Remarks From the SIFMA Compliance & Legal Division's Annual Seminar

Richard G. Ketchum

Chairman & Chief Executive Officer

March 23, 2009

Good morning and thank you. It's great to see you all. Today I'm giving my first speech as FINRA's Chairman and CEO—and I can't think of a better audience for the occasion, although all of us wish the economic circumstances of the occasion were quite different. The fact that you are here speaks volumes about your commitment to build the most effective control environment possible at your firms.

I would like to take this opportunity to discuss with you my observations about the current environment—and hopefully plant the seeds of thought that can lead to longer term change. I believe that the survival of this industry is dependent on putting the interests of investors first. I am sure that you have heard this from a myriad of regulators in the past, but I believe recent events provide irrefutable evidence on that score. And I want to emphasize that my comments today are meant as an honest assessment from which we can all learn and develop a task list that you can bring back to your firms as thought leaders. Because legal and compliance people need to be welcomed as thought leaders in their respective firms.

I've been a regulator for a long time now, but no one alive today has experienced the shattering economic events of this global recession—a recession that has left virtually no asset class untouched. Firms notable for having survived the depression and other severe market contractions are gone or have been significantly impacted. A nationwide housing price collapse that was once unthinkable has occurred. The contraction of credit to households and businesses is tangible in a manner none of us have seen before. And while we may have some cause for optimism in the long term, we must acknowledge the gravity of the present environment and react in a responsible fashion.

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.

Perhaps most importantly—to firms, investors and the markets—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.

This kind of dramatic reform for the regulatory system as a whole will take time. But in the short-term, investors need help now. They can't be allowed to fall through the gaps that will still exist until reform is completed. Right now it's not enough to carry on like we were doing. We need a new pace and urgency.

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. And that is a tough mission to accomplish in this environment. Recently, Hector Sants, Chief Executive Officer of the FSA, a regulator heralded by financial services firms because of its commitment to less obtrusive principles-based regulation, said, "There is a view that people are not frightened of the FSA. I can assure you that this is a view I am determined to correct. People should be very frightened of the FSA….A principles-based approach does not work with individuals who have no principles. We will seek to make judgments on the judgments of senior management and take actions if in our view those actions will lead to risks to our statutory objectives. This is a fundamental change."

Harsh words indeed and the mood in Washington is not far different from the sentiments behind that quote, even though we have never had a regulatory regime that mirrored the lighter touch of the FSA. Let me be clear, FINRA has never been nor ever will be about fear, but this is a time when it is critical for all of us to define a new era of accountability for both regulators and the industry. My purpose here today is a dialogue that will lead to an industry perspective based on recent events that has the potential of being integrated permanently into the culture of the firms we regulate.

Okay, let me go first, for it is important to emphasize that regulators, too, are not exempt from this process of lessons learned. We must better perfect the tools and efforts around our mission.

A prime example of the learning on our part is FINRA's newly created Whistleblower Office. The SEC embarked on a similar initiative recently.

The new Office of the Whistleblower 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.

It's important to point out that FINRA's new whistleblower initiative will not replace our long-standing process for handling thousands of routine tips and customer complaints. FINRA has long responded to complaints and tips by taking significant actions against any firm that has treated investors poorly and have flouted the standards they are required to meet.

We don't, however, intend to stop there. We are determined to review the way we share information throughout our organization, with the SEC and other regulators, and with the industry. We need to continue to improve our sophisticated understanding of changes in the financial industry, the introduction of new products and increase our monitoring of outside resources that may indicate concern with maverick firms whose business practices threaten investors with serious loss.

Okay, let's talk about your challenges. Everyone in this room knows that we are in the midst of the most challenging market of our lifetime. No area of the financial services industry has been left untouched, and there is no product, service or organization that is not facing some manner of crisis of confidence.

Unfortunately, what is lost in the wave after wave of bad news is an appreciation for some of the strides that have been made in compliance in the past few years.

With many of the firms represented in this room, I've seen a real commitment to technology, a real understanding of the importance of an independent compliance function, and a genuine belief that good compliance is essential to the brand. And it's the people in this room and many others like you that are responsible for those strides.

Yet, while we have made progress, there's one thing we haven't done: we really haven't been successful in making a culture of compliance second nature at firms. I know this phrase has become trite and you must roll your eyes when you hear it, but the simple lesson of the last two years is that we are still not there.

There must be a cultural shift in financial services firms' thinking about risk, compliance and the interests of investors. And that cultural shift cannot occur through your efforts alone. It must reflect a fundamental change of attitudes and participation throughout the firm, particularly senior management.

Let's talk about risk management.

