One of the most fascinating aspects of our free market, but heavily regulated economy is that it is a bit like living in Alice in Wonderland. One decade the sky’s the limit and the next decade we seem to be living in a bottomless pit. Adding insult to injury regulators seem to change from the Cheshire Cat to the Queen of Hearts. [is it Queen of hearts or spades in Alice].

I used to joke when I was a regulator that I started life as a lawyer a class that many hate as a race and then I became a regulator which was viewed as one step lower on the evolutionary ladder. As a lawyer regulator, I was sure people saw me as slithering along the bottom. (This always got a great deal of laughs then.)

But whether we love them or hate them, the fact of life is that regulators are here to stay, and in times like these they become a much greater part of the American business world. This is particularly true in our post Enron/World-Com business world.

I have been a regulator and I have spent 30 years working in and around the regulatory community in the tough city of Washington, but what I have seen over the past 3 years as our company Promontory Financial has worked with over a dozen major financial entities in resolving their regulatory difficulties is stunning. We are entering and will live in a different era from a regulatory perspective.

Accordingly, I thought I would try to answer several questions that are likely to be on your mind about the tenor of regulation and regulators over the next year plus. The questions are: (1) How is the SEC likely to behave post-Enron & Worldcom and now with a new chairman? (2) Are the regulators generally going to get tougher or ease up? (3) Will Basel II be adopted? (4) Will more banks get in trouble in the next year? (5) What do you see as the major safety and soundness challenges for the next several years? (6) Have we seen a pattern of mistakes in the many troubled and near-troubled bank situations we have worked on that can be avoided by institutions that are on their toes? (7) Do you have any thoughts about what a financial services company can do about the trends you have just described?

[Speaking of the tough city of Washington, I am reminded of a typical Washington politics joke which is my current favorite. So if you will indulge me. – tell Russell Long joke]
FREQUENTLY ASKED QUESTIONS

HOW IS THE SEC LIKELY TO BEHAVE POST ENRON?

As I have noted earlier in my talk, we are entering a new regulatory era. Nowhere is this new era more apparent than at the SEC. From the early days of the Bush Presidency, the proud SEC has had a rough time. Enron and WorldCom would have been in and of themselves enough for them to have to explain to Congress. Explaining to Congress for federal regulators is never fun. But, the SEC has had to read about itself for months and months now as the sad Harvey Pitt saga played out.

Typically, when an agency has gone through the trauma that the SEC has just gone through, the career staff is mad and emboldened. They revert to bright lines and going “by the book” and then some. And that is what has happened at the SEC. In short, we see a tougher and more aggressive SEC. The staff further believes Congress wants that and expects that.

In short, the bar has been permanently raised in the areas of disclosure, corporate governance and accounting. And, in my view the pendulum will continue to swing a bit in a harsher direction, notwithstanding the arrival of the new chairman. However, there will be one maddening aspect to what the SEC does. It will be idiosyncratic. Some companies will get more and some less attention than they deserve.

This lack of uniformity is a function of an agency that is understaffed, and of course it is a product of individual regulators, even at the same agency, seeing things a different way. However, my strong advice to everyone in this room is to take an even more careful look at disclosures, accounting treatments and board involvement issues than in the past. Believe me this is necessary. I have seen some matters lately that would curl your hair. [aside]

ARE THE REGULATORS GENERALLY GOING TO GET TOUGHER OR EASE UP?

The trend at the SEC I have just described is being played out to a greater or lesser degree at all the federal financial supervisory agencies. Let me say a word about each of the banking agencies.

The Federal Reserve from a supervisory perspective varies markedly from Reserve Bank to Reserve Bank. Lately Cleveland and San Francisco have been a bit harsher. Chris Moore the head of supervision is a talented fellow and a nice fellow but he can be tough and Cleveland is developing a tough examination culture. But that can shift as different Reserve Bank Presidents and senior supervisors shift chairs. For example, Chet Feldberg in New York was a terrific head of supervision. He has been succeeded by Bill Rutledge who is a very fine fellow but with a very different style. Both have a tendency to be more measured than Chris or say Teri Swartzkof in San Francisco.

