Saturday, June 27, 2009

Insight: SEC gets tough on Wall St tribalism

In recent years, Henry Hu, a finance professor of Texas University, has often been a thorn in the side of the banking world. In his academic research, Hu has repeatedly highlighted the systemic risks created by credit derivatives and other complex instruments.

Most recently, he has expressed alarm about the so-called “empty creditor” problem – or the fact that lenders, such as banks or hedge funds, are increasingly using credit derivatives to hedge in ways that create perverse incentives to tip companies into default.

Now, however, Hu is being given a chance to put his theoretical musings into practice. The Securities and Exchange Commission will soon announce that Hu is joining the agency, in a senior risk position. And that will give him practical input on many policy issues – such as the emotive “empty creditor” matter.

The move is an intriguing straw in the wind of some bigger shifts in Washington. Until now, the SEC staff has been dominated by lawyers and accountants, trained in law enforcement or an efficient market ethos. But last year Mary Schapiro arrived as the new head of the SEC and she is now quietly trying to widen the employee pool, by recruiting not just academics – such as Hu – but former traders, bankers and investors too.

In part, that reflects the SEC’s desire to plant flags in a regulatory turf war, and stave off justifiable political criticism of its past (multiple) failures. It also, though, reflects a little-known quirk of Shapiro’s own past: before she moved into the world of law and finance, she studied social anthropology as an undergraduate. As a result, she has always firmly believed in the importance of analyzing incentive structures to change financial behaviour – and focusing on incentives when creating policy. Recruiting former traders and behavioural finance experts such as Hu is one part of a drive to do that.

But there is a second, more tangible, reason why Hu’s appointment is striking. Ever since the Obama administration said earlier this year that it plans to regulate the derivatives world, a furtive fight has been brewing about who will run that. In theory – as most Washington officials, such as Shapiro, know well – the logical solution would be to create a unified oversight agency. That would mean merging bodies such as the SEC and CFTC.


Unsurprisingly, Wall Street banks are now trying to exploit these tribal divisions to the full. In recent weeks some have been lobbying for the Federal Reserve or the CFTC to take responsibility for derivatives, since they think that the CFTC would adopt a lighter- touch approach than the SEC (which, is ironic, since a decade ago the banking industry was furiously lobbying to keep the CFTC away from derivatives).

But the US Treasury has now signaled that while the CFTC will have responsibility for regulating interest rate, foreign exchange and commodity derivatives, credit derivatives are likely to pass to the SEC. And this week Schapiro forcefully stuck her flag in that patch, stating in public testimony that the SEC will be the primary regulator for credit derivatives.

The practical implications of that remain to be seen. Though the Obama administration unveiled its white paper on reform last week, that paper was vague on most crucial details and the practical implications are likely to take months – at best – to be sorted out. However, Shapiro, for her part, appears keen to rein in the credit derivatives sphere, using incentives such as sliding scale of capital and margin requirements to push as much activity as possible onto exchange and clearing houses. She is also determined to clamp down on some of the abuses that have marred the credit derivatives sphere in recent years. Hence Mr Hu’s timely arrival.

But in practice, SEC officials know they will need to share some oversight functions with the CFTC. And Wall Street banks are gearing up for a furious lobbying campaign, in an effort to water down some of the reform proposals. They are also determined to exploit any regulatory cracks they can find, not just between the CFTC and SEC but Europe and London too.

It remains unclear whether Shapiro will have the political clout to navigate – let alone win – all these tribal fights. She has not hitherto been regarded by Washington insiders as a real firebrand, or heavy hitter. Nevertheless, her soft-spoken, pragmatic style is respected, and many of her ideas strike me as laudable common sense. In that respect, I hope she succeeds (and not just because I share a background in anthropology). Nevertheless, she has her work cut out. So does Hu. Stand by for plenty more debate on the “empty creditor” issue in the coming months – particularly given all the companies that could yet tip into default.

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