Remarks From the FINRA Fall Securities Conference

Mary L. Schapiro

Chief Executive Officer

FINRA Fall Securities Conference

October 23, 2008

Note: An audio podcast of this speech is available for download at

Good Morning. Thank you so much for being here with us today. I hope you will find the next two days to be a productive use of your time and that you will leave with valuable information and perhaps even some new friendships.

I am reminded of the old saying "Prosperity is a great teacher; but adversity is a better one."

This is an extraordinary time for our industry and it presents those of you on the front line—whether serving customers or maintaining your firm's commitment to good compliance—with true opportunities.

The history of our markets has always been defined by periods of great adversity—from the Panic of 1907, to the crash of 1929 to the bursting of the technology bubble in 2000, we have had our share of adversity. The question is: What will adversity teach us this time?

Maybe the most important lesson will be very simple: to remind us that during times like these, firms and regulators must be united in serving investors and safeguarding the marketplace. For the industry, these times and these markets present an opportunity to be the source of the best service and the most trusted advice as investors navigate this new, complex and frightening marketplace. Time and again, I have seen this industry rise to the occasion and do just that.

I thought I would spend some time this morning talking about what is happening 3,000 miles away in Washington, and how I hope regulators and policymakers will approach the inevitable restructuring of financial regulation that will come from this crisis. Clearly, our regulatory system failed to compensate for the failures of market discipline and failed to appreciate the interdependencies of financial institutions and the risks they shared. That is not to say that tremendous, heroic efforts have not been made by many regulators over the past 12 months. But it is to say, the system did not allow regulators to stay ahead of this crisis and prevent it from ever occurring.

And, while we are still very much in the middle of this period of uncertainty, I want to offer two predictions. First, our nation will recover. We and our markets are incredibly resilient. Second, policymakers in Washington will inquire in detail and at length about the causes of this crisis, and how we can ensure that it never happens again.

Congress will hold hearings and will spend many months exploring these issues. The new Administration will, too. Indeed, the financial bailout plan directs the Treasury Secretary to report to Congress by April on the regulatory environment.

Congress, the new President, and other policy makers will consider a range of issues. Should we limit the securitization of mortgages and other debt obligations? How can firms improve their analysis and management of risk? Can regulators rely on even improved measurements of risk? Are international capital standards adequate? They will ask many questions about the credit default swap market and its effect on liquidity and market volatility. They have inquired about the role of credit rating agencies as gatekeepers to the financial markets, and how oversight of these agencies can be improved. There will be more hearings on the housing market, on Fannie Mae and Freddie Mac, and on the regulation of mortgage originators.

And, Congress and the new Administration will consider how we can finally make our system of regulation more rational and make the protection of consumers more consistent across functional lines.

I believe that one of the strengths of our system-with all its flaws—is our willingness to look clear—eyed at what has gone wrong and how we can fix it. You might recall that more than a year ago, in a flurry of special studies and task forces, we began to consider how to improve our regulatory system as a way to ensure our continued global competitiveness. Now we are compelled to move ahead by a graver threat—the sustenance of our financial institutions and a need to re-build investor confidence.

It is my hope that financial services regulatory reform will be guided by the following five principles:

First, we must manage systemic risk and protect investors. For too long, these two objectives have operated independently, and perhaps even at odds with one another.

Historically, banking and insurance regulators have focused more on systemic risks. They have sought to maintain the solvency of large institutions, and prevent financial failures that could lead to larger market or even macroeconomic crises. They have prohibited excessive risk-taking and required firms to preserve their own capital.

Securities regulators have focused more on investor protection and on the preservation of customer assets, separate and apart from the assets of the broker-dealer. They have required issuers and intermediaries to disclose the facts about their products and services. They have required intermediaries to recommend products and services only if they are suitable based on an individual investor's needs and circumstances.

I think we can all agree that both the management of systemic risk and the protection of individual investors are important to the smooth operation of our financial markets. But are they really at odds with one another? In my view, they represent two sides of the same coin.

Of course regulators must be ever mindful of systemic risks. As we have seen when fear escalates and investors flee, financial markets crumble. Credit markets dry up and stock markets plummet. Our ability as an economy to allocate capital to create jobs and growth is impaired. We must develop a more coherent way to calibrate risk-taking and to monitor and correct systemic deficiencies, regardless of the particular market in which a firm operates.

But protecting investors is just as important. As investors lose faith in the issuers and intermediaries with which they do business, markets shrink or fail to materialize. Without rules to protect investors, financial systems will not raise capital and the economy will not grow.

In the current crisis, the insolvency of firms has harmed their investors and customers. On the other hand, the marketing of inappropriate investments has undermined investor confidence and imperiled the capital of those firms. These two problems—insolvency and investor harm—can develop a symbiotic relationship, in which each one contributes to the destructive tendencies of the other. If the failure to manage risk and to protect investors are two sides of the same coin, then so is the solution. We must create a regulatory system that gives equal weight to systemic risk and investor protection.

My second principle of regulation is the following: We must decide how to regulate institutions that are too big, or too interconnected, to fail. Let us be honest that some firms, because of their size, because of the risks that they present to their counterparties, enjoy a special status that departs from traditional free market economic theory. Permit me to quote Alex Pollock of the conservative American Enterprise Institute:

Here's as close to an empirical law of government behavior as you'll ever get: When government financial officers—like Treasury secretaries, finance ministers and central—bank chairmen-stand at the edge of the cliff of market panic and stare down into the abyss of potential financial chaos, they always decide upon government intervention. This is true of all governments in all countries in all times."

To which one might say "thank heavens they do." This intervention in our capital markets is not surprising considering the importance of some large institutions to the financial system. Given the way global markets operate today, there is simply no way we can put that genie back in the bottle.

