How Wall Street's watchdog may be muzzled

As Bear Stearns collapsed, the head of the SEC was at a party rather than on the crucial conference call. Is the regulator set to be another victim of the credit crunch? Stephen Foley reports

For Bear Stearns, the end came with a sonic boom. With Fannie Mae and Freddie Mac, there has been a "dead man walking" hush since the Treasury stepped in to prevent their collapse. But for another of the major institutional victims of the credit crisis, we may be only at the start of a slow death.

That victim is the Securities and Exchange Commission, Wall Street's regulator for the past 74 years.

For months, the agency has seemed superfluous to the battle to protect global finance. After the Federal Reserve came to the rescue as a lender of last resort to beleaguered Wall Street banks, the SEC could only watch as the US central bank rode roughshod over its traditional territory. Worse, when the SEC finally did pipe up, its actions against short-sellers were widely damned as a hysterical over-reaction.

Now the SEC's chairman, Christopher Cox, a mild-mannered former Republican congressman, stands accused by some of his own staff for failing to stand up for the agency, as the Bush administration manoeuvres to replace it with something more amenable to Wall Street.

That fraught weekend in March, when the collapse of Bear Stearns threatened to engulf the rest of the financial system, it was the Federal Reserve, under its activist chairman, Ben Bernanke, which stepped in with the billions of dollars in credit needed to keep the investment bank on life support. And it was the Fed which underwrote the cut-price takeover of Bear by extending $30bn in lending to its acquirer, JPMorgan Chase.

Since then, it has agreed to extend credit wherever necessary to investment banks, something it previously only did to the deposit-taking commercial banks directly under its supervision. Since then, the Fed has been arguing that, now everybody knows that it will prop up the investment banks, it needs also to have the power to regulate them – power that currently resides with the SEC.

An uneasy "memorandum of understanding" between the Fed and the SEC, which allows for the sharing of information, is hardly going to be the last word. Whichever party controls Congress and the White House after November, an overhaul of financial regulation in the US is going to be on the agenda.

In this climate, revelations that Mr Cox was not on crucial conference calls between the Fed and the US Treasury during the effort to prop up Bear Stearns are particularly damaging. He was at a birthday party on the Saturday night in question, and went on holiday a week later, with global finance still on life support – and his protestations of having been constantly in touch have done little to improve the perception of irrelevance.

The SEC is vulnerable to losing its powers of oversight over the investment banks, says the former SEC commissioner Roel Campos, now a partner at the law firm Cooley Godward Kronish – and he doesn't reckon that would be a good development.

"I don't think a lot of the criticism is fair, but the SEC has not done as good a job in describing its role and what it was doing immediately prior to the collapse of Bear Stearns. It is not widely understood that the SEC was there with the Fed, looking at the risk management of Bear Stearns on a day-to-day basis for a long period before its demise. The SEC has huge amounts of knowledge about how broker-dealer functions work and about the intricate relationships between counterparties – expertise that is not at the banking agencies and not at the Fed. By pointing that out, the SEC could recover some of its credibility.

"The SEC has not had a champion with the Treasury, and the chairman has chosen not to make his case for the agency loudly. Mr Cox is a team player and doesn't want to be seen as at odds with the Treasury, but the people thinking up policy are naturally favourable to the Fed."

The creation of the SEC in 1934 was part of the effort to rebuild American finance after the horrors of the Great Depression. It was the organisation charged with ensuring that companies and brokers who offered securities for sale to the public actually told the truth about these investments and their risks. To reflect its importance, President Franklin D Roosevelt appointed Joseph Kennedy, President John F Kennedy's father, to serve as the first chairman of the commission.

That easy division, with the SEC looking after the investment banks and the Fed guaranteeing and controlling the commercial banking system, has looked a bit anachronistic since the repeal of the Glass-Steagall Act by the Clinton administration, which allowed investment banks to create their own lending operations and helped to puff up the entire edifice of leveraged lending and complex derivatives that has come crashing about our ears. This has been monitored by the SEC under an informal agreement with the investment banks. The battle over who gets the ultimate power to regulate it, when it gets slowly rebuilt after the current crisis, is a battle the SEC appears to be losing.

