McKinsey Executive Roundtable Series in International Economics: Beyond Firefighting: Rethinking Financial Market Regulation

New York City, New York

JOHN GAPPER:  Welcome, everybody.  I'd just like to welcome everybody.  This meeting we're having this morning is part of the McKinsey Executive Roundtable Series in International Economics.

I'd just like to remind everybody to turn off their cell phones, BlackBerrys, iPhones, whatever, because apparently they interfere with the sound system.  So please do turn them off.  And I'd just like to remind everybody this meeting is on the record.

I'm John Gapper with the Financial Times.  And we're privileged, actually, this morning to have a distinguished panel to discuss the issue of financial market regulation.

I think it's safe to say that we're actually at a historic moment.  We don't exactly know what history will say about this moment, but we do know that it will at least record it and say that it was a turning point of some kind, both in the financial sector generally and in regulation, particularly.

And to discuss that topic this morning we have with us Bill Donaldson, former chairman of the SEC, as well as co-founder of Donaldson, Lufkin & Jenrette.  And beside him, Steve Friedman, the former chairman of Goldman Sachs and also chairman of the National Economic Council, the job to which Larry Summers was appointed by President-elect Obama yesterday.  And next to him, Ernie Patrikis, a partner in White & Case, former number two at the New York Fed, and who also worked for a time with Hank Greenberg at AIG.  So you can see that we've got a panel that knows a great deal about both the public sector and the private sector in finance.

And I'd just like to start, actually, by asking Steve Friedman a question.  Everyone says now, given the extraordinary events we've been seeing, that we clearly need more regulation.  Do we need more regulation?

STEPHEN FRIEDMAN:  Well, I wouldn't phrase it as more, because it's an interesting irony that some of the parts of the system that blew up the earliest and really set off the conflagration were intensely regulated.  I would say we certainly need more effective regulation.  I think it would be very, very hard to make a spirited defense for the regulatory system that existed before.

I think it's now become accepted wisdom that the U.S. has a hodgepodge of regulatory structures set up that were not designed for the 21st century.  Indeed, they were -- it was some form of congressional logrolling, giving everyone something that they wanted, and it's remarkably inefficient, and it allows things to fall between the slats.  There just isn't adequate talent to go around unless you concentrate your fire more effectively.

So we need a totally rethought regulatory system in this country.  I think there's a myth that capital-markets people, of whom I am one, and a lot of people in the audience are from that, basically think that the free markets are so perfect that they will be intricate self-regulating mechanisms.

Just -- everyone in this room looks old enough to remember the events of the last 25 years.  Go back to the Latin American debt crisis, the real estate crisis and the bank crisis of the late '80s and the early '90s, Long-Term Capital, the dot-com bubble, the Asian debt crisis, and the current, which is by far the worst.  And I've probably left some out.

We have a financial system that in many ways is bipolar.  It seems to range between heights of speculative euphoria and then depths of panicky despair and the drying-up of liquidity and (co-relations ?), gravitating towards one.

And you know, that -- you don't have to be a great historian to know that's been the pattern over many, many, many centuries.  You can go back to tulip bulbs and South Sea bubbles and the railroad bust-ups in the 19th century.  So it seems to be something endemic in human nature.

And we need a regulatory system that, without taking the risk-taking and creative genius of the system out of it, substantially moderates the highs and the lows.  It needs to be completely rethought.

The last thing I would say is, it is a frightening thought to me that Congress, without immense preparation, would try to take on that job, trying to do it in a period where there would be thoughts of retribution and punishments and populism.

You know, the -- people have talked a lot about the Bretton Woods conference.  It took several years of intense study before that conference, preparation by technicians, before the movers and shakers were able to move.  And I think it would be very well advised for some kind of blue-ribbon bipartisan group to be appointed by the new president -- incoming president and Congress to study this, let a little bit of time pass and establish a template.

GAPPER:  Will Donaldson?

WILLIAM H. DONALDSON:  Yeah, I don't think it's a question of more regulation.  I think it's a question of more effective regulation.  As Steve intimated, if you go back to 1929 and the early 30s, the formation of the SEC, the Securities Acts of '33 and '34, Glass-Steagall to separate investment banking from banking, all of these regulatory -- regulations, regulatory agencies were set up in 1930.

You fast-forward, present time, the Gramm-Leach-Bliley law threw out Glass-Steagall and allowed everybody to get into everybody else's business.  And yet the regulatory organizations were organized -- the Federal Reserve to give prudent -- prudential regulation to the banking system, the SEC to be the policeman, if you will, the -- basically the investors' protector.  And what we need to do, I believe, is to totally rethink these regulatory agencies and to totally rethink what their responsibilities are going to be.

Once we get that job done, we are not an island unto ourselves here in the United States.  We're dealing on a global basis and we're going to have to figure out how we can mesh a new, more effective regulatory system with the other parts of the world.  And everybody's totally familiar with how pervasive global investing has been and how impossible it is to simply get our own house in order unless the rest of the world's house is in order.

And for those of you who've wrestled with this -- I know Steve and I have -- in terms of attempting to get the independent nations of this world to agree, regulation is almost impossible.  There's totally different ideas on what is good regulation.  There are totally different ideas on what is good accounting.  There are all sorts of ways of going about this.

I think we have pretty good enforcement regulation right now with other jurisdictions.  There's pretty good rules and regulations with agencies comparable to the SEC, sharing information on real wrongdoers.  But as far as the rules of the road, we've got a long way to go.

ERNEST T. PATRIKIS:  There's supervision; there's regulation.  They're not the same thing.  Supervision is qualitative; regulation is on-off, good-bad, yes-no.  I'm a believer in supervisor, coming out of the bank supervisory world.  It requires talented examiners to go into institutions and examine them.  The bank supervisors do that with varying skills.

So many federal agencies involved in bank supervision.  Fifty state agencies do bank supervision; 50 insurance state agencies.  Federal level, the SEC -- not too much involved on a -- (inaudible word) -- state level, a check for attorneys general.

The greatest impediment to all of this?  Congress.  Agricultural Committee has responsibility for futures.  They want to give it up to a committee?  And that has been an absolute difficulty for us.  And maybe next year -- the second half of next year, we'll start to deal with that situation.

Structurally, I look at the industries.  What we -- we're too close to it right now to appreciate what had happened -- the large number of non-banking organizations becoming bank-holding companies under the Fed's umbrella.

And that's significant.  It changes leverage.  There's a leverage ratio.  And I think it will take us a while to sort it out.  We haven't really seen them restructure.  You know, is there going to be a massive movement of assets from non-banking parts of those organizations into the bank, where those will really be megabanks?

In the long run -- I can start with the long run and work back -- I believe in universal banks.  There should be a charter.  You should be able to do whatever -- our competitors around the world, except Japan, which lags us in terms of following us, have universal banks.  The bank can decide what it wants to do.  You can be a consumer bank.  You can be an investment bank.  You can be an everything bank.  It's up to management to decide that.