Several months ago on CNBC, John Gutfreund was asked about the leverage ratios employed by Salomon Brothers under his watch as the head of that organization. He replied that leverage ratios of eight to one gave him heart palpitations. Whatever the accuracy of that assertion, there is no question that leverage ratios rose to unsustainable heights and were rationalized under the banner of the more efficient use of capital. When the system is so leveraged and that leverage begins to unwind, then credit freezes, contract settlements cease, and no institution of any size in terms of revenue, cash flow or capital is safe—especially if that institution is dependent upon external sources of funding, which is the very nature of financial service institutions.

And, of course, it wasn't only leverage itself, but also the nature of the assets being leveraged. A certain amount of financial hubris set into the belief that modeling risk essentially crowded out, what people now term in various ways—as "black swans," "idiosyncratic risk" or "fat tails." Whatever term you may use, it is the consideration of what happens when that portion of risk at the tail end of the curve happens to manifest. We also now understand correlational risk as perhaps never before—the risk that if there is a two percent modeled risk of default in an asset, the occurrence of that event substantially causes the market in that entire asset class to cease to exist. It is ongoing in an ever more complex financial world.

In my short time in the industry, I participated in risk management exercises, and let me emphasize that I understand just how difficult that process is. But the painful lessons learned from the last 18 months cannot be forgotten. I will leave to the SEC and Fed to determine how leverage and capital requirements must be adjusted, but changes in the risk management process is equally important. First, scenario analyses need to be performed by independent risk managers that are not in love with the positions or the strategies. Second, scenarios must always evaluate cross-asset contagion risk. Third, the firm must react immediately when there are dramatic market and economic changes to reevaluate the exposures and maximum potential losses, with a careful appreciation of funding implications resulting from holding company exposures and careful concern as to how customers are being advised. And finally, this must be a task that is not delegated by the CEO and senior management of the broker-dealer no matter what the press of other business. Beyond each of these points, compliance must be an active participant in this process. The artificial border between risk management and compliance must end. No, you can't run the numbers, but your instincts and natural concerns regarding impacts on your customers are critical to effective risk management oversight.

Similar to risk management, there are critical lessons learned for the compliance function rising from the market collapse and credit crisis. The classic example of this, of course, is the auction rate securities market. Investors didn't lose money simply because of a compliance failure on the part of firms, but the impending scarcity of new buyers at auction was, at some point, not a real secret.

What is clear from the recent experience with auction rate securities is that every broker-dealer must understand the risk-reward quotient of products and that understanding must extend from the product originator to the furthest down-line 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.

If we've learned anything from the ARS episode, it's that senior management at firms must be involved in compliance. Compliance officers need to have access to senior leaders and there needs to be a genuine demonstration in responding to potential problems, investing in technology solutions and, most important, providing adequate staffing in the area of compliance.

How about now, after the fall? I know every firm is under pressure today, but a firm's obligation to compliance has not changed.

This is especially true now as investors may be looking to recoup the losses they've been hit with over the past year or so. Some investors are going to be tempted to overreach in their search for higher returns. They may be less cautious at a time when they should be extremely cautious.

What I'm suggesting is an ongoing new products process. Firms need to look at their list of products and make fairly difficult assessments as to whether they are still right for their customers. That requires an in-depth understanding of the components of the products. It demands a sophisticated analysis of which external forces could influence their behavior, and how.

The need to understand how products and services change over time has never been more pressing. 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.

As investors find what are perceived to be safer places to put their money, firms need to be able to communicate to them not just the risks of those products now, but anticipate and communicate the risks if conditions change. And the concerns don't always focus on new structured products.

For example, we will see even greater retail participation in the muni market, and given the increased financial exposure of some state and local governments, what bonds remain appropriate and what changes in disclosure are necessary to reflect new risks? What controls do you have in place to identify municipalities entering into financial distress and to make sure that information flows to your retail customers? How about the ETF market and the increasing number of leveraged trading vehicles in that sphere? Certainly not all munis and ETFs are created equal.

In the past, I've talked about what I call "wealth events." These are events that happen once or twice in a family's or individual's lifetime.

It could be the death of a parent or spouse or simply entering retirement these days. The one thing all "wealth events" have in common is they involve large amounts of money being turned over and they fundamentally change the way investors interact with their broker or financial adviser.

When an investor finds themselves in such an event, an adviser's first reaction may be to recommend selling everything and starting over, which of course, generates a lot of commission fees—but may not be the best course of action.

That's why I believe these "wealth events" need to be supervised more closely. They need to be on senior management's radar screen, not simply as a revenue opportunity, but as a crossroads moment with a client. Similarly, these events need to be a particular focus of your compliance reviews. Where there is greater risk and incentives there has to be greater attention.