But we can do better. We can better define the types of institutions that the government will save. We can establish criteria for intervention, and make the forms of intervention more predictable. Of course, the government will need flexibility to address different market conditions. But in recognizing that we will intervene, we should make more predictable how we will intervene.

By admitting this fact, we also will be forced to improve our capital adequacy standards, to ensure that all large institutions, regardless of sector, maintain necessary levels of capital and liquidity and do not engage in the type of risk-taking that will require intervention. These policies could dampen economic growth. But it also could contain the risks that large institutions present to the financial system and to taxpayer money. I, for one, would be willing to make the trade-off of better capitalized, more closely supervised, but less profitable institutions for less volatility and less potential to imperil the entire financial system.

My third principle of regulation is the following: —And this has been a constant theme of mine for years—consumers of financial products and services must receive the same level of protection regardless of the product or service that they purchase. An investor in a variable annuity or an indexed annuity, a customer of an investment adviser, a mortgage broker, a securities broker, or an insurance agent, should receive similar levels of protection.

Today, more than ever, we place upon the shoulders of the average consumer the burden of planning for his future. Largely gone are the days when workers hope to live off employer-sponsored pensions, or when they deposit their assets in savings accounts. We expect our citizens to plan for their retirement, and to figure out how to live on a combination of their own savings and investments and the threatened programs of Social Security and Medicare. Defined contribution plans and individual investments have become the basis for the financial future of many of our citizens.

We cannot expect consumers to wade through a labyrinth of regulators or to decipher which product or service will afford the greatest protection.

Let me provide an example that will be familiar: If an investor buys a variable annuity, FINRA will have reviewed the product's sales material to ensure that it is fair and balanced. The salesperson will have passed a qualification exam and kept up with industry trends through continuing education and training programs. The customer will receive information about the general features of the annuity, including potential surrender charges and periods, tax penalties, and fees and expenses. A registered principal will have ensured that the recommendation to purchase the product, to invest in particular sub-accounts, and to choose particular riders and features are suitable based on the customer's individual needs.

If an investor buys an indexed annuity, the level of protection he receives will depend upon the state where he lives. In some states, he may receive detailed information about fees and expenses. In other states he may not. There may be some kind of suitability requirements depending upon the state. FINRA normally will not review the sales material. In some cases, the investor will be deprived of the same quality of disclosure that he would have received with a VA.

Why should a purchaser of an indexed annuity receive less protection than a purchaser of a variable annuity? How are investors, the financial industry, or we as a society, better off by maintaining this regulatory inequality?

I do not mean to pick only on indexed annuities. We can raise the same question for many other products and services. Investment advisers are subject to a different regulatory system than broker-dealers. Insurance agents are subject to different regulation than either one. The suitability analysis required for a $100 mutual fund investment is a lot more than for a $1 million mortgage.

It will not come as a surprise to you that I believe private sector regulation has an essential role to play. At a time of shrinking federal budgets and scarce government resources, independent, private regulators such as FINRA can dedicate enormous resources to investor protection. And, working with our fellow regulators, we can help ensure that consumers of different financial products receive a comparable level of protection.

My fourth principle of regulation is the following: We must strike the right balance between innovation and the need to protect investors. Innovation is the hallmark of the American financial markets. In the past few years, many new products and services have especially helped investors meet their retirement goals. However, the current crisis has revealed the risks that come with innovation.

For example, the securitization of mortgages and other debt obligations facilitated the financing of home purchases and commercial enterprises. Yet securitization also has separated the interests of the lender from those of the borrower. It has encouraged mortgage companies and other loan originators to compromise their underwriting standards, since their loans will be sold away.

Reverse mortgages exemplify another innovative product that presented an opportunity for misuse. Reverse mortgages were intended to give aging home owners access to liquidity to meet their daily living needs, without having to give up their homes. This purpose may have been a worthy one. However, some market participants have abused this innovative product. Some of them convinced home owners to take out a reverse mortgage in order to fund a lavish lifestyle. Others convinced home owners to use the liquidity to invest in other products—products that presented their own risks but generated more fees for the firm.

Of course, variable annuities have been the subject of remarkable innovation in recent years. The introduction of guaranteed lifetime benefits has been a boon to the insurance industry, but it also has permitted some investors to stay fully invested during times of volatility. It is important for investors to understand how these guarantees work, and the fees associated with the guarantees, so that they can make an informed decision about whether the guarantees are best for them.

My final principle of regulation is the following: We must bring large systematically important yet unregulated participants in the financial markets under the regulatory umbrella and we must develop centralized clearing houses and exchange trading facilities for products that can affect the capital of our large institutions. Of course, I am principally speaking of the credit default swap market. I have been advocating a centralized clearing house to eliminate counterparty risk for nearly 15 years. Credit default swaps and other over-the-counter derivatives are being traded in volumes that could not have been foreseen even a few years ago. A turn in the CDS market can threaten the capital adequacy of a large firm. At the same time, a firm with a large CDS position, with many counterparties around the world, may be a firm that the federal government feels compelled to support with taxpayer money. At a minimum, this market needs a centralized clearing house so that the participants are known, adequate margin or collateral supports positions and the risks from counterparty failure are minimized.

The financial crisis will require a lot of soul-searching in Washington. It will expose our shortcomings and it will provide an opportunity to improve our regulatory system and to take the steps necessary to ensure that the adversity we face today is not repeated. At the same time, your willingness to dig a little deeper, to get to know clients better, to spend more time understanding their needs, will make this industry stronger, healthier and more prosperous in the long run—no matter what kind of adversity we face in the future.

Thank you again for the opportunity to speak to you today.