Working back from that, there are difficulties with a number of agencies.  I'll go back to the short term.  People say:  Oh, CC -- Comptroller of the Currency, Office of Thrift Supervision.  Move them both together.

The Office of Thrift Supervision supervised AIG.  Now that means that it would have looked at AIG financial products.  Must have been a great job that they did.

Once we can get step one done, and if there are other parts of it, I believe the Fed should end up with 25, 35, 50 of the largest (systemic prone ?) organizations -- commercial banks, investment banks, hedge funds, private funds, whatever -- and every year, every three years, that list change, and they come in under the Fed's prudential supervision.

And we are perhaps the greatest principles-over-rules nation.  I hear all the time that the FSA in London is the -- you know, has the best rules.  Well, they have rules.  They have nine rules.  If you can't find the answer in the 10,000-page rule book, you go to the nine rules.

In bank supervision, unsafe, unsound banking practice -- New York banking law turn of the last -- last century -- all the bank examiner has to say is, "This is an unsafe, unsound practice.  Stop it."  You don't stop it, you get spanked.  That's the best rule that there is.

What's unsafe and unsound?  I know what it is.  You know what it is.

Now, the one issue that I have concern with is the quality of staff necessary to do it.  If you're going to rely on supervision as opposed to regulation, you need quality of staff.  And that becomes a matter of payment, how much you pay people.

At the New York Fed, when I was first vice president, my biggest challenge was how do I keep someone five years instead of three, how do I keep him seven years instead of five, how much good work can I throw at them, and how much money can I pay them within constraints, knowing that the private sector is much greater.

And I can list all the people who left who didn't want to leave but left because they bought a home or they had kids who wanted to go to college.

But I think part of this is a realization that those that do this work need to be paid not the private-sector level, not what they're paid today.  There's got to be something there that will keep them there.  That, (plus high ?) income, will keep them there if they have quality.

If we don't do that, then you get what you pay for, and we just continually don't expect the public sector then to be able to address the issues in the private sector and stop them, because they're not capable of doing it.  (I'll stop ?) with that.

GAPPER:  Okay.  Well, let's just take a step back there.  I mean, it seems to me, from some of what we've talked about this morning, that this situation is hopeless, and it's hopeless in two ways.  One is, we have an extraordinarily complex system of regulation in the U.S., never mind internationally, with a lot of internal political rivalries.  So it's going to be extremely hard to shift anything in that arena.  And I'd like to come on to the specifics on that.

But before we do, I'd like -- the other area in which it appears to be hopeless is, we had Fed regulators who clearly didn't quite know what was going on.  But on the other hand in the private sector, managers clearly didn't know exactly what was going on, that the, that the much more highly paid risk managers in the private sector, who Ernie has talked about, clearly didn't have a full grasp of the risks those organizations were taking.

So I'd just like to examine that issue for a second.  How can we move to a system where we don't just inevitably have a period of excess, where there are risks taken within private sector institutions that the institution itself does not understand what it's doing, never mind the regulators?  Or are we always just going to be stuck in that cycle?

DONALDSON:  Let me try that one.

We spoke about staff being well paid.  I would say that the structural organization, of how the staff is organized, is equally important with the quality of the staff.  Again you take an institution like the SEC.  It's been organized along stovepipe lines forever; very little cross-fertilization between the different departments, if you will.  And that results in a lot of regulatory harassment, I suspect, coming out into the marketplace itself because of a lack of coordination inside, likewise underorganized, and what I would call risk management from a regulator's point of view.

One of the buzzwords at the SEC when I was there was that we've got to figure out how to look over the hill and around the corner and anticipate some of the things that are going to happen here, as opposed to arriving at the scene of the accident after it happened.  And that has to do with a risk management function within an organization like the SEC that attempts to anticipate and also attempts to educate, if you will, based on anticipation, on seeing something coming over the hill; instead of waiting till it happens and slapping somebody hard, getting out there and trying to prevent it from happening.

FRIEDMAN:  To the amazement of many, so many organizations that were highly respected have managed to implode, doing things dramatically against their interest.

I think when you look at organizations, most things are explainable in terms of three things: the quality of the people, the quality of the culture and, to some extent, the strategy which is in many ways the least important.

I think when you look at organizations that are good in terms of risk management, I think, culturally there is a sense that the people in the trading desk have a partnership mentality.  They are working for the firm.  Their interests are aligned.

Alignment is a crucial, is a crucial concept.  And that means their job is to be elevating, to their boss's level, areas that they think are getting excessively risky.  Like the classic example is the mortgage area well before it became -- obviously was in deep trouble.

When you look at organizations that have problems, you'll see, you'll see the opposite cultural artifact.  You'll see, trading desk very often appears to be playing for their own bonuses.  And you'll get a sense that the news flows upstairs to the chairman's office in a very, very tardy kind of a way.

The awareness of the risks, despite stacks of reports, are slow.  It's almost as if they're gaming the system.  I think that, I think, another culturally thing is, are the risk managers, are they as highly talented, as well paid?

Do they have as much clout and prestige in the firm as risk takers?  A sign of impending crisis is always when the risk managers are perceived as somehow subordinate in terms of prestige and authority to the risk takers.  And certainly it's a potential (death ?) when they have some reporting relationship to the risk takers.

So, culturally firms have to rethink.  Some have been quite effective, but many have not.  I think the category of people -- you know, the financial system is a little bit like an expansion baseball league; there aren't that many 300 hitters to go around.  And with 8,000 hedge funds siphoning off talent, a firm is going to have to basically say the defensive capacity is incredibly important to our survival and our business, and that's where we're going to put a lot of talents in.

Culturally I'll say this.  I think there was a huge follow-the-leader kind of an impulse.  Someone was doing well in a certain area, and other people decided to pile into it; if it was working for them, it should work for us.  But what happens is these kind of follow-the-leader impulses always bring the seeds of destruction because an area gets over-bought.  You get these giant, crowded (frays ?) that you can't get out of.

And here is a very crucial point.  At the end of the day, boards of directors who are supposed to be asking tough questions are not adequately educated to ask them.  Very few boards of directors would determine how much to pay the chief executive officer without having it expertised by some independent consultant firm, mostly to cover their own rear ends.  Well, unless they have extremely good risk managers -- and some firms do -- who are presenting to them and giving them a lot of confidence, why aren't they reaching outside for consultants who can help them ask the tough questions?  It's not necessarily that management is consciously deceiving them.  They're probably not.  Management is capable of making mistakes.

And here is -- and I'll close on this.  A friend of mine who is a retired four-star admiral has a rule -- he calls it Ellis's rule -- that amateurs, he said, study the plan; the professionals study the assumptions.  If you look at where people went astray, they had these intricate, complicated models, but the underlying assumptions they put in weren't adequately challenged by the boards of directors and senior management.