All of these challenges I've been discussing aren't unique to compliance officers—these are the same challenges that FINRA faces. We are constantly asking ourselves, "What can we do to become more forward-looking and more flexible?" In part, that was the mandate when we created FINRA nearly two years ago.

FINRA continues to do its part in creating a regulatory approach that is more rational and more responsive—so let me give you a brief update on that work.

The integration of NYSE Regulation and NASD regulatory operations continues to be on schedule. We have completed the integration of the examination, enforcement and arbitration programs. We're about 80 percent done with the technology integration and about 70 percent complete with Board approval of the rulebook consolidation.

The first phase of newly consolidated FINRA rules became effective in December. Tangible proof of that progress was the appearance of a binder containing the FINRA manual, not an NASD binder, on my desk earlier this month. If only that meant we were done.

As you understand, just getting the rules through our Board is just part of the effort.

Many rules, especially those that place new or changed obligations of firms, will go through two rounds of comment, first through our Regulatory Notices and then through the SEC. That pipeline is already getting crowded, and there is still more to come.

It is our hope that the rulebook will be close to completion by the end of next year, at least in terms of having everything filed with the SEC. That said, we are sensitive to, and share, the somewhat conflicting desires of getting to a single rulebook and giving the firms time to comment and to prepare. In that debate, it has been our bias to choose quality over speed.

FINRA is just one regulatory organization. Even if we and you did everything perfectly, the gaps that currently exist in today's regulatory structure would still persist.

From investment advisers to hedge funds to over-the-counter derivatives, there are whole swaths of the marketplace where regulatory oversight should be improved.

And that's the challenge to policymakers and regulators: To eliminate the gaps that put investors in jeopardy, put firms at risk and threaten confidence in the markets.

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 leads to an environment where investors are left without those consistent and effective protections.

So, first, what protections should be provided to investors? FINRA believes that investors should be able to enter into any transaction knowing that:

  • every person who provides financial advice and sells a financial product is tested, qualified and licensed;
  • the advertising for financial products and services is not misleading;
  • every product marketed to them is appropriate for recommendation to that investor; and
  • there is full and comprehensive disclosure for the services and products being marketed.

Unfortunately, not all financial products come with these important attributes or protections.

Second, what products, activities and services should be regulated, and how? As I mentioned earlier, there are a number of gaps across our system, both in terms of similar products and services that are being regulated quite differently. Where we can identify these regulatory gaps that compromise investor protection and pose risk to the financial system—from sensible and balanced oversight of hedge funds to steps to decrease counterparty risk and increase transparency in OTC derivatives—now is the time to move forward.

Let me highlight the regulatory gap that, in our view, is the most glaring example of what needs to be fixed in the current system: the disparity between oversight regimes for broker-dealers and investment advisers. The lack of a more meaningful examination program for investment advisers impacts the level of protection for every member of the public that entrusts funds to one of those advisers.

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 neither has the resources by themselves to engage in a regular and vigorous examination program and day-to-day oversight for the investment adviser community.

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.

Simply put, FINRA believes that the kind of additional protections provided to investors through its model are essential. Does that mean FINRA should be given this role to regulate for investment advisers? That question ultimately must be answered by Congress and the SEC, but FINRA is uniquely positioned from a regulatory standpoint to build an oversight program for investment advisers quickly and efficiently.

Quite simply, as we learned from Madoff, it does not make sense for two, separate, independent regulatory bodies to oversee investment advisers and broker-dealers, especially when these businesses may exist in the same legal entity. This case, in particular, highlights what can happen when a regulator like FINRA is only allowed to see one side of the business. There is no doubt that Madoff and others have cynically designed their schemes to fit between the jurisdictional cracks to decrease the likelihood of detection. Those opportunities must be stopped now!

We recognize that although similar in many ways, there are some differences between services provided by investment advisers and broker-dealers. What is needed is the development of a system that is tailored to fit the investment advisers, and not simply export in wholesale fashion our existing rulebook or governance structure. We do 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 keeping with our view that there should be increased consistency in investor protections across financial services, we believe it makes sense to look at the protections provided in various channels and choose the best of each. In 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.

Right now, investors are watching us. They're watching and waiting.

They're waiting to see if we're serious about redoubling our commitment to compliance. They're waiting to see if compliance can truly be flexible and adaptable to a shifting marketplace. They're waiting to see if we really will eliminate the dangerous gaps in the system that jeopardize their financial well-being.

But above all, investors are waiting to see if we deserve to earn their trust again. Thanks to the commitment of the people in this room and many others in the industry, we all know that the answer to this question is a resounding yes—now it's time to prove it.

Thank you very much for listening.