However, as the Fed asserts itself as a committed financial supervisor, as it is doing, I expect that we will see a trend toward tougher exams and stronger enforcement action at most of the Federal Reserve Banks.

The OCC has also been toughening up. However, the senior supervisors in charge are people of character and judgment and we will not see a repeat of the late 80s and early 90s. The key people there Tim Long, Dave Gibbons, Dough Roderer are young but with a great deal of judgment. Nonetheless, the trend here too is for more enforcement and generally tougher exams. Julie Williams and Brian McCormelly etc. are extraordinarily nice people and are very supportive of a strong and growing banking system, but they can take forceful supervisory positions when needed. Having said that I would note that the one thing the OCC does have is a very strong Ombudsman, Sam Golden, and Ombudsman system that can be very helpful if you are in a jam.

The OTS is clearly swinging in the direction of much tougher exams and a sterner tone. Having been at the center of the maelstrom in the 80s and early 90s, the OTS knows that its survival is tied to convincingly serious supervision. At the same time, the OTS is threatened as an agency by the conversions of the larger thrifts to banks and would be much hurt were WAMU to become a bank. They too have quality folks. Rick Riccobono and Scott Albinson are the top supervisors. They work well as a team and are supportive of the industry but they too can be very tough in individual cases.

At the FDIC we see a similar story, but given the FDIC’s baseline, perhaps a bit more moderation. Don Powell himself is a man of moderation and judgment as is Mike Zamorsky the head of supervision at the FDIC. Nonetheless, this is an agency that reflexively gets tough when the economy sags and we see that today.

I will not discuss the states or the state AGs. We have worked with all of them. I can address this if you want in Q&A.

All the agency’s have greater than normal concern with respect to sub-prime activities and monolines generally. There is also a considerable degree of focus on compliance matters in addition to the normal safety and soundness concerns. Credit has been weak and may be weakening.

WILL BASEL II BE ADOPTED?

Let me turn to Basel II for a minute if I may. Will it or a near approximation eventually be adopted? Yes, probably. The question is when and exactly in what form. Here is an area where if you care enough you can be immensely influential. The proposal as you know is quite complicated and has some new and highly controversial aspects, for example the operational risk provisions.

The staff in Basel, ably led by Danielle Nouy is able and will listen but they don’t, in the end, call the shots, the member country supervisors call the shots. A rift on Basel II has developed between the OCC and the others, with the OCC now publicly questioning just how workable the proposal is. Congress too has gotten involved. Finally, Fed. NY President Bill McDonough is retiring. Bill is a wonderful person and enormously able. Basel II has been his baby while he has been chairman of the Basel committee, something he has done in addition to his Fed President duties. If he retires without Basel II being locked up, then it is less likely that the effort will proceed with as much vigor.

Having said that, there has been an enormous amount of work put into Basel II by the U.S. banking agencies; this has created its own momentum. And, issues like this are ones that Congress can get pretty bored with and easily influenced by Chairman Greenspan and others. Congressmen are reluctant to get in front of a speeding safety and soundness train.

Bottom line – Basel II will happen sometime unless bank push back is vigorous.

WILL BANKS GET IN TROUBLE NEXT YEAR?

How challenging next year is going to be for banks will depend of course upon the economy. However, because the condition of banks and other financial intermediaries has a tendency to lag the economy, we could see an economic upturn and still have six to 18 months of less than optimal bank performance.

The fact is that financial intermediaries too often are stuck with assets put on the books in earlier periods that need to be worked down. And, regulators turned cautious take a time to retool their thinking.

Accordingly, at best, I see some institutions that will continue to be fighting alligators well into 2004. However, because there has been a considerable amount of discipline shown by financial institutions in the past bull market, many institutions will turn up more quickly than would have been true in earlier cycles.

However, if the economy turns south on us because of the war or otherwise, I think some financial intermediaries will face a very challenging patch to work through. I have some more granular thoughts about individual institutions but I can’t really share that here.

WHAT DO I SEE AS THE MAJOR SAFETY AND SOUNDNESS CHALLENGES FOR THE NEXT SEVERAL YEARS?