If you plug in the assumptions -- for instance, that housing prices are going to continue going up -- well, at the end of the day the model will grind out results that don't give you adequate warning.  A strange irony of our present situation is that risk management for people in the year 2010 or 2011 will be a lot more effective, for a number of reasons.  One, we've backed into the hot stove, but the second reason is, senior management will now no longer have to argue about what dire assumptions to plug into the -- to plug into the plans.  We're living it.

GAPPER:  I'd just like to ask, since we have -- I wouldn't say we've got representatives of the Fed and the SEC here, but we have people with knowledge of those institutions.  In some ways, it seems like the Fed -- and correct me if I'm wrong -- has had a good war, in the sense that it's done a lot of decisive things, and it's powers seem to be, if anything, expanding; and in some ways it seems like the SEC has had a bad war, in that it's got blamed for a lot of stuff and it's got somewhat shunted to the sidelines while the Treasury and the Fed have been stomping around doing things.  Bill, what's your perspective on the future of the Fed and the SEC and their sort of relative weight and functions for the new system?

DONALDSON:  Well, I think a couple of things.  Number one is that the Federal Reserve is a prudential regulator.  And what that means historically is the Fed has gone into the banking system, examined it.  If it finds things wrong, it corrects those things behind the scenes, but its total focus is on the system working and not being broken down by malfeasance on the part of a single bank.

The SEC's mission is totally different.  The SEC is investor protection, and it basically does that by disclosure, by assuring that accounting is clean and assuring that everything that's going on in the company is exposed to the investing public.

And I think as we move ahead what I'm fearful of and -- is that because of what's happened in the last couple of years, the role of investor protection is going to be diminished.  Much of the suggestion that has come out of -- frankly, out of -- in reaction to Sarbanes-Oxley and trying to push that regulatory pendulum back -- many of the suggestions on how this whole thing should be organized diminishes the possible role of an independent agency for investor protection.

The total suggestion has been that the CFTC and the SEC be merged together; but you look at some of these plans, and it's a diminished entity, if you will.  And I must say that during my career in -- for too many years -- the SEC has been the most respected agency in the federal government.  It is constantly getting kudos for being independent, non-political -- not loved, but honest and dispassionate.

I think that reputation has been severely damaged in the last couple of years.  And I hope when the reorganization comes about, it will not be just to make the markets work more effectively, or not to make it easier for corporate America or financial America to run their business, but that this dimension of protection will be thought of as we reorganize.

Ernie?

PATRIKIS:  Well, I think the SEC fell down in the prudential supervision of broker-dealers.  It's not the nature of the agency.  It's a great enforcement agency.  It does a great job on disclosure, on fraud, market manipulation, all of those issues.  That should continue.  And if it's with the CFTC, which does market manipulation, that, to me, all -- all make sense.

I remember Commissioner Atkins saying (in 2007 ?) the SEC did fewer enforcement actions because the examination staff had come up with all of these remedial actions that should be taken that went to the enforcement staff, and they spent all their time doing it.  That told me that the examination staff wasn't spending time on prudential supervision.  It was regarded as the feeder for enforcement.

In bank supervision, it's the other way around.  The major effort is on prudential supervision of the institution, financial integrity of the institution.  C-A-M-E-L-S:  capital, earnings, management, effort -- management, earnings, liquidity, sensitivity -- CAMELS, very easy, very simple.  That's what bank examiners do.  So I would strip from the SEC the prudential supervision, at least of major organizations -- (inaudible) -- 25 or 50, saying they're just not up to it.  And I think that the Fed is up to it.

As to the Fed's role, we set monetary policy aside, and I think the Fed, once it figured out there was gridlock in the market, took a little time.  When the European Central Bank did the first study of liquidity, I said to myself:  Gee, look at them.  They're trying to show how great they are, et cetera.  How showboat.

And then the Fed a little while later followed.  And I now say:  By God, they had it right.  They got it right first time.  They saw it.  They understood it.

And I think it took too long for us to realize that the wholesale financial markets had just totally freezed up.  And I wish we had been a little faster on that.  So I don't give the Fed on "A" on that.  Once the Fed got on it, I give the Fed an "A" in terms of doing everything it can.  The only thing left is helicopters flying over the city, dropping currency out.  (Laughter.)  There's limits of how much currency they can drop.  It's much easier to credit banks' accounts.

In supervision, the Fed is that good.  And the people are that good.  One reason for it is all of these Ph.D. economists.  When I was there, there was a least 90 of them.  I don't know if there's more or not.  And some of those would go over to the supervisory side.

And that just brings a lot of brainpower and other insight and people who do believe in -- I don't call it the free market.  I call it the somewhat free market.  I mean, in my lifetime, there hasn't been a free market.  We need to maintain that somewhat free market, and economists are the only ones who really believe in it.  I mean, businessmen don't want a free market.  They want a monopoly.  (Laughter.)  And they bring something to the table that is really worthwhile.  And so for the reason, it has -- it has done well.

A lot of the banks in trouble; the Fed doesn't really supervise major banks.  We have an issue of -- do we need this animal called a bank-holding company?  Do we need a separation of banking and commerce?  What should banks be able to invest in?  Who should be able to invest in banks?  I take a very broad view of that.  I would open up that we can invest in banks.  We have so many limitations on who the bank can lend -- what affiliates it can lend to, that sole control, that the potentials for abuse are really rather small.  So I'm not as concerned about that.  But on the whole the Fed, I think, has done a great job.

Last thought:  Internationally, if we're talking about that, I'd hate to see an international supervisor making rules for the United States and the rest of the world.  A department of supervisors committee works.  That's the G-10, which we know is 11, and their invitees.

I would change that group.  I would have some major country -- I'd make it more like the Security Council, some permanent members and rotating members so that China and India could become real members.  And they come up with expanded minimum rules, which I think are doable.  And each nation can enact them and add to it and make them harsher.  That works.  It has to be a relatively small group.  A very, very large group is not as effective.  IOSCO is okay, but nowhere as near as effective as the Basel supervisors.  And that should continue.

Colleges:  I read the G-20 report, which I thought was, I mean, so much better than the usual G-7 report.  It actually had meat on it, had timetables on it.  That -- for an institution, I can see a college of supervisors getting together.  But there's a competitive issue.  Some -- if you learn too much -- you know, some supervisors in some countries have closer relationships to their organizations than we do in the United States.  And sometimes it doesn't take long for those -- that information, which can be competitively harmful information get out.  But there's something to that.

I attended -- final thought -- the last meeting of the college of BCCI.  And I watched them.  I didn't do it; they did it.  Look -- that was, I didn't not do it; they did not do it, in terms of who is responsible for supervising BCCI.  Needs to be one supervisor, one institution, home country, whatever that is, and for them to do it well, and then coordination with others.

I have not heard of any problems in international cooperation and supervision in the credit crisis.  I've not seen anything in any country.  I mean, I hope we don't have a problem there to solve that isn't there.

GAPPER:  Okay.  Well, we've got a lot of topics there.  And clearly, it would take more than an hour to cover them all.  But we're going to squeeze ourselves in anyway.

