer the most attractive risk-adjusted returns but because they face the least regulation.

 

The market-distorting examples of regulatory gaps are plain to see. The inevitable result of mutual fund regulation has been the growth of hedge funds. The inevitable result of broker-dealer regulation has been unregistered high-frequency traders. The inevitable result of futures and options regulation has been the creation of the OTC swaps market. And the inevitable result of securities offering regulation has been the growth of private offerings and private capital.

 

This is meant in no way to question the validity of any of these regulatory structures that are fundamental to efficient markets and investor protection, but only to note the reality that in today's global environment, products and intermediaries will change to fill specific needs and avoid, wherever possible, the costs of regulation. We could, of course, control this tendency by shifting to a more command and control economy, but few would recommend it and, moreover, it would be self-defeating, unless embraced across all major global markets. The Obama administration's plan probably does the best it can to address this gap by filling regulatory voids in the OTC derivatives and hedge funds, and giving the Fed cross-market systemic authority. But I predict that the next serious crisis will not come from Citibank or Bank of America, but from entities that today we would not recognize.

 

In the same vein, there is a need for companies to exercise more responsibility in determining precisely how they will submit to regulation. Because America's financial regulatory infrastructure is a web of overlapping—and sometimes conflicting—jurisdictions, companies frequently look for opportunities to abide by the least demanding regulation, or to exploit gaps in regulation. We saw this dynamic at work in the case of Bernard Madoff. And while he is an extreme case, as he was determined to evade all regulatory statutes, the larger point is that regulatory gaps and inconsistencies create temptations for honest people to make bad decisions. Regulatory reforms are needed that close these gaps. But even more important is for companies to avoid the temptation to play the regulatory arbitrage game in a cynical effort to boost their short-term profits.

 

Educators

 

I'd like to close by talking briefly about the role of education in helping to promote an ethical marketplace.

 

I hope that schools—and business schools in particular—will use the financial crisis as an opportunity to review their coursework, and look for ways to integrate ethics, and professional responsibility, into their core teachings. For example, a class that's focused on structured products should include extensive discussion of the risks associated with the products, and the importance of judging whether the buyers fully understand the risks.

 

We've begun to see some changes, with recent articles noting that schools have begun offering more courses related to risk management and financial modeling. But I think more introspection is needed.

 

I was encouraged by a New York Times article earlier this year that profiled a group of students at Harvard Business School who had created something called an "MBA Oath." This is a student-led pledge that commits the signers to act with utmost integrity, focus on the long term, and to "serve the greater good by bringing people and resources together." The oath has attracted signers at business schools throughout the world, and while we can't measure its immediate impact, it's an encouraging sign that the incoming generation recognizes the need for ethics to be at the center of business.

 

At institutions offering both a JD and an MBA, I'd also like to see students from these schools take classes together. My experience at Citigroup was that lawyers and business managers speak a different language and embrace different values. Both sides need to understand how the other wrestles with legal and ethical problems and gain a better appreciation of how to work together.

 

We need to move past the present environment where the only thing that is valued in business lawyers is that they are excellent at finding "practical solutions to legal problems." Practical solutions are great as long as the person receives equal credit for just saying "no" when the legal risks are unacceptable.

 

Conclusion

 

Having spent most of my professional life working in financial-market regulation, I've seen the commitment to a strong culture of compliance ebb and flow—often in correlation with market movements. And while there's been progress at financial services firms, one of the lessons of the past two years is that these firms still have work to do to embed the culture of compliance into their collective DNA. There must be a cultural shift in financial services firms' thinking about risk, compliance and the interests of investors. It must reflect a fundamental change of attitudes and participation throughout the firm, particularly senior management.

 

The regulatory reforms pending before Congress can help to wring some excesses out of the system, and prevent abuses. But we should 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, integrity, and professional responsibility.

 

In the absence of this commitment, we'll see an erosion of investor confidence, which brings its own set of challenges. 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 take your questions.