Harvey Pitt, who was chairman of the Securities and Exchange Commission from 2001 to 2003, admits that the agency has major flaws, but says it shouldn´t be demolished. Mr. Pitt discussed with BankThink his idea for how to improve examinations without more spending, and what to do about the Commodity Futures Trading Commission.

BankThink: What should happen to the SEC in the future? Should it be demolished?

Harvey Pitt: I don´t believe that the SEC´s critical functions can be dispensed with. They´re very necessary to ensure the continued good reputation of our own capital markets. The important question is, are those functions provided for and will they be handled in an appropriate way? I think that there is room for discussion about whether the SEC should continue in the exact form it is now-whether it should be merged, for example, with the CFTC. Those are clearly questions that need to be addressed as part of the overall re-visitation of our financial regulatory system because it´s a badly broken system.

BT: Does the SEC need more money and more people?

HP: I think the answer in part is the SEC is always going to need more people and also need more resources. But the real question in particular in light of the Madoff situation, is that the Madoff problem is not going to be solved simply by providing the SEC with more money and more people. It will be solved if we revisit the current paradigm for the SEC´s examination program and try to reorient it in a way that would set the SEC up for success as opposed to the current system which I think effectively sets the SEC up for failure.

BT: How does it set up for failure?

HP: There are now about 11,000 investment advisors and probably 6,000 or 7,000 broker-dealers. There are transfer agents, clearing agencies, self-regulatory bodies, and that´s before you even get to the notion of whether you would want the SEC to inspect and oversee hedge funds, of which there are about 7,000 right now. The plain fact is that the SEC will never have enough people and enough resources to be able to do the kind of inspection program that I think is necessarily to make sure that our capital markets are functioning at their best. And in addition it´s very hard to take kids out of college who are making arguably $60,000 or $70,000 a year and expect that they are going to be able to catch deliberate frauds by people managing multibillion dollar portfolios. If you look at what happened with Madoff, the real shock is not so much that the SEC was hoodwinked but the real shock is also that some of the country´s most sophisticated investors were hoodwinked. And when you have somebody who is deliberately trying to perpetrate a fraud, that makes it all the harder for anyone to be able to catch a deliberate fraud.

BT: How could the SEC fix the inspection process without more resources?

HP: I had proposed in 2003 that the SEC require everyone that manages portfolios to secure a comprehensive examination either every year or in the case of smaller ones perhaps once every other year, making certain that every investment manager would be inspected and evaluated by somebody who is completely independent and does nothing else for the firm except these inspections. An investigation and examination according to standards the SEC would set. The inspector would then write a report both to the firm that was inspected and to the SEC. That would at least enable the SEC to use its limited resources far more efficiently and also it would provide greater sophistication because these examinations would have to be done by qualified people who met SEC standards of what would be qualified.

BT: That would be sort of like legislating the outsourcing of the examination?

HP: That´s almost exactly how I described it.

BT: But how would that combat lying and fraud?

HP: If somebody is deliberately intent on violating the law and hiding it, the likelihood that the SEC or any regulator will find it goes way, way down. But if everyone knows that they´re going to be examined every year, and the SEC would have control over who examines which particular firms, I think you could, at a minimum, create an environment in which people would be reluctant to violate the law because of the very great likelihood that one way or another they might be caught by someone with enough expertise to look for the kinds of fraud that need to be looked for.

BT: But what´s to stop the examiners from being in cahoots with the firms?

HP: You wouldn´t have the same people do the examinations every year. The SEC would be in a position to control, essentially, who would do what examination-so the only thing that the private company would be doing would be paying the bill. But if somebody, as I said earlier, is hellbent on committing fraud there are always going to be people who come up with new ways to defraud the innocent. That´s why the government and the SEC have to remain vigilant so that if anybody tries to do anything like that they are treated as harshly as is humanly possible.

BT: How much would this cost?

HP: A program of this nature wouldn´t cost the public or taxpayers any more money. But it would obviously increase compliance costs for firms that are in the business but it seems to me that would be an appropriate cost of doing business. Somebody has to pay for it; logic says it ought to be the person that´s benefitting from this, not taxpayers.

BT: How about a merger between the SEC and the CFTC?

HP: I think ultimately that´s probably going to make sense. It´s not necessarily the first thing that needs to be done, but eventually that´s the direction we´re likely to see things go. The need right now is for a very clear focus on making certain that one there is complete transparency in all of our capital markets that all facets of it, whether it be derivatives, CDS, ABS, whatever-that all of that be the subject of a continuous data stream that ensures that both regulators and the marketplace are fully informed about what exactly is going on and what potential systemic risks may be implicated by developing trends. I also think there has to be a clear delineation of responsibility and accountability so that when the next crisis hits and there will be a next crisis and it won´t be something we are fully capable of anticipating, perhaps, at the moment, but when it hits, that we will at least know whose responsibility it is to try and deal with the questions and issues and there won´t be any question that there is sufficient authority to respond to whatever has to be done to protect the public interest

BT: Should hedge funds be regulated?

HP: I think that hedge funds and every other participant in the marketplace should be required to provide a steady stream of information about their activities in the market so that we have-and our regulators have-all of the tools they need to see when various risks may be heightened because of trends in the marketplace. The SEC and indeed any regulator probably can´t effectively regulate hedge funds until there´s a sufficient data flow so that people have some idea of what it is they should be looking for. Until that happens, setting up a specific regulatory regime will only serve in my view to do one principle thing-to give people a false sense of comfort that now that they´re regulated nothing bad can happen. What I´d rather make certain of is that we´re in a clear position to understand what regulation may be necessary and to makes sure that the government never wants for the authority to do what it needs to do to deal with any crisis that may arise.

BT: How should regulatory restructuring proceed?

HP: I think the Treasury blueprint did a very good service to the country because it´s raised all of the right issues. My own predilection would be to have an independent regulator of systemic risk and monetary policy-that would be the all the Fed would do-because the more you pile onto the Fed´s plate the more likely it is that it will not do a good job. Then all other financial services firms should be regulated by what I would call an uber-regulator, a single firm that would combine banking, commodities, securities, insurance, in one location. What´s critical is there has to be some way of insuring that all of the regulators are acting in concert and not operating on cross purposes.

BT: Should there be a strict separation between commercial banking and investment banking?

HP: I think the repeal of Glass-Steagall itself was fine and actually may have served us well by avoiding some of the fiscal problems that would have occurred if these banks did not have access to a steady flow of deposits. But what I do see as essential is if you´re going to allow everyone to get into everyone else´s business then they all have to be regulated the same. You can´t have multiple regulatory systems. Everybody who´s essentially doing the same thing has to be treated exactly the same way so there´s no regulatory arbitrage possible.

BT: Thanks