I'd just like to, at this point, open the meeting up to questions from the floor.  And please wait for the microphone, speak into it.  Can you just say who you are and your affiliation, if you have one?  And could you just limit yourself to one question -- and by question, I mean a short sentence with a question mark at the end -- (laughter) -- so we can get as many people as possible in?

Yeah?

QUESTIONER:  Good morning.  I'm Mark Levinson.  I'm with JPMorgan Chase.  A lot of the financing done by banks and insurance companies these days is done with so-called hybrid securities, which the regulators have strongly encouraged.  These, for folks who don't know, have differing levels of subordination.  So supposedly, you have a differing chance of getting paid out in the event of failure and therefore get a different interest rate at each level.

It seems that when institutions are too big to fail, hybrid securities don't work anymore and everybody gets paid out.  Does that make any sense?  Does this kind of funding structure make any sense if the owners of all sorts of hybrid securities get treated equally?

DONALDSON:  Well, I think we are victims of so-called hybrid securities, derivatives, the infamous default swap securities and so forth.  And I think it brings into question just how we go about regulating.  You know, should there be a Food and Drug Administration approach to toxic instruments?  Should there -- should certain sorts of instruments be outlawed?

And I'm not -- that's a very controversial area, particularly in a free-market arena such as we have in this country.  But I think when we start to look at this reorganization of the regulatory mechanism, we've got to go at it with a total clean slate and forget about the way we've been regulating before and think about something as radical as the outlawing of a toxic instrument.

And that is not to say that some of these instruments don't have a purpose.  But some of them are pretty fancy.  The people that designed them really don't understand them.  And they tend to blow up.

GAPPER:  Well, that's an interesting point.  Is it simply a question of sort of leverage within the system, or is it -- (inaudible) -- inherently toxic things?

PATRIKIS:  Well, I hate the word "toxic" when I -- when I hear it.  I mean, the issue to me is is it credit-impaired instrument, market-value-impaired instrument?  Market-value-impaired instrument has to do with this crash.  There's value there.  I'd hold on to the damn thing.  At maturity, I'm going to get my money back if I have enough capital.  That's the issue.  That's long-term capital management.  That's the banking system.  That's AIG.

Bank clients -- (inaudible) -- who bought the triple-A tranches of certain instruments thought they were buying great instruments.  They didn't think enough about it.

The issue goes to, really, the buy side, the investors.  Do they understand what they're buying?  The other guy will sell anything he can sell.  They'll manufacture it.  Should I buy it, if I'm a state pension fund, or I'm whatever?  That -- I think we haven't heard enough criticism of the buy side.  I mean, these people have a responsibility -- it's fiduciary for many of them -- to ensure that they understand the products.

Should -- I don't believe in -- too much in product regulation.  I believe in fraud and dealing with fraud.  I don't think credit default swaps should be regulated.  I think the instruments did fairly well, considering everything.  I think management and supervision failed, not -- the instrument didn't fail.  The instrument did fairly well.  So I approach it from that way.

FRIEDMAN:  Yeah, I agree with Bill that everything needs to be on the table.  I would be very, very uncomfortable with bureaucrats determining which products can be used in the financial system and which not.  I mean, one of the positives of our system is we do have a great deal of creativity, and that -- we don't want to lose that.

I do think, though, that it would be totally appropriate for -- look, the same instrument in my hands may be dangerous because I have too much of it and I have too much leverage there.  In Bill's hands it may be very prudential because he is using it to hedge some other exposure.  And I just don't think the regulatory system is capable of wisely dealing with that.

I think it may be capable of saying:  Let's run those stress tests, and let's run them on the following assumptions.  For instance, in the insurance world, which is not the ultimate paradigm, but they might say:  If -- you're going to write this much and if you want to keep your rating at this level -- and they're the de facto regulators, the rating agencies -- you have to establish for us that after a one-in-a-hundred-years storm plus a one-in-250-year earthquake, you're still up and in good shape to write business.

I mean, here are the assumptions.  Here is the pros looking at the assumptions.  And you want to have that security in your books, fine.  Prove to us that you can survive a debacle.

Now the other point that the gentleman raised was the "too big to fail."  When this whole thing started, I had the utopian and -- view that the ultimate goal of the new regulatory system ought to be to make sure that no one was too big or so intertwined that we couldn't let them go under.  I mean, that's a pretty good way to concentrate people's minds:  You won't be bailed out.

Unfortunately, the necessities of the crisis have meant we've moved in the other way and we've made people bigger and less able to fail.  I do think that there are some things, like credit derivative swaps being on a clearinghouse and other things, that need to be done so we are able to -- there are fewer and fewer institutions who are too big to fail or too intertwined to be allowed to fail.

GAPPER:  Okay.

DONALDSON:  Yeah, let me just add one thing to what Steve was saying, which is that I remember back a number of years ago when there -- and I think it was in the mid-'80s -- there was a thing called portfolio insurance, dynamic hedging.  And I can remember sitting on the board of a company where the staff came up and suggested that we engage in this.

And it depends upon there being a market there.  And one of the directors said:  Well, what happens if you can't dynamic-hedge, if a market's going down and you can't lay this product off?  That's not going to happen.

Well, it did happen.  The over-the-counter dealers in 1987 didn't answer their telephones.  Now, who would have thought of that?  What Ph.D. in economics would have thought that a segment of the market was not going to answer the telephones in a down draft in the market and therefore make dynamic hedging not work?

GAPPER:  Okay.  I'm going to go there.  Yeah.

QUESTIONER:  Stanley Arkin.  Ernie, you mentioned supervision, regulation.  You mentioned AIG.  Steve mentioned populism, maybe intensified.  Is there any role for criminal prosecution in the regulation of the markets?

PATRIKIS:  Oh, there certainly is the case of fraud.  In the case of organizations, I can't say too little about Eliot Spitzer and his threats.  And you know, to me, I've always believed that in dealing with attorney generals like that, the SEC and times at the Fed, that this is not the United States, this is not a democracy.  The issue for any major corporation is, how much do I have to pay to get out of this picture?  You can't fight.  You're not permitted to fight.

If you want to fight, they'll say, "Well, we'll indict the company."  And that's just plain wrong.  That's un-American.

But for individuals, I certainly do believe there are people who should get extended vacations, courtesy of the government, when they violate laws.  There certainly is a need for that.

FRIEDMAN:  I think there ought to be law that said anyone who is a prosecutor has to have a -- two-, three- -- you pick it -- -year waiting period before he can run for higher office.  (Laughter.)

GAPPER:  Okay.  Another question?  There.

By the way, I should say that unlike the financial markets at the moment, we've got an excess of demand and not supply in matters of time, so I'm going to -- (inaudible).

QUESTIONER:  I'm Kenneth Bialkin.  I -- we've had a perfect storm.  No one performed what they should have done.  There was a dereliction of duty at every level, whether it's in the left or the right.

But there's one area that has gotten occasional notice and goes nowhere, and that is the accounting rule by which banks and financial institutions are obliged to strip their earnings and strip their capital, mark their assets to some notional market, depleting their surplus and coming up with massive losses, all of which is the result of an accounting convention introduced in 2006 called fair value.

