Amid Turmoil, SEC's Role Scrutinized

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MICHELE NORRIS, host:

The Securities and Exchange Commission is facing mounting criticism when it failed to act more aggressively the police the markets and to help Wall Street once the crisis took root. For more on the SEC and its role, we turn now to Jack Coffee. He's a professor of law and the director of the Center on Corporate Governance at Columbia University Law School. Welcome to the program, Mr. Coffee.

Professor JACK COFFEE (Director, Center on Corporate Governance at Columbia University Law School): Pleasure to be here.

NORRIS: First, what do you make of the SEC's temporary ban on short selling. The market has soared on the news, but was this move a bit too late in coming?

Prof. COFFEE: I'd put this way. We're in a time of crisis and the cost of doing too little is far greater than the cost of doing too much. Had the SEC done nothing, there was a danger, a real danger of a financial meltdown all across financial stocks. The price of doing it this way is to suspend short selling and close down some traders and possibly to curtail the option market as well. But that's a small cost compared to the dangers of doing too little.

NORRIS: Can we take a step back? I want you to help us understand what exactly the SEC does and the constellation of federal financial institutions - the Federal Reserve, the Treasury. Where does the SEC fit in?

Prof. COFFEE: The SEC is principally a regulatory body that regulates disclosure and enforces anti-fraud rules. However, the SEC also has jurisdiction over the major securities firms and broker dealers, and it regulates their capital adequacy. And it's in that area where there has been some controversy because the recent failure of several of our leading investment banks does suggest that many of our investment banks became seriously over leveraged, and thus, they were not able to survive when a time of crisis hit. And that does represent a SEC decision. Back in 2004, the SEC permitted some investment banks, the very largest, to effectively double their level of leverage up to about a 30 to one ratio. And that decision today looks like something that contributed to the current financial crisis.

NORRIS: Former SEC chair, Lee Pickard, this week said that that exemption that you're talking about was one of the things that directly led to the meltdown.

Prof. COFFEE: I think it contributed. Now it's certainly not the major cause. Historically, investment banking firms were more advisory than consulting firms that offered services. But in the world of structured finance and asset back securitizations, they developed their own products and sold them and that meant their own capital is at risk and that's what basically killed Lehman and very seriously challenged the other firms.

NORRIS: Christopher Cox is under very harsh spotlight right now. John McCain said he should be fired. George Bush says he stands by Cox. But did Cox have the right background and knowledge to take over an agency at a time when the market was entering this sort of new and uncharted drain?

Prof. COFFEE: In fairness to him, he's a very intelligent man, and he was the principal author as a congressman of something called the Private Securities Litigation Reform Act. He knew an awful lot about securities litigation. I think he knew a little bit less about financial structure and the position of broker dealer firms. I think everybody in the industry was surprised to just how fragile broker dealer firms proved to be. This may have been a consequence less of the SEC than of the repeal of the Glass-Steagall Act back in 2000. That suddenly put these free-standing investment banks into competition with the major commercial banks that were now permitted to underwrite debt securities. As a result, that competition may have forced investment banks to put more of their capital into transactions in order to satisfy their clients, and that involved making them vulnerable to risks that they couldn't survive in a period of great market stress.

NORRIS: The SEC was founded during a period of great market stress, founded during the crash of the 1930s to step in and help stabilize the market. This sounds like this is the worst financial meltdown that this country has seen since then. How might the SEC change going forward?

Prof. COFFEE: I think the SEC is principally a consumer protection and disclosure agency. But I don't think that it should be the body entrusted to regulating the safety and soundness of financial institutions. I think that kind of prudential, financial regulation function should be better entrusted to the Federal Reserve and the Office of the Comptroller of the Currency, not just over investment banks but over insurance companies like AIG, where they did not have jurisdiction, or over hedge funds and other new financial institutions, all of which can destabilize our system through a major failure.

NORRIS: Jack Coffee is a professor of law and he's the director of the Center on Corporate Governance at Columbia University Law School. Mr. Coffee, thanks so much for being with us.

Mr. COFFEE: My pleasure.

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