May 17, 2007
HP-409

Under Secretary for Domestic Finance
Robert K. Steel
Remarks Before the Council on Competitiveness
"Strengthening our Capital Markets
Competitiveness"

It is a privilege to be here at the Council on Competitiveness. You are fortunate to have Deborah's strong leadership. She has served here at the Council since 1993 and has helped your organization develop a great reputation of excellence.

For nearly two decades, the Council on Competitiveness has brought together our nation's business, academic and labor leaders to help us chart a course for global competitiveness. Your mission reflects a commitment to the future prosperity of all Americans and enhanced U.S. competitiveness in a global economy. These important objectives echo one of Secretary Paulson's key goals for the Treasury Department – to encourage the competitiveness of U.S. capital markets.

Today, Secretary Paulson announced the first stage of his plan to enhance U.S. capital markets competitiveness. These steps focus on strengthening financial reporting to enhance investor protection and encourage a vibrant, sustainable auditing profession. I will discuss today's announcement in more detail, but first would like to offer some general perspectives on how we think about issues of competitiveness.

For some, optimism about the future of our capital markets comes less easily today. We at Treasury do not share that view. Instead, we start with the fact that our markets are the strongest in the world. Earlier in this decade, our markets passed safely through several perils, including the burst of the technology bubble, a terrorist attack and a series of corporate accounting scandals. Today, our economy is healthy – the labor market is strong, core inflation is contained and we are transitioning from an unsustainable to a sustainable rate of growth. Our markets are deep, vibrant and efficient, and our financial system remains the envy of the world.

We plan to keep things that way. Maintaining this leadership requires having the confidence to continually self-assess our position and when appropriate, make changes or adjustments. For that reason, Secretary Paulson has asked the Treasury Department to engage in a broad, ongoing initiative to strengthen the competitiveness of our capital markets.

Our efforts kicked off last November with a major speech by Secretary Paulson in New York, which served to frame the issues. Since his address, an enriching period of public discourse has followed, highlighted by the release of three separate and independent reports. In March, Secretary Paulson hosted a conference on capital markets competitiveness. We heard from key policymakers, consumer advocates, business representatives and academics, each with different perspectives on ways to keep U.S. capital markets the strongest and most innovative in the world.

The many voices involved both in our conference and the three reports have illuminated the vital role capital markets play in our economy.

Markets serve as a bridge, connecting suppliers of capital with users of capital. They connect those who have resources to invest with those who could use this capital to turn new ideas into businesses, generating jobs and contributing to the economy.

The most effective bridges allow participants and their capital to cross from one side to the other with as little friction as possible. Effective bridges facilitate an open, transparent flow of information, and are built on strong pillars of investor protection, market integrity and risk mitigation.

The structure, management and regulation of a bridge are each crucial. We seek to ensure that the policies in place for managing our bridge are effective in protecting investors and consumers, while at the same time enhancing the entrepreneurial spirit and innovation that has made America great.

As keepers of our bridge, we must carefully consider what measurements we will use to gauge the strength of our markets, not just for today but also for the future. The indicators we examine include more than just public offerings. IPOs have become an often-referenced benchmark of capital markets competitiveness, but focusing solely on that measurement is too simple and not forward-looking enough.

We should start with a global vision and look broadly at measures that gauge our ability to foster human capital, encourage innovation and reward efficiency. As these conditions are met, we will continue to excel in areas such as:

• skills for asset management;
• alternative asset management, such as venture capital, private equity and hedge funds;
• trading and execution models characterized by leading-edge technology;
• innovation in all types of investor products, including listed and unlisted derivatives;
• and the accessible advice of a trusted advisor for governments, companies and investors.

By most measurements we remain the uncontested world leader. We are well ahead of the rest of the world in mutual fund and hedge fund assets, venture capital and private equity, securitization, syndicated loans, and yield in equities and exchange-traded derivatives.

• 45% of global mutual fund assets are housed in the U.S., compared to 35% in Europe and 11% in Asia.
• Of the $2.1 trillion in global hedge fund assets, $1.5 trillion resides here in the U.S.
• Worldwide, there are 351 hedge funds with at least a $1 billion in assets, and almost 70% (241) of them are located in the U.S.
• Last year, more than 80% of outstanding OTC foreign exchange derivatives worldwide were in the U.S. Dollar.
• The number of futures contracts traded on organized exchanges in the U.S. in 2006 was 1.3 times higher than what was traded in Europe and more than 5 times higher than trading volume in Asia.