I wondered if you could, among the many issues that went wrong, talk about the failures of the accounting regulators -- standard regulators, the supervisory regulators, including the SEC and the Fed, as to how they let the banks get into a situation where they had to report themselves essentially being bankrupt by having to make believe there was an asset in your portfolio that if you had to sell it and you couldn't sell it, therefore you should mark it down.  I wondered if you could focus on that.  Steve might want --

DONALDSON:  You bring up an entire Pandora's box of accounting in this country.  I think that it's clear to say that we have very confused accounting rules who have become more and more obfuscated as we try and cover everything, rule after rule after rule.  There's an attitude of precision in accounting that just isn't there.  There's judgment in terms of reserving for losses, et cetera, et cetera.

It's not a precise profession, if you will.  And efforts to talk about rules versus principles-based accounting starts to get into this arena.  I believe that we need to move toward an international accounting system with some consistency to it.  And we're starting to move toward that.

Unfortunately, that movement is going to be interrupted, I believe, by the mess we're in now.  It was moving pretty rapidly, and I think it's going to be interrupted.  But we need to come down on a better way of doing accounting and recognizing the imprecision of it.

FRIEDMAN:  Can I make a comment?

GAPPER:  Yeah.

FRIEDMAN:  Kenny, I want to express my strenuous disagreement with the premise of your question.  First of all, there is no -- there is no accounting system that is remotely close to perfect.  They all -- it's like Churchill saying about democracies:  each of them is like the worst of all systems, except for anything else mankind has tried.  You know, at least fair value is.

But the alternative is banks essentially carrying something at approaching cost, and over time making a judgment:  Well, I do or don't think this is impaired.  And that, you'll remember, after Enron, was called Enron-style accounting because it was -- I think Warren Buffett's phrase -- marked to (miss ?).  And there was a substantial amount of -- there's a substantial amount of room there for self delusion as to what things are worth.

Fair value basically says it's worth what I can sell it for.  And I'm going to grant you, there's a big problem when markets freeze up.  But what fair value does is, it's like -- it gives management an early warning system.  It makes sure those lines of communication from the trading desk to the chairman's office are not blocked up by wishful thinking:  I'd like to believe this will happen, and besides, I'll get my bonus if this happens.  It's a discipline.  It's like the patient in the -- is constantly strapped to the sensors as to what's going on.

Once you get to a crisis where people are not answering their phone and you have illiquidity, none of these systems work.  And there's got to be -- in the famous level three assets, there has to be more judgment.  But I would be very nervous if we took away the warning systems.

The chairman of the Financial Accounting Standards Board, when someone made the argument you made, basically said:  Well, we have a public policy interest that we would like to have consumers out there spending, so my modest proposal -- said he, ironically -- is we'll instruct every brokerage firm, when they send you your brokerage statement, let's put in the prices for back in last June.  This will be much more cheering and won't lead to the declines in your net worth, and you'll go out and spend.  And you know, it's rumored that if he was forced to go move away from fair value, he'd retire.

He made that as a semi-joke.  Turns out, the Europeans basically said -- and some of their major banks took advantage of it -- why don't you go back and market that -- mark that to where it was on June 1st?

Now, try to imagine, if you're trying to raise money from an outside capital source, are they really going to come in and look at your numbers marked at June 1st and say, "We'll make our capital injection based on that fantasy"?  Of course not.  They're going to try to figure out what it's worth today.  So right there you're in the stage of having two sets of books:  one for Joe Public, who's buying your stock, and the other for the Mideastern sovereign wealth fund that's injecting money.

GAPPER:  Okay.  We'll try and get a couple more questions.  Yeah.

By the way, I always had a soft spot for the old German private banking accounting, where they didn't have fair value; they declared their results on the basis of what they thought their assets were worth.  And then they had hidden reserves, as well; so you really didn't know.

QUESTIONER:  I'd like to find those hidden reserves.

This is Lauren Mullen from Bank of America.  And I wanted to note that Donaldson had mentioned earlier in his talk about the impact of the Gramm-Leach-Bliley Act and how that had somehow broken down some of the barriers between the banking and the securities acts for what the banks could do, but the agencies had not really kept up; and also noted a little bit about the investor protection mandate at the SEC.

And I wondered as he was talking about that if perhaps the mandate of the SEC needs to really be expanded to focus more on a global market protection; given that the impact of the crisis we're facing now, being that it's a market-wide impact, is having much larger impact on investors than the individual order-by-order, trade-by-trade, investor-by-investor protection would have.

What regulatory changes -- what are maybe the three biggest regulatory changes that you see we need to get through this crisis?

GAPPER:  Okay.  Well, let's ask the panel; three quick regulatory changes.

DONALDSON:   Well, clearly, and most immediately, I think we need to plug the hole of mortgage lending that has somehow -- that's been unregulated.

Secondly, I think we need to plug the hole of derivative responsibility, if you will.  The fallout from Gramm-Leach-Bliley was to take derivatives and make them under the jurisdiction of no one.  The CFTC has no jurisdiction, the SEC has no jurisdiction, the Federal Reserve has no jurisdiction.  That's why we got in the trouble we've gotten in.  So we're going to have to plug that hole.

I could go on and on about the holes that need to be plugged.  What agencies should do that is another question.  And that's why I think we need to relook at the whole thing.

FRIEDMAN:  Figure out how to deal with hedge funds.  There's thousands of them.  There'll be a lot fewer thousands by the end of the year, but there's thousands of them.  Figure out how to deal with them through their prime brokers or the banks that lend them.  But you're right, I don't think it would be possible to get in there to each of them.

Finalize the plans for credit derivative swaps being dealt with on clearinghouses, and setting up margin product goals.  And rationalizing this weird overlap of regulatory agencies and get it into something approaching fighting trim.

GAPPER:  Okay.  Ernie?

PATRIKIS:  Don't blame Gramm-Leach-Bliley.  Bank of America was able to make an acquisition overnight because of Gramm-Leach-Bliley.  JP Morgan/Chase was able to do it.  Morgan Stanley and Goldman Sachs were able to convert their bank holding companies overnight because of it.  We're very lucky that we had Gramm-Leach-Bliley.

All Gramm-Leach-Bliley did was level the playing field so that investment banks could do what commercial banking organizations could do.  None of them did it, though, because they're afraid of the Fed and the Bank Holding Company Act.

And they bit the bullet.  And then the question is, did they bite the bullet because of access to the window, or did they bite the bullet also because it's coming under the Fed umbrella, because internationally doing business --

GAPPER:  If that's good, what's the bad?

PATRIKIS:  Well, it's the umbrella supervisor, which -- (inaudible) -- requires, and (abroad ?) I think the Fed has more credibility in terms of supervision for it.  So I look at Gramm-Leach-Bliley and say we're very fortunate we had it in place.

GAPPER:  Okay.  Yes.  Okay.

QUESTIONER:  John Beattie (sp), from UBS.