"There is growing bifurcation between investor and consumer protection on the one hand, and the safety and stability of markets on the other, and we are at a watershed," says James Cox, a securities law professor at Duke University who is no relation of the SEC chairman. "The debate now is about whether the market stability function will go with the Fed or with a new executive arm.

"One place it is not going to go is the SEC. Frankly, there has never been evidence that the SEC has the tools or the culture to deal with market stability issues. It has an enforcement culture, with strengths in fraud, company filings and disclosure rules.

"As the credit crunch has unfolded, the SEC has looked superfluous. Partly that is because of its remit, but partly it is because of the natural hesitancy and reticence of Christopher Cox and his senior advisers about what is the proper role of governments in markets. They believe in letting institutions shake out. Hank Paulson, US Treasury Secretary, and Mr Bernanke have proven themselves 'survivalists', who have been able to overcome their predilection towards market forces."

It won't have helped the SEC's cause that when it came to the issue of auction-rate securities – the first and most obvious mis-selling scandal of the credit crisis, where hundreds of thousands of ordinary investors were stuffed with impossible-to-sell bonds they thought were the equivalent of cash – it has been Andrew Cuomo, the combative attorney-general of New York state, who has wrung restitution out of brokers thanks to his legal threats, rather than the SEC.

And Mr Cox did not appear to cover himself in glory with regard to short-selling. He surprised the market with an emergency rule that made it much more difficult for hedge funds to bet on declines in the share prices of 19 major financial companies, announced to coincide with an appearance before politicians on Capitol Hill, but the details of which did not emerge for hours, had to be tweaked several times before they could be introduced, have not been proven to have influenced the trading in any of the stocks, and ultimately were left to expire this week, undermining Mr Cox's insistence that they were vital to preventing financial panics.

Christopher Cox has begun pressing his case for regulation of the investment banks to stay with a beefed-up SEC. But he starts an important battle for the soul of US financial regulation several laps behind the Federal Reserve and opponents on Wall Street who see this as the perfect time to take a few teeth out of the SEC.

A blueprint for regulatory reform by Mr Paulson, which envisages the Fed as a super-regulator with only a narrow role for the SEC, was forged out of Wall Street's frustration with SEC red tape and what investment banks complained was their diminishing competitive advantage over London. Britain, they argued, had a risk-based approach to regulation that was light-touch in day-to-day matters and only descended on institutions regarded as risking damage to the financial system. The SEC, with its raft of rules, would be wrapped into a much-diminished third-tier regulator responsible for protecting investors and market participants from fraud and market manipulation.

Supporters of the SEC, such as Mr Campos, argue that the stage is set for a battle between those who favour the current SEC approach, an "enforcement" approach to regulation, and those who prefer a "prudential" approach which, he argues, would "blunt regulators' teeth". It is a battle that can be won in a Democrat-controlled Congress or with a Democrat administration, he says – but only if the SEC starts fighting for its life.

FSA gets tough under new regime

Early last year the UK was lording it over the US as business flowed into London, attracted by the Financial Services Authority's "principles-based" regulation over the US Sarbanes-Oxley rules. But the run on Northern Rock exposed gaping holes in the FSA's scrutiny of financialinstitutions.

Bankers accused the FSA of prioritising consumer issues over supervision of institutions and markets and of having staff of patchy quality. To try to draw a line under the Northern Rock affair, the watchdog flagellated itself in a report and parted company with Clive Briault, head of its retail division.

Hector Sants, the FSA's chief executive, has warned that getting supervision up to scratch will drive its costs up this year. After replacing a swath of its enforcement division, the FSA is getting tough. Last month eight members of staff from UBS and JPMorgan Cazenove were arrested for alleged insider dealing, and on Wednesday the FSA fined Credit Suisse £5.6m because the bank's traders inflated the value of their positions.

The FSA has won a turf war with the Bank of England over which regulator should take the lead when a bank is close to failing under new banking rules.

Sir Callum McCarthy steps down as chairman next month and will be replaced by Lord Turner, former head of the Confederation of British Industry. The City expects the FSA to dole out more warnings to financial institutions under the new regime.

Sean Farrell