Let's be straightforward here: Financial markets in the U.S. are second to none. Our exchanges in New York and Chicago, asset management industry based all across the U.S., and commercial and investment banks with a global reach are unrivaled on an international scale. Additionally, our accounting and auditing professions, legal advice and management and consulting industries are the strongest in the world.

Globalization is an Opportunity to Advance our Leadership

Certainly, our markets are not immune to challenges. But we view challenges as an opportunity to improve – to make the best capital markets even better. Often when you are doing well proves to be the best time to focus on improvement. We are a nation and an economy that overcomes challenges and creates solutions. Americans are a creative, innovative people; we are entrepreneurs, risk-takers, and most of all competitors and winners.

Secretary Paulson's capital markets competitiveness initiative is about using recent trends like globalization as an opportunity to leverage our competitiveness and bring even greater benefits to our economy and citizens.

Today, emerging markets throughout the world are rapidly expanding and progressing. More and more countries are borrowing our expertise, emulating our success and moving to market-based systems. As a result their economies are growing and becoming stronger. Leaders around the world now realize that a market-driven economy has the best chance of producing economic growth and productivity, a higher standard of living and lower rates of unemployment.

Without a doubt, financial capital is more mobile now than ever before, and with more choices, investors are able to access capital all over the world that was once available only in the U.S.

This development is not something to fear. In fact, during my career in the financial services industry, I worked with many companies to take advantage of globalization, helping firms develop new markets overseas and working with small companies to become big corporations.

Just as athletes perform better under the pressure of healthy competition, so too can we use this opportunity to raise our game and further enhance our competitive edge.

The world has continued to evolve. Competition has become more flexible, but there are many things we can do to compete more effectively, including addressing internal challenges that our system itself has created over time.

The current U.S. regulatory structure has been evolved together over 150 years – with act on top of act, initiative on top of initiative – so that today we have a series of individual regulations, each designed in response to specific circumstances and lacking an overarching set of guiding principles.

This creates a difficult environment for both regulators and those being regulated. Certainly, regulators must find ways to appropriately balance issues of investor protection, market integrity and systemic risk, as well as the historic tension between state and federal boundaries. In addition, our structure was born institutionally focused and now is adapting into one that regulates activities rather than entities.

As we heard from participants at our conference, these ambiguities generate inconsistent applications and reduce predictability of outcomes.

If we were starting fresh and had a blank page, no one would choose to draw a regulatory structure that resembles our current picture. Too often, however, discussions about ideal regulatory philosophy and structure have been reduced to a black and white debate of rules vs. principles. This oversimplification undermines the complexity of these issues, and is not constructive. As Chairman Bernanke said earlier this week, it is a mischaracterization to draw a "sharp distinction" between the approach to financial regulation in the U.K. and the U.S. In fact, the U.K.'s so-called "principles-based" system supplements their eleven principles with over 8,000 pages of rules, and our system in the U.S. utilizes some principles.

At Treasury, our goal is to elevate public thinking, so that we are not engaging in an either/or debate. The optimal construct should balance both rules and principles. We need a new, modernized approach to regulation – one that is risk-based, globally oriented and flexible in scope. A prudent approach recognizes that we should be guided by principles at an overarching level. But regulation at the retail level will require some focus on rules, particularly to protect less sophisticated market participants, where investor protection must be a paramount focus.

Other key elements of this risk-based approach are:

• Benefit-Burden Analysis – We reject calling for regulation just for regulation's sake. Instead, we should engage in rigorous cost-benefit analysis of proposed and current regulation.
• Materiality – Regulators need to focus on issues that are material to investors and consumers. It is not simply a matter of collecting more material to review; rather, we should have measures in place to ensure that we are collecting appropriate, useful material.
• Engagement between regulators and the regulated – We need to facilitate a move for constructive dialogue between regulators and the entities they regulate. There should be a clear process for businesses to engage with their regulators when they have questions or need clarification.

In short, the modernized regulatory regime we seek should be, in the words of Chairman Bernanke, "principles-based, risk-focused, and consistently applied."