There's been a lot of press recently on the need to regulate or better regulate the securities markets, primarily from the issuer's perspective, as opposed to focusing on the investor's perspective, which I think is a point you mentioned.  By way of example, there has been -- there's been a lot of -- despite qualitative disclosure on the risks of investing in complex products, large financial institutions nevertheless went ahead and invested, and lost lots of money.

In order to make regulation more effective from the perspective of disclosure, is there likely to be discussion on bolstering qualitative disclosure with more quantitative risk disclosure, particularly for complex products?

PATRIKIS:  I think that's pillar three of Basel II, which is disclosure.  If we believe in the market and the market as a governor, then we'll need more disclosure.  There was a program that started maybe 10 years ago in that direction, but it died, I think, because of opposition from various aspects of the financial industry.  I think we'll see that start up again.

But there is the other issue.  If you've ever read a prospectus for a plain old one- to four-family mortgage-securitized transaction, it's mind-boggling, and you really don't learn anything.  So the issue has to be the effectiveness of disclosure.  All the things I've wanted to read aren't in that prospectus, in terms of what the servicer can do and what the trustee does and all of those.  So a little rethink is needed.  Just disclosure in itself doesn't do it.  Quality disclosure.

GAPPER:  Okay.  Anyone else on the disclosure?  All right.

Okay.  This is going to be the last question.  Sir.  That gentleman there, yes.

QUESTIONER:  Hi.  I'm Andrew Rice, from Portfolio, Conde Nast Portfolio.

I have a question for Mr. Friedman.  You mentioned the congressional role, and Barney Frank has announced that he's going to take up the question of regulation in the -- early in the next Congress in a very muscular way.  And I was wondering, I mean, is that something that you're apprehensive about, or what is your attitude towards those plans?

DONALDSON:  Well, I --

FRIEDMAN:  Yes --

DONALDSON:  Oh, go on.  Go on.

FRIEDMAN:  Yeah, I am apprehensive, not because I disagree that we need muscular regulation, but because I don't think that -- and so I applaud his desire to do it.  I just think the groundwork has to be -- this is a very complex effort, and I think the groundwork needs to be set with very serious, dispassionate studies before that work is done.

Partly, it will involve some tricky political questions, but it'll also involve a lot of international questions.  And I just think a template needs to be set that they can then accept or reject, but use as a -- at least a polar setting.

GAPPER:  Okay.

DONALDSON:  I just say that I totally agree with Steve.  I think that one of the big dangers now is that we -- well, after the turn of the year, we leap into a political discussion in Congress in terms of doing a remake that needs to be done.

I think we need to have a totally dispassionate, non-political, independent group think this thing through.  Now, they can give the results of what they do to Congress and let them play around with it, if they will, politically.  But in terms of that deliberative body coming up with the sophisticated tradeoffs that are needed in a political environment, I think that's going to be very tough.

GAPPER:  Okay.  I'm going to say that I think the moderator only has one important duty, which is to end the meeting on time.  So I'm going to do that.  And I'm going to thank our panel for a fascinating discussion.

DONALDSON:  Thank you.

(Applause.)

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THIS IS A RUSH TRANSCRIPT.

New York City, New York

JOHN GAPPER:  Welcome, everybody.  I'd just like to welcome everybody.  This meeting we're having this morning is part of the McKinsey Executive Roundtable Series in International Economics.

I'd just like to remind everybody to turn off their cell phones, BlackBerrys, iPhones, whatever, because apparently they interfere with the sound system.  So please do turn them off.  And I'd just like to remind everybody this meeting is on the record.

I'm John Gapper with the Financial Times.  And we're privileged, actually, this morning to have a distinguished panel to discuss the issue of financial market regulation.

I think it's safe to say that we're actually at a historic moment.  We don't exactly know what history will say about this moment, but we do know that it will at least record it and say that it was a turning point of some kind, both in the financial sector generally and in regulation, particularly.

And to discuss that topic this morning we have with us Bill Donaldson, former chairman of the SEC, as well as co-founder of Donaldson, Lufkin & Jenrette.  And beside him, Steve Friedman, the former chairman of Goldman Sachs and also chairman of the National Economic Council, the job to which Larry Summers was appointed by President-elect Obama yesterday.  And next to him, Ernie Patrikis, a partner in White & Case, former number two at the New York Fed, and who also worked for a time with Hank Greenberg at AIG.  So you can see that we've got a panel that knows a great deal about both the public sector and the private sector in finance.

And I'd just like to start, actually, by asking Steve Friedman a question.  Everyone says now, given the extraordinary events we've been seeing, that we clearly need more regulation.  Do we need more regulation?

STEPHEN FRIEDMAN:  Well, I wouldn't phrase it as more, because it's an interesting irony that some of the parts of the system that blew up the earliest and really set off the conflagration were intensely regulated.  I would say we certainly need more effective regulation.  I think it would be very, very hard to make a spirited defense for the regulatory system that existed before.

I think it's now become accepted wisdom that the U.S. has a hodgepodge of regulatory structures set up that were not designed for the 21st century.  Indeed, they were -- it was some form of congressional logrolling, giving everyone something that they wanted, and it's remarkably inefficient, and it allows things to fall between the slats.  There just isn't adequate talent to go around unless you concentrate your fire more effectively.

So we need a totally rethought regulatory system in this country.  I think there's a myth that capital-markets people, of whom I am one, and a lot of people in the audience are from that, basically think that the free markets are so perfect that they will be intricate self-regulating mechanisms.

Just -- everyone in this room looks old enough to remember the events of the last 25 years.  Go back to the Latin American debt crisis, the real estate crisis and the bank crisis of the late '80s and the early '90s, Long-Term Capital, the dot-com bubble, the Asian debt crisis, and the current, which is by far the worst.  And I've probably left some out.

We have a financial system that in many ways is bipolar.  It seems to range between heights of speculative euphoria and then depths of panicky despair and the drying-up of liquidity and (co-relations ?), gravitating towards one.

And you know, that -- you don't have to be a great historian to know that's been the pattern over many, many, many centuries.  You can go back to tulip bulbs and South Sea bubbles and the railroad bust-ups in the 19th century.  So it seems to be something endemic in human nature.

And we need a regulatory system that, without taking the risk-taking and creative genius of the system out of it, substantially moderates the highs and the lows.  It needs to be completely rethought.

The last thing I would say is, it is a frightening thought to me that Congress, without immense preparation, would try to take on that job, trying to do it in a period where there would be thoughts of retribution and punishments and populism.

You know, the -- people have talked a lot about the Bretton Woods conference.  It took several years of intense study before that conference, preparation by technicians, before the movers and shakers were able to move.  And I think it would be very well advised for some kind of blue-ribbon bipartisan group to be appointed by the new president -- incoming president and Congress to study this, let a little bit of time pass and establish a template.

GAPPER:  Will Donaldson?