Because financial services is so impacted by globalization and technology change, new instruments, new competition, new challenges, nothing in my view, nothing is more important than keeping up in the safety and soundness area. Not to do so means that sooner or later the markets will kill you if the regulators don’t get to you first.

Perhaps the key challenge for financial institutions from a safety and soundness as well as commercial perspective will be just keeping up. New manifestations of risks and new combinations of risks will appear constantly as the markets change. More specifically, major challenges I see are the following:

• Keeping a highly motivated, stable, well trained and risk averse work force. Too frequently I am seeing a shallow and tired bench strength at some institutions.
• Finding and motivating a chief risk officer who has the background and ability to take an enterprise-wide view of risk and can manage a team of risk professionals and business leaders. [aside]
• Understanding complex areas of finance that all institutions are having to deal with is a major challenge. By this I mean derivatives, and derivative modeling, interest rate risk modeling, credit portfolio modeling and other modeling. Let’s face it, how many people in senior management really read and understand their own risk reports, let alone the trading models used by their own teams? [aside]
• Getting sufficient return for the risks taken on what may even be traditional businesses. Margins are under pressure in many businesses and on a risk adjusted basis, many CEOs would be shocked at what they are really earning.
• Reputation risk will continue to be a very big deal as AGs and others get into the bank regulatory act, as all financial intermediaries get into new businesses, and baskets of businesses they understand less well than they think; and
• The difficulties of managing ever larger groups of people too many of whom can cause the institution immediate or worse long tail harm for a whole host of reasons from ineptness to venality.
• For some the difficulties of measuring and managing cross border risk.

HAVE WE SEEN A PATTERN OF MISTAKES IN THE MANY TROUBLED AND NEAR-TROUBLED BANK SITUATIONS WE HAVE WORKED ON THAT CAN BE AVOIDED BY INSTITUTIONS THAT ARE ON THEIR TOES?

Yes, patterns do emerge given the dozens of troubled situations we have seen. Let me list a few.

• Overreaching. The business was a good one but we expanded too rapidly and lost control. [aside – Superior]
• Failure to take the regulators seriously. [aside PNC, Citi]
• Failure to have sufficient, well trained control personnel. [aside – too many]
• Lack of accountability. [BT, PNC]
• Hubris. Taking on new businesses and/or new teams who had run businesses at other companies and expecting that you can do better than they did. This is a particularly bad thing where there is a lack of control. [PNC, Insurance co, Allfirst]
• Repeated underestimation of how dangerous derivatives are and how much one has to check mathematical risk models. [insurance co, Allfirst National Asutrialia]
• Cutting corners. Lack of energy and enthusiasm. [PNC, Wachovia]
• Forgetting the customer in a drive toward profits.

DO YOU HAVE ANY THOUGHTS ABOUT WHAT A FINANCIAL SERVICES COMPANY CAN DO ABOUT THE TRENDS YOU HAVE JUST DESCRIBED?

In some ways what I have just said, sets up patterns that are didactic in nature. From the patterns obviously emerge steps to be taken and steps to be avoided. However, let me list a few items as I finish this talk which I think might prove particularly helpful.

• Let me be a shameless advertiser for a second. Whether we do it or you get someone else to do it for you. Each of you should have an outside safety and soundness audit periodically, just like an annual physical. Having said that, I know that it is human nature, none of us like to eat our spinach when we don’t have to. I am the same way.
• When you smell the first signs of smoke, jump right on the problem, whatever it is.
• Never underestimate the power of any of your regulators to cause trouble.
• Do not go cheap on controls.
• Beware the easy audit or exam.
• Try to assess as quickly as possible how changed circumstances, e.g. interest rate changes will affect you.
• Even if Basel is beaten back, take operational risk seriously.
• Similarly, reputational risk issues are here to stay. Think about what you do not in terms of what is mincingly legal but whether if the activity were described on the front page of the New York times for your neighbors to read would it pass muster.
• This is not the era in which you want to cut corners on disclosure.

CONCLUSION

In sum, as you know as well as I, finance is at its heart about change and risk management. In the end the companies that prosper will be those that understand this deeply and continually make efforts to accommodate to the changes and to stay on top of managing the risks in their businesses.