finra

Remarks by Mary L. Schapiro
Chief Executive Officer, FINRA

SIFMA Annual Meeting
Boca Raton, FL
November 9, 2007

Good morning. I am delighted to be with you today. Before I begin, I just want to say a few words about Marc Lackritz.

Marc, this may be your last annual conference as CEO and President of SIFMA, but the work you have done, and its impact on the markets, is going to be felt for a long time to come.

As someone who has always been a strong advocate and influential voice for this industry, it's only fitting that one of your final acts as CEO was to help lead the charge for the transformation of the self-regulatory model.

Self-regulation gives industry a voice in the regulatory process. It guarantees collaboration in maintaining strong and healthy markets. And it ensures everyone has a stake in protecting investors.

As the CEO of the SIA and SIFMA you understood this and that's why I can say, as a regulator, it has been a pleasure working with you—your leadership will be missed and I wish you only the best in the future.

I also want to acknowledge the tremendous leadership of Annette Nazareth—in the area of the reform of self-regulation, but far more broadly across virtually every issue of importance to our capital markets over the past 10 years. When Annette leaves the SEC, there will be an enormous void.

Well, it is hard to believe another year has gone by and we find ourselves here in Boca yet again.

I've been a regulator for more than 20 years and I've been coming to conferences like this for just as long—but this year is different. A major restructuring of the regulatory model, a groundswell of concern from many thoughtful voices about U.S. capital markets competitiveness, and of course, recent events around the credit markets mark this year as a defining moment for self-regulation, systemic market health and investor protection.

But let me begin on the self-regulation front. When I think back to last year's conference—my first as CEO of NASD—I recall there was a rumor and much speculation that NASD and NYSE Regulation were seriously talking about merging regulatory operations.

The idea really wasn't that farfetched. It was something many in the industry, including SIFMA leadership and committees, had been talking about for some time.
In fact, an SIA white paper published in 2000 was one of the sparks that helped light the fuse that led to consolidation. And for that, I thank you—your advocacy was crucial.

But the industry could very easily have been content with the status quo and resisted the merger. After all, resisting change is always the easiest course.

But as JFK once said, "Change is the law of life. And those who look only to the past or present are certain to miss the future."

Fortunately, this industry has always looked to the future—it's always open to new, innovative ideas. It simply can't afford to be content with the status quo in a marketplace that is constantly evolving—it must keep pace—and it was no different when it came to regulation.

Member and market regulation had always been spread among the various competing self-regulatory organizations and the result was redundant, or sometimes competing, regulation, with firms having to ferret through the minor and major distinctions by each SRO and build a compliance program around those distinctions.

But then came the opportunity that accompanied the change in the business structure of exchanges. When the non-profit model gave way under competitive pressures to public ownership of markets, the industry seized the opportunity to support a change in self regulation in the interests of efficiency through the end of redundancy.

SIFMA, the NYSE, NASD, the SEC and others believed that it was possible to create a better regulatory system.

A system that more accurately recognizes the different business models and sizes of firms.

A system that doesn't subject firms to unnecessary duplicative rules and exams.

A system poised to better protect investors in this new global marketplace.

That new system is the Financial Industry Regulatory Authority—the single, non-governmental regulator for the entire securities industry—which was formed this summer.

But as I thought about my speech for this conference, a recurring thought kept popping into my head. "What if we hadn't consolidated?"

I'm sorry to say these are the things regulators think about, even right before they're headed for beautiful south Florida.

Seriously, though, what if the industry had been content with preserving a regulatory regime that hadn't been updated in 70 years? What would the implications be?

In my opinion, the consequences of inaction would have been potentially disastrous.

While monumental changes are taking place all around us in the capital markets, U.S. firms would be, in perpetuity, unnecessarily subjected to two rulebooks—sometimes in conflict—two exam programs and the expense of supporting two technology platforms and suites of applications that enable the regulatory programs of NASD and NYSE, in doing largely the same things.

Securities regulation would remain fractured in an already fragmented domestic financial regulatory environment—and cooperation with foreign regulators would remain haphazard and disjointed.

We certainly would have done our best to address all these issues, but the fact is we would be stuck with a regulatory framework incapable of fully addressing any one of these problems effectively.

Thankfully, for you and for me, I don't have to give that speech today.