Other Components of Treasury's Competitiveness Initiative

We have already made some progress toward these goals.

For instance, earlier this year the President's Working Group on Financial Markets (PWG) – chaired by the Secretary of the Treasury – released principles and guidelines for private pools of capital. Private pools of capital, which include hedge funds, private equity and venture capital, exemplify the creativity and innovation that have helped make our financial markets the strongest in the world.

These principles and guidelines show that issues of systemic risk and investor protection are best addressed by a combination of market discipline and government oversight. They put forth a forward-looking, principles-based framework specifically designed to possess the flexibility to deal with global and dynamic nature of modern capital markets. These principles are not an endorsement of the status quo. They represent a uniform view from a broad group of key independent regulators that heightened vigilance is necessary and desired to address market developments. Treasury is currently actively engaged to ensure the adoption of these principles among each respective group of stakeholders – investors, pool managers, and creditors and counterparties.

Other important steps toward modernized regulation are being taken by the regulators, and Treasury strongly supports these steps.

The Sarbanes-Oxley Act of 2002 brought much needed reform and restored investor confidence. This successful piece of legislation is now being replicated around the world. Public companies have faced significant costs and challenges in the application of Sarbanes-Oxley's Section 404 internal control requirements, but we do not believe new legislation is required to amend it.

A reinterpretation is currently in progress, which will reduce unintended and unnecessary costs of Section 404 to small businesses. Treasury supports the work of the SEC and the PCAOB, who are actively engaged in replacing Auditing Standard 2 (AS2) with Auditing Standard 5 (AS5). These efforts will make the implementation process of Sarbanes-Oxley section 404 more risk-based. As a result, we are optimistic that this change will achieve the appropriate balance.

Another encouraging development that is underway at the SEC is the move to allow foreign companies to file their financial statements according to International Financial Reporting Standards (IFRS) without reconciling to US GAAP. As contemplated, the U.S. would recognize both major accounting languages – US GAAP and IFRS.

However, the auditing industry faces other challenges, which if remedied will enhance our competitiveness. These solutions will take time to develop, but we will begin to lay the groundwork now for longer-term improvements.

As he announced in an op-ed this morning, Secretary Paulson has asked us to establish a non-partisan, public federal advisory committee that will develop proposals for creating a stronger, sustainable auditing profession. We have asked former SEC Chairman Arthur Levitt and former SEC Chief Accountant Donald Nicolaisen to co-chair this effort.

This soon-to-be-chartered committee will develop recommendations to address challenges facing this profession, such as industry concentration, competition, financial soundness, and employee recruitment and retention. The group will focus on three areas: (1) audit market competition and concentration, (2) human capital and (3) financial resources.

We will solicit a broad range of individuals representing views from the auditing profession, public companies, investor community, and other financial market participants. We intend to solidify membership this summer and anticipate a first meeting in the fall.

Auditing plays a unique role in our economy. A resilient and quality auditing profession is vital to the strength of our capital markets. Of course, management is ultimately responsible for a company's financial statements but requiring these companies to have their financial statements audited by an independent accounting firm enhances investor confidence. Strong, trustworthy auditing helps to encourage entrepreneurs and capital providers to take appropriate risks.

At the same time, Treasury will seek solutions that will serve to enhance financial reporting, make the presentation of financial information more meaningful and accessible to investors, and gain a better understanding of why financial restatements have increased over the past decade. We will also encourage managers, directors and investors to focus on long-term value creation while maintaining frequent and accurate financial reporting.

Conclusion

The steps I have outlined today represent the first in a series of initiatives that we will undertake to strengthen our bridge that connects suppliers and users of capital. The maintenance of this bridge will require that some tolls be paid. These tolls will pay for sound and effective regulation. They enable the free movement of capital, support appropriate protections for consumers and investors, while also encouraging innovation and entrepreneurship.

Our markets remain the most liquid, efficient and transparent in the world. And we are committed to maintaining that competitive edge.

The world is indeed changing, but we will use this as an opportunity to reassess our position and improve our leadership. As we undergo a period of construction, the work on our bridge will take time and require patience. These issues do not lend themselves to easy fixes. But I am confident that we will succeed, and the legacy we leave behind will be one of enhanced capital markets competitiveness.

Thank you.