WILLIAM H. DONALDSON:  Yeah, I don't think it's a question of more regulation.  I think it's a question of more effective regulation.  As Steve intimated, if you go back to 1929 and the early 30s, the formation of the SEC, the Securities Acts of '33 and '34, Glass-Steagall to separate investment banking from banking, all of these regulatory -- regulations, regulatory agencies were set up in 1930.

You fast-forward, present time, the Gramm-Leach-Bliley law threw out Glass-Steagall and allowed everybody to get into everybody else's business.  And yet the regulatory organizations were organized -- the Federal Reserve to give prudent -- prudential regulation to the banking system, the SEC to be the policeman, if you will, the -- basically the investors' protector.  And what we need to do, I believe, is to totally rethink these regulatory agencies and to totally rethink what their responsibilities are going to be.

Once we get that job done, we are not an island unto ourselves here in the United States.  We're dealing on a global basis and we're going to have to figure out how we can mesh a new, more effective regulatory system with the other parts of the world.  And everybody's totally familiar with how pervasive global investing has been and how impossible it is to simply get our own house in order unless the rest of the world's house is in order.

And for those of you who've wrestled with this -- I know Steve and I have -- in terms of attempting to get the independent nations of this world to agree, regulation is almost impossible.  There's totally different ideas on what is good regulation.  There are totally different ideas on what is good accounting.  There are all sorts of ways of going about this.

I think we have pretty good enforcement regulation right now with other jurisdictions.  There's pretty good rules and regulations with agencies comparable to the SEC, sharing information on real wrongdoers.  But as far as the rules of the road, we've got a long way to go.

ERNEST T. PATRIKIS:  There's supervision; there's regulation.  They're not the same thing.  Supervision is qualitative; regulation is on-off, good-bad, yes-no.  I'm a believer in supervisor, coming out of the bank supervisory world.  It requires talented examiners to go into institutions and examine them.  The bank supervisors do that with varying skills.

So many federal agencies involved in bank supervision.  Fifty state agencies do bank supervision; 50 insurance state agencies.  Federal level, the SEC -- not too much involved on a -- (inaudible word) -- state level, a check for attorneys general.

The greatest impediment to all of this?  Congress.  Agricultural Committee has responsibility for futures.  They want to give it up to a committee?  And that has been an absolute difficulty for us.  And maybe next year -- the second half of next year, we'll start to deal with that situation.

Structurally, I look at the industries.  What we -- we're too close to it right now to appreciate what had happened -- the large number of non-banking organizations becoming bank-holding companies under the Fed's umbrella.

And that's significant.  It changes leverage.  There's a leverage ratio.  And I think it will take us a while to sort it out.  We haven't really seen them restructure.  You know, is there going to be a massive movement of assets from non-banking parts of those organizations into the bank, where those will really be megabanks?

In the long run -- I can start with the long run and work back -- I believe in universal banks.  There should be a charter.  You should be able to do whatever -- our competitors around the world, except Japan, which lags us in terms of following us, have universal banks.  The bank can decide what it wants to do.  You can be a consumer bank.  You can be an investment bank.  You can be an everything bank.  It's up to management to decide that.

Working back from that, there are difficulties with a number of agencies.  I'll go back to the short term.  People say:  Oh, CC -- Comptroller of the Currency, Office of Thrift Supervision.  Move them both together.

The Office of Thrift Supervision supervised AIG.  Now that means that it would have looked at AIG financial products.  Must have been a great job that they did.

Once we can get step one done, and if there are other parts of it, I believe the Fed should end up with 25, 35, 50 of the largest (systemic prone ?) organizations -- commercial banks, investment banks, hedge funds, private funds, whatever -- and every year, every three years, that list change, and they come in under the Fed's prudential supervision.

And we are perhaps the greatest principles-over-rules nation.  I hear all the time that the FSA in London is the -- you know, has the best rules.  Well, they have rules.  They have nine rules.  If you can't find the answer in the 10,000-page rule book, you go to the nine rules.

In bank supervision, unsafe, unsound banking practice -- New York banking law turn of the last -- last century -- all the bank examiner has to say is, "This is an unsafe, unsound practice.  Stop it."  You don't stop it, you get spanked.  That's the best rule that there is.

What's unsafe and unsound?  I know what it is.  You know what it is.

Now, the one issue that I have concern with is the quality of staff necessary to do it.  If you're going to rely on supervision as opposed to regulation, you need quality of staff.  And that becomes a matter of payment, how much you pay people.

At the New York Fed, when I was first vice president, my biggest challenge was how do I keep someone five years instead of three, how do I keep him seven years instead of five, how much good work can I throw at them, and how much money can I pay them within constraints, knowing that the private sector is much greater.

And I can list all the people who left who didn't want to leave but left because they bought a home or they had kids who wanted to go to college.

But I think part of this is a realization that those that do this work need to be paid not the private-sector level, not what they're paid today.  There's got to be something there that will keep them there.  That, (plus high ?) income, will keep them there if they have quality.

If we don't do that, then you get what you pay for, and we just continually don't expect the public sector then to be able to address the issues in the private sector and stop them, because they're not capable of doing it.  (I'll stop ?) with that.

GAPPER:  Okay.  Well, let's just take a step back there.  I mean, it seems to me, from some of what we've talked about this morning, that this situation is hopeless, and it's hopeless in two ways.  One is, we have an extraordinarily complex system of regulation in the U.S., never mind internationally, with a lot of internal political rivalries.  So it's going to be extremely hard to shift anything in that arena.  And I'd like to come on to the specifics on that.

But before we do, I'd like -- the other area in which it appears to be hopeless is, we had Fed regulators who clearly didn't quite know what was going on.  But on the other hand in the private sector, managers clearly didn't know exactly what was going on, that the, that the much more highly paid risk managers in the private sector, who Ernie has talked about, clearly didn't have a full grasp of the risks those organizations were taking.

So I'd just like to examine that issue for a second.  How can we move to a system where we don't just inevitably have a period of excess, where there are risks taken within private sector institutions that the institution itself does not understand what it's doing, never mind the regulators?  Or are we always just going to be stuck in that cycle?

DONALDSON:  Let me try that one.

We spoke about staff being well paid.  I would say that the structural organization, of how the staff is organized, is equally important with the quality of the staff.  Again you take an institution like the SEC.  It's been organized along stovepipe lines forever; very little cross-fertilization between the different departments, if you will.  And that results in a lot of regulatory harassment, I suspect, coming out into the marketplace itself because of a lack of coordination inside, likewise underorganized, and what I would call risk management from a regulator's point of view.

One of the buzzwords at the SEC when I was there was that we've got to figure out how to look over the hill and around the corner and anticipate some of the things that are going to happen here, as opposed to arriving at the scene of the accident after it happened.  And that has to do with a risk management function within an organization like the SEC that attempts to anticipate and also attempts to educate, if you will, based on anticipation, on seeing something coming over the hill; instead of waiting till it happens and slapping somebody hard, getting out there and trying to prevent it from happening.

FRIEDMAN:  To the amazement of many, so many organizations that were highly respected have managed to implode, doing things dramatically against their interest.