Rather, I can tell you about the steps FINRA is able to take to confront these challenges head-on. Simply put, FINRA affords us unprecedented opportunities to speak with a unified voice to fellow U.S. financial regulators, as well as our counterparts in other countries, all while we build a more sensible and streamlined regulatory regime for investors and the industry.

Our efforts at streamlining will continue to gain momentum as we complete the integration process.

For example, the transformation of NASD and NYSE's enforcement departments into a single program is at the point where I think it can be considered complete. Fortunately, even before the consolidation took place, NYSE and NASD had begun to eliminate a lot of investigative overlap.

Integration of the two arbitration departments was similarly straightforward. As of now, the NYSE Arbitration forum is closed to new cases, with FINRA staff managing the remaining cases.

Technology integration is moving ahead with the goal of having the full suite of technology applications integrated within 24 months, though most will be complete within 12 months.

Merging the rulebooks is a complex process and it will take some time. There are five major principles that we're simultaneously seeking to achieve in the final work product.

First, we're committed to not only picking the best of the legacy NASD and NYSE rules, but we're also going through a very deliberative process to determine if there might be a better way to address regulatory concerns than simply picking between two existing rules.

Second, we aim to tier some rules according to firm size, business model or type of customer. For example, I think it's worth exploring whether a new definition of institutional investor is needed and whether such investors need to be subject to all the same rules as retail investors. The diversity of firms, in terms of size and business model, cries out for a more tailored approach to regulation, consistent with investor protection.

Third, we want to consider whether rules can be grouped in a more conceptual manner so firms have a better understanding of the regulatory scheme for each area of regulation.

Fourth, we'll re-write rules to make them as clear as possible. Compliance is challenging enough without enacting rules that are hard to understand.

And finally, we're considering areas where a more principles-based approach could be appropriate. We certainly aren't going to throw out all our rules—keep in mind that the FSA's 11 core principles are backed up by more than 8,000 pages of rules—but we are going to examine where principles can be beneficial.

As in all things, there is a balance to be achieved. Indeed, the current FINRA rulebook is a mix of rules and principles and we are very comfortable pursuing whether that mix can be tweaked.

But, experience tells us that principles often give way to some form of prescriptive standards—which, I hasten to add—is not because of a bait-and-switch approach by the regulator. Rather, it is the outcome of human nature as compliance professionals prefer "bright line" standards. It is because people always seek to know where the line between the permissible and impermissible resides and they come to us for guidance.

Similarly, our regulator, the SEC, wants to know the parameters of our regulatory and surveillance programs even around principles-based rules, of which we already have many in place.

But I don't bring up these pressures on principles-based rules as a reason to deny their place in the rulebook. The elasticity of principles-based rules is attractive to both the regulator—who is seeking to promote good public policy and investor protection—and those who are regulated and don't want to spend their time worrying about tripping technical requirements that do not threaten the overarching purpose of the regulatory scheme.

The formation of FINRA was not just a merger; it serves a higher regulatory purpose—to find new, innovative ways to strengthen investor protections, not to simply rely on the old ways of doing business.

Like the rulebook, integrating the exam processes presents an equal challenge.

Our goal on Day One, especially for the firms that were members of both NASD and NYSE, was to ensure that we spoke with a single voice to all firms.

But that simple concept requires a fair amount of internal preparation and coordination.

Fully integrating the exam program in time for 2008 is our goal, but that's not to say there aren't some hurdles we have to negotiate.

Each organization's exam program had different strengths, and often had slightly different approaches, but next year you will see a unified exam process with significant changes.

For the first time, there will be one team of FINRA examiners for each exam.

They may conduct reviews of different areas—for example, financial operations or sales practices—but the FINRA team will coordinate all information requests and conduct one opening meeting and one exit meeting with firm management.

The new FINRA exam program will also be more risk-based—and better able to take into account the scale and scope of each firm's operations. This will help ensure that our resources are more appropriately deployed.

That's important in today's marketplace. Crisis can appear suddenly, with the subprime situation being just the latest incarnation.

Having the necessary resources to deal with a problem like subprime isn't a luxury, it's a requirement. FINRA realizes this and has taken significant action in this area. I can assure you that both our surveillance and examination staffs are fully engaged.

