“Pro Bono Publico” Prepared Remarks before the Peterson Institute for International Economics

Good morning. Thank you, Roger, for the kind introduction. As is customary, I'd like to note that my views are my own as Chair of the Securities and Exchange Commission, and I am not speaking on behalf of my fellow Commissioners or the staff.

Pro bono publico. For the public good.

Adam Smith, known as the father of modern economics, noted in The Wealth of Nations more than 200 years ago that the whole economy benefits when the price of information is lowered, or information is free.

Reliable, comparable, accessible data benefits everyone. No one private entity, though, has the incentive to create reliable, comparable, and accessible data, even if they themselves may benefit from others doing so. Thus, such data is a public good.

President Franklin Roosevelt and Congress understood this when they laid out a basic bargain in our securities laws: Investors get to decide which risks to take so long as those companies raising money from the public make what Roosevelt called, "complete and truthful disclosure."

Nearly 40 years later, economist George Akerlof published a paper about how markets price goods in the face of uncertainty about the quality of such goods. He discussed the used car market to illustrate the importance of disclosure in the pricing of both good cars and lemons.[1] His thesis applies just as well to the securities markets. Without credible disclosure, a market unravels.

Now let me turn to something else that is good for the public.

My dad ran a small business in Baltimore. If he got into trouble and couldn't make payroll on a Friday, the city wasn't going to come to his rescue on Monday.

Whether it was my dad's small business or a large financial firm, this is good for the public. First, it helps promote the efficient use and allocation of resources and capital. Second, it better aligns incentives toward good economic ideas and products and away from excessive risk taking. In essence, it lowers moral hazard.

History is replete with times when tremors in one corner of the financial system or at one financial institution spill out into the broader economy. When this happens, workers, families, investors, and businesses inevitably get hurt.[2] Thus, around the globe, regulation and safeguards have been put in place to lower the risk of financial institution failures to the public.

In the aftermath of the 2008 financial crisis, there was a consensus to further enhance those regulations. Governments worked with financial institutions to create mechanisms for private sector capital market investors to bear the costs of failures, through what's called "loss absorbing capital." In the face of a potential failure, large financial institutions would conduct a major recapitalization. Though such a restructuring has yet to occur at any global systemically important financial institution, the goal is to protect taxpayers by having private sector investors bear the costs of the institution's problems.

That brings me back to the public good of disclosure.

If a large financial institution is restructured, the market's need for disclosure doesn't go away. Indeed, I believe the market's need for robust disclosure becomes all the more critical. First, it is the best way to ensure that investors, counterparties, and depositors will have sufficient confidence to remain with the firm. Second, it's critical to addressing Akerlof's issue of lemons: the uncertainty of the quality of financial institutions-the restructured one as well as others.

Further, the time to best prepare for that disclosure is when there isn't a tornado.

Communities that Need the Disclosure

The success of a large financial institution restructuring will be deeply dependent on addressing questions which will be on the minds of multiple communities.

First, disclosures will be important to the securities holders, including any remaining debt holders (both at the holding company and its affiliates) and the new equity (or rights) holders following a restructuring.

Second, disclosures will be critical to the financial institution's counterparties, including swaps, repurchase agreement (repo), and securities lending counterparties, as well as clearinghouses.

Third, depositors (particularly uninsured depositors) will want a close look at disclosures.

All of these communities will be focused on a set of questions that can be boiled down to: Should they stick with the financial institution or cut their risks?

In 1995, when Barings Bank in London was on the brink, I was a partner of Goldman Sachs, working in Japan overseeing fixed income and currency trading. While my partners were still asleep in New York, I made the call that no money or securities were going out to what sure looked like a lemon to me.

In the face of uncertainty and lacking updated disclosures, there's simply too great an asymmetry in incentives.

On the one hand, if everything works out, investors, counterparties, and depositors could get a return for sticking with an institution. On the other hand, if things don't work out, such parties may lose a significant amount of money. So, the natural reaction of many will be to manage downside risk, ring fence, and protect their own houses.

Further, other market participants will be considering selling on the news, through short selling or credit default swaps.

In the absence of confidence on the parts of investors, counterparties, and depositors, taxpayers and the official sector will bear the costs. Contagion also will more readily spread. What I am saying is that transparency is one indispensable step in regaining market participant's trust.

Market Needed Disclosures

At a minimum, upon the opening of markets on the Monday following a restructuring, market participants will be seeking disclosures to address the key question these communities are facing: What risks are there if they stay, and has the restructuring solved the problems that caused the institution to become a lemon?

Based on financial sector history, it's rare that the problems which led to a financial institution failure were solely due to liquidity issues. So, though the management team or members of the official sector may emphasize that it's just a matter of liquidity, market participants will be looking for disclosures addressing valuation, solvency, and viability.

Thus, investors, counterparties, and depositors will benefit from answers to the following questions:

First, what does the restructured financial institution look like, including what are its pro forma financials and the institution's current judgment about any material impairments, or asset revaluations?

To the extent a financial institution's problems are related to its assets, market participants will be looking for financial disclosures regarding adjustments for the financial institution's current judgment about the assets, any material impairments, or revaluations. Absent such disclosure, interested communities will be left with uncertainty about the quality of the assets and ultimately the quality of the financial institution itself. In essence, they're left wondering, how big was the hole and has it yet been adequately filled? Is this institution still a lemon?

