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Grace B. Vogel

Executive Vice President, Member Firm Regulation

Remarks at the New York Regulation and Compliance Conference

September 10, 2008

New York, NY

Welcome, it's great to see all of you here this morning. We have a great program for you today.

I don't know how many of you read it, but there was an interesting article in The Economist last month about risk management. The title of the story was “Confessions of a Risk Manager.”

The "confessor" worked at a large global bank. In the article, the author laments how, leading up to the current market crisis, his firm's risk management department had been focused on fighting what he called “the last war.”

He went on to explain that the focus of his firm's risk management effort was on the loan portfolio in the “banking book” and not on mark-to-market assets in the “trading book.” The trading book was the domain of equities, government bonds and the like, and it was monitored daily.

But with the growth of CDOs, eventually a gap developed in the firm's risk management operation. As the author tells it, CDO's and other asset-backed securities sat somewhere between market and credit risk.

He explains how the market-risk group never embraced these investments—and the credit-risk department viewed them as market risk since they were in the trading book.

As the structured credit market continued to grow, he said his firm's risk management response atrophied. He described it as “half-hearted.” Yes, portfolio limits were set but for the most part, he described an environment where the trading desk had free reign—and the pressure on risk managers to approve transactions was “immense.”

While all this was happening, the firm's risk managers made faulty assumptions—which they would pay dearly for.

They believed that all mark-to-market positions would receive immediate attention when losses occurred. And they assumed that if the market took a hit they could liquidate their positions quickly, especially triple-A rated securities.  The risk group thought they were correctly focusing on the noninvestment grade paper and didn't pay enough attention to the ever growing highly rated assets that were becoming illiquid.  They had not fully appreciated that 20 percent of a very large number could cause much greater losses than 80 percent of a small number.

Obviously, those were yesterday's assumptions—and they were wrong. Today we face a different world—and we need to prepare ourselves to fight a new war against risk—operating under new assumptions and using innovative tactics.

As we move through this market turmoil, we're seeing not only the effects of excessive leverage, but securitization, lax lending standards and a questionable ratings system.

In the early stages of the crisis, FINRA's focus was on understanding its depth and causes as well as the potential impact to our member firms.  We began meeting with firms to understand their exposures to the credit markets, their liquidity, their capital position and the state of their risk management systems.

It became clear to us that, in many cases, risk management systems simply broke down. There was an over-reliance on internal models, teaching us again the painful lesson that models only work within a certain confidence interval and management needs to supplement models with robust stress testing.

FINRA is focused on doing our part to prevent a repeat of this episode. We are taking action across the board, from conducting special examinations to reviewing liquidity risk to implementing supplementary reporting, where appropriate.  We are working closely with the SEC to examine the viability of the capital rules.   

But it isn't just FINRA—every regulator is figuring out how a change in its approach can increase market stability. Because if we've learned one thing from this crisis, it's that the structural risks inherent in our modern financial system no longer impact one institution or sector at a time.

Risk now reverberates throughout the entire marketplace in an instant, threatening firms and exposing investors to harm.

With the Treasury Blueprint now public, the regulatory structure that's been in place for decades is being put under a microscope.

We at FINRA don't agree with everything in the Blueprint, but the report begins to lay out the problems that have plagued regulatofor decades—issues that stem from a highly-fragmented regulatory structure.

It's clear the existing regulatory structure lacks the coherence to most effectively deal with a financial crisis like the current one.

With multiple issues and players at every level, from mortgage origination to securitization to sales, the system is simply unable to address the problems in a comprehensive way.

The credit crisis underscored the limits of functional regulation. When each regulator is focused on a single product line—whether it's banking, securities or insurance—there's no one surveying the overall market.

And when no single regulator has the full picture, systemic risks are either left unchecked or may even go unnoticed.  

Under the Blueprint, there would be one regulator monitoring market stability. There would also be a prudential regulator to ensure the soundness of firms.  And finally, there would be a business conduct regulator—whose main concern is front line investor protection—overseeing the activities of all financial firms.

The Blueprint also recognizes the importance of self-regulation.

And with the creation of FINRA, we have seen the most visible structural change in regulation in decades. Since July of 2007 when FINRA was formed, we have made substantial progress in integrating NASD and the member regulation operations of The New York Stock Exchange.

One of the key advantages of combining our operations has been the creation of a consolidated examination process, encompassing sales practice, financial and operations.

On the enforcement front, I'm pleased to report we've aligned NASD and NYSE operations completely.

FINRA's enforcement team combines great talent from both organizations and is effective in eliminating the possibility for concurrent investigations of the same conduct and in sending a consistent and fair message that practices that could hurt investors will not be tolerated.

Then there's the rulebook.

FINRA staff and our Board of Governors, which is made up of industry and non-industry members, is very engaged in the rulebook process—and there's been a lot of discussion about what the new rulebook will ultimately look like.

Earlier this year, we issued regulatory notices seeking comment on four proposals for the new rulebook. The four areas are: Financial Responsibility, Supervision, Books and Records, and Investor Education and Protection.

We've also submitted directly to the SEC a proposal to move NASD marketplace and procedural rules into the new FINRA rulebook without any material changes, except renumbering and reorganizing them into a more user-friendly format.

The FINRA Board of Governors will continue to review tranches of rules as we continue to build the FINRA rulebook, and you will see them on a rolling basis as they are published for comment.

As always, we encourage you to let us know your thoughts while these rules are open for comment. We're committed to listening to industry concerns—we want to make FINRA as effective as possible and that can only happen with your input.

Firm compliance, prosperous business and stronger investor protection go hand in hand. When compliance is weak, investors suffer and ultimately so will the business.

The same goes for the regulatory structure itself. When the regulatory structure is effective and efficient, firms and investors are better served. When it's not, everyone suffers.

And it's not only firms that get frustrated with a fragmented regulatory system. Investors are in the same boat—and share the same frustrations.

Too often, many investors don't quite understand what product they're buying, who regulates it, the legal protections they might be entitled to or the qualifications of the person selling it. 

In the long run, this frustration on the part of investors could have a negative impact on the marketplace—and we need to find a way to address it before it does.

FINRA CEO Mary Schapiro has talked about this before—stressing that every investor should have four primary protections.

Mary believes investors should be able to enter into any transaction knowing that every person selling a financial product is tested, qualified and licensed; that the product's advertising is not misleading; that every product sold is appropriate for them; and that there is full, comprehensive disclosure for all products being sold.

Unfortunately not all financial products come with these simple guarantees or protections.  Whether an investor is dealing with a mortgage broker, an investment advisor, a broker or buying securities, annuities or derivatives, basic protections should be part of every transaction.

That needs to change. It would go a long way toward restoring investor trust.

But no matter what FINRA does or what regulatory changes are made, regulators can't do it alone—we all need to work together. If compliance isn't working at the firm level, our system won't work.

One of the most important things we can do as regulators is keep the lines of communication between us open, providing support and guidance.  I want you to know we're committed to doing that—and it's why we're here today.

We regulators can write rules, conduct examinations, and bring cases, but it's you, in the firms, on the front lines, who carry an important share of the regulation of the industry. 

You see what goes on day to day and can spot small problems before they become large ones. You're the ones who develop specific practices and policies from our rules and guidance, to make regulation work in concert with your business, not against it. 

We have a lot to do today, so I think I'll stop there.

Today, senior FINRA officials and industry experts are going to talk to you about the latest emerging regulatory issues and discuss FINRA's examination, enforcement and risk management priorities, particularly those related to complex financial products.

I think you'll find the day to be very informative and interesting. 

Thank you for listening—and I hope you enjoy the conference.