Beginning in early summer, FINRA surveillance staff began to reach out to firms with large fixed-income and mortgage-backed securities exposure.

Our coordinators continue to talk with these firms daily regarding the valuation of securities, the collectability of margin calls and the reissuance of asset-backed commercial paper.

As a result of large losses—as well as sizeable inventory exposure—we have heightened our surveillance of several firms, many of which have received significant capital infusions.

We continue to work with individual firms that have contacted us about problems they may be having with affiliated hedge funds and transactions with certain mortgage originators that are under duress.
Many of the broker-dealers that are significant players in the subprime market are receiving a targeted examination from either the SEC or FINRA, with a focus on inventory valuation, controls over pricing and collateral monitoring.

Other areas we're concerned about are the lack of liquidity in the asset-backed market, as well as the lack of pricing transparency, and the magnitude of the rating agency downgrades. We'll continue to monitor this situation closely.

I do think what we are experiencing is a cautionary tale to be considered even without reaching conclusions as to the many reasons for these underlying problems. We have all been impacted by recent events and, indeed, it remains to be seen how the macro-economy will be affected by the fallout of what could be an ensuing credit crunch.

The challenge I pose to all firms is to use this crisis as an opportunity to ask themselves some tough questions about what they did right, and, equally important, what they did wrong.

I started this morning by talking about the new FINRA and possible new approaches to regulation, whether it is the tiering of requirements or a principles-based approach. We hear often that the regulator should take a more prudential and less prescriptive approach.

The reason? To strike the correct balance of promoting adequate regulation and investor protection without hurting global competitiveness and innovation. I'd say that's a fair request, because pro-investor should not mean anti-business. This is a challenge we can embrace.

We recognize that competition and innovation are not risk-free propositions. We understand that losses occur even when there are adequate risk control policies and practices.

But, for our system of regulation to work, it is mandatory that firms always ask the question—both before and after problems occur—do we have adequate controls to assess risk and act in a prudential manner in accordance with the information from such assessments?" And it is a matter of course that the regulator will always ask that same question.

So I challenge you today to ask yourselves the tough questions that can make principles-based and prudential regulation more than just a slogan.

Does your firm have viable risk-control policies and procedures? And do the models or methodologies that you use to perform this function have a set of assumptions that are realistic?

Is that methodology informed by the people who have a vested interest in generating revenue as opposed to controlling risk?

Do you have concentrations of market risk, credit risk, revenue sources, customer dependencies, product dependencies? If so, do you have a clear understanding of these concentrations and are you comfortable with them?

Do you understand the products you are manufacturing and marketing and can you explain them in plain English to an unsophisticated investor? Would you hold them in your personal portfolio?

If your firm does not insist on a strict separation of business person from risk manager, have you thought through how you manage those conflicts in a prudential manner?

Does your firm have a process where the decisions of senior management to override risk controls are resolved at the highest level, perhaps by an appropriate committee of the Board?

Let me be clear that I am not announcing today new regulatory standards or implicit rules, nor am I drawing regulatory conclusions about the current debt crisis. I am simply indicating that the burden on firms under principles-based and prudential regulation is not an easier form of regulation. It is hard work because it requires the asking of hard questions like these and resolving the problems raised by the answers.

And it requires that the regulator recognize the difference between bad things happening in the face of otherwise prudential practices and the absence of sufficient prudential practices that lead to bad things.

The pursuit of an efficient regulatory system that protects investors, markets and our economy while retaining the potential for competitiveness and innovation must be a matter of common purpose between the regulator and the regulated, and each of us will ask the other hard questions in that pursuit.

As we continue our integration efforts—now in month four—we look forward to building the finest regulatory programs that are befitting a modern regulator.

We will seek to ensure that investors have choices—in the types of firms they seek to do business with and the array of products and services those firms offer.

We will continually survey the landscape for new regulatory issues and work to correct them before they harm investors and the markets, and take swift and certain action when investor harm has occurred.

We will be committed to finding new ways to assist the industry in meeting its compliance obligations, as well as fully engaging and educating investors to help ease their interaction with the marketplace.

And we will reach out to other regulators, as we are already doing with the FSA, to work cooperatively—understanding that we operate in a world where business is not confined by geography or time zone.

I look forward to working with all of you. Thank you.