Second, what's the business narrative of the restructured financial institution? Market participants will be looking for robust disclosures about what problem or problems got the institution into the mess in the first place. Further, what is the core business strategy going forward? The narrative about the restructured financial institution needs to provide investors, counterparties, and depositors confidence that the restructuring sufficiently addresses whatever underlying solvency, liquidity, or other material problems had existed.

Third, who is running the operation, and who is the new management team?

Fourth, what is the nature of government support specifically for this institution? Is the government support just for depositors, or is it broader than that?

A financial institution may not have all the answers that weekend. The more it lacks answers to these questions, however, the more difficult it will be for the restructuring to be successful.

Just as important as the information to be disclosed is when it's disclosed. To maximize the chance of success, my view is that the disclosure be released by the time markets open in Asia after the restructuring. Given how such events generally will occur over a crisis weekend, that's likely to be on Monday morning Asia time-or Sunday afternoon in the U.S. and Sunday night in Europe. In the absence of such timely disclosure, the capital markets will be left with uncertainty as to the quality of the restructured financial institution.

Back to Akerlof's lesson about signals, it's not just about confidence in the financial institution being restructured, but it's important at such times for other institutions to consider additional disclosure. Other institutions likewise will need to keep the markets apprised about their current financial situation. Otherwise, as Akerlof said, "good cars may be driven out of the market by the lemons."[3] Lack of confidence in one financial institution can spread to others.

Many Peterson Institute participants may be more familiar with this from the history of monetary policy, Gresham's law: bad money drives out good.[4]

Disclosure and U.S. Securities Law

My main focus of this speech is on the public good of disclosure by financial institutions, particularly in the context of the restructuring of a large financial institution.

During discussions about financial institution disclosures with market participants and regulators, the SEC is regularly asked about what is required under U.S. securities laws. As important as the details of securities laws are, though, the goal is to have private sector investors-rather than the taxpayers-bear the brunt of a systemically important financial institution's restructuring. The best way to achieve that is through robust disclosures that meet market expectations, not just legal requirements.

Nevertheless, the focus on what is required by U.S. law is understandable, given that the U.S. represents more than 40 percent of the world's capital markets.[5] Of the 29 global systemically important financial institutions, 19 are reporting companies under the Securities Exchange Act.[6]

Further, many financial institutions have subsidiaries that may themselves come under U.S. disclosure obligations. Those that aren't reporting companies are likely to be accessing U.S. capital markets in other ways, such as through entering into swaps or funding transactions, selling securities, and advising clients.

To the extent any of these systemically important financial institutions access U.S. capital markets, they have to comply with U.S. securities laws.[7]

First, institutions that are offering or selling securities must make sure their disclosures are not materially misleading. Thus, to the extent financial institutions after a restructuring want to access the public U.S. capital markets, they will need to make material disclosures regarding the restructuring. To the extent these financial institutions are accessing private capital markets, any disclosure that is made also must meet the standard of not being materially misleading.

Second, when offering or selling securities to U.S. investors, an institution must register the offering with the SEC or qualify for an exemption. The conversion of debt to equity itself is an offer or sale of securities. Converting debt directly to equity, however, may have an available exemption from the Securities Act of 1933, such as under Section 3(a)(9).[8] By contrast, converting debt into some form of interim right (which later is to be exchanged into equity) may not meet the requirements of a 3(a)(9) exemption.

Third, there is a requirement for current reporting of certain material events. For U.S. issuers, this is done by filing a Form 8-K. Foreign private issuers do so through filing a Form 6-K if the information is required by home country law, stock exchange rules, or otherwise distributed to shareholders.

Fourth, there's a requirement not to trade on material nonpublic information. In addition, for U.S. issuers, under Regulation Fair Disclosure (FD), if material information is disclosed to certain persons, that material information also must be disclosed to the broader market.

Overs the years, SEC staff has had ongoing constructive discussions with regulators from around the world on how their respective plans would work under U.S. securities laws.

Planning for Robust Disclosure

As I said earlier, the time to best prepare is when there isn't a tornado. Congress understood this when they included important provisions about resolution planning in the Dodd-Frank Act.[9] Since that time, much work has done by financial institutions and regulators around the globe to implement and enhance these plans.

Given how important prompt disclosures will be to the success of any such restructuring, the lawyers, accountants, and management of global systemically important financial institutions should be including in their plans how they would prepare for the disclosures that the capital markets would demand on the Monday (Asia time).[10]

This is not an easy task. I do think, though, that it's critical to think through and anticipate such disclosures, including both what is legally required and what the markets will demand. It's best that an institution knows who will be tasked (and those individuals are prepared) to write disclosures during the crisis weekend. We stand ready to continue discussions with firms and their authorities on these issues.

Conclusion

The age-old need for disclosure-as Smith, Roosevelt, and Akerlof understood-creates a public good. It is relevant in normal times and times of stress. Absent full disclosure, investors are left in the dark, reliant on speculation and rumors, unable to distinguish between lemons and non-lemons.

There are no exemptions from the animal spirits of markets hungering for disclosure, particularly in times of stress.

Disclosure by financial institutions, in the context of the restructuring of a large financial institution, is integral to ensuring investor confidence.

The best way to have private sector investors-rather than the taxpayers-bear the brunt of a restructuring is through robust disclosures that meet market expectations.

Pro bono publico.

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