I think when you look at organizations, most things are explainable in terms of three things: the quality of the people, the quality of the culture and, to some extent, the strategy which is in many ways the least important.

I think when you look at organizations that are good in terms of risk management, I think, culturally there is a sense that the people in the trading desk have a partnership mentality.  They are working for the firm.  Their interests are aligned.

Alignment is a crucial, is a crucial concept.  And that means their job is to be elevating, to their boss's level, areas that they think are getting excessively risky.  Like the classic example is the mortgage area well before it became -- obviously was in deep trouble.

When you look at organizations that have problems, you'll see, you'll see the opposite cultural artifact.  You'll see, trading desk very often appears to be playing for their own bonuses.  And you'll get a sense that the news flows upstairs to the chairman's office in a very, very tardy kind of a way.

The awareness of the risks, despite stacks of reports, are slow.  It's almost as if they're gaming the system.  I think that, I think, another culturally thing is, are the risk managers, are they as highly talented, as well paid?

Do they have as much clout and prestige in the firm as risk takers?  A sign of impending crisis is always when the risk managers are perceived as somehow subordinate in terms of prestige and authority to the risk takers.  And certainly it's a potential (death ?) when they have some reporting relationship to the risk takers.

So, culturally firms have to rethink.  Some have been quite effective, but many have not.  I think the category of people -- you know, the financial system is a little bit like an expansion baseball league; there aren't that many 300 hitters to go around.  And with 8,000 hedge funds siphoning off talent, a firm is going to have to basically say the defensive capacity is incredibly important to our survival and our business, and that's where we're going to put a lot of talents in.

Culturally I'll say this.  I think there was a huge follow-the-leader kind of an impulse.  Someone was doing well in a certain area, and other people decided to pile into it; if it was working for them, it should work for us.  But what happens is these kind of follow-the-leader impulses always bring the seeds of destruction because an area gets over-bought.  You get these giant, crowded (frays ?) that you can't get out of.

And here is a very crucial point.  At the end of the day, boards of directors who are supposed to be asking tough questions are not adequately educated to ask them.  Very few boards of directors would determine how much to pay the chief executive officer without having it expertised by some independent consultant firm, mostly to cover their own rear ends.  Well, unless they have extremely good risk managers -- and some firms do -- who are presenting to them and giving them a lot of confidence, why aren't they reaching outside for consultants who can help them ask the tough questions?  It's not necessarily that management is consciously deceiving them.  They're probably not.  Management is capable of making mistakes.

And here is -- and I'll close on this.  A friend of mine who is a retired four-star admiral has a rule -- he calls it Ellis's rule -- that amateurs, he said, study the plan; the professionals study the assumptions.  If you look at where people went astray, they had these intricate, complicated models, but the underlying assumptions they put in weren't adequately challenged by the boards of directors and senior management.

If you plug in the assumptions -- for instance, that housing prices are going to continue going up -- well, at the end of the day the model will grind out results that don't give you adequate warning.  A strange irony of our present situation is that risk management for people in the year 2010 or 2011 will be a lot more effective, for a number of reasons.  One, we've backed into the hot stove, but the second reason is, senior management will now no longer have to argue about what dire assumptions to plug into the -- to plug into the plans.  We're living it.

GAPPER:  I'd just like to ask, since we have -- I wouldn't say we've got representatives of the Fed and the SEC here, but we have people with knowledge of those institutions.  In some ways, it seems like the Fed -- and correct me if I'm wrong -- has had a good war, in the sense that it's done a lot of decisive things, and it's powers seem to be, if anything, expanding; and in some ways it seems like the SEC has had a bad war, in that it's got blamed for a lot of stuff and it's got somewhat shunted to the sidelines while the Treasury and the Fed have been stomping around doing things.  Bill, what's your perspective on the future of the Fed and the SEC and their sort of relative weight and functions for the new system?

DONALDSON:  Well, I think a couple of things.  Number one is that the Federal Reserve is a prudential regulator.  And what that means historically is the Fed has gone into the banking system, examined it.  If it finds things wrong, it corrects those things behind the scenes, but its total focus is on the system working and not being broken down by malfeasance on the part of a single bank.

The SEC's mission is totally different.  The SEC is investor protection, and it basically does that by disclosure, by assuring that accounting is clean and assuring that everything that's going on in the company is exposed to the investing public.

And I think as we move ahead what I'm fearful of and -- is that because of what's happened in the last couple of years, the role of investor protection is going to be diminished.  Much of the suggestion that has come out of -- frankly, out of -- in reaction to Sarbanes-Oxley and trying to push that regulatory pendulum back -- many of the suggestions on how this whole thing should be organized diminishes the possible role of an independent agency for investor protection.

The total suggestion has been that the CFTC and the SEC be merged together; but you look at some of these plans, and it's a diminished entity, if you will.  And I must say that during my career in -- for too many years -- the SEC has been the most respected agency in the federal government.  It is constantly getting kudos for being independent, non-political -- not loved, but honest and dispassionate.

I think that reputation has been severely damaged in the last couple of years.  And I hope when the reorganization comes about, it will not be just to make the markets work more effectively, or not to make it easier for corporate America or financial America to run their business, but that this dimension of protection will be thought of as we reorganize.

Ernie?

PATRIKIS:  Well, I think the SEC fell down in the prudential supervision of broker-dealers.  It's not the nature of the agency.  It's a great enforcement agency.  It does a great job on disclosure, on fraud, market manipulation, all of those issues.  That should continue.  And if it's with the CFTC, which does market manipulation, that, to me, all -- all make sense.

I remember Commissioner Atkins saying (in 2007 ?) the SEC did fewer enforcement actions because the examination staff had come up with all of these remedial actions that should be taken that went to the enforcement staff, and they spent all their time doing it.  That told me that the examination staff wasn't spending time on prudential supervision.  It was regarded as the feeder for enforcement.

In bank supervision, it's the other way around.  The major effort is on prudential supervision of the institution, financial integrity of the institution.  C-A-M-E-L-S:  capital, earnings, management, effort -- management, earnings, liquidity, sensitivity -- CAMELS, very easy, very simple.  That's what bank examiners do.  So I would strip from the SEC the prudential supervision, at least of major organizations -- (inaudible) -- 25 or 50, saying they're just not up to it.  And I think that the Fed is up to it.

As to the Fed's role, we set monetary policy aside, and I think the Fed, once it figured out there was gridlock in the market, took a little time.  When the European Central Bank did the first study of liquidity, I said to myself:  Gee, look at them.  They're trying to show how great they are, et cetera.  How showboat.

And then the Fed a little while later followed.  And I now say:  By God, they had it right.  They got it right first time.  They saw it.  They understood it.

And I think it took too long for us to realize that the wholesale financial markets had just totally freezed up.  And I wish we had been a little faster on that.  So I don't give the Fed on "A" on that.  Once the Fed got on it, I give the Fed an "A" in terms of doing everything it can.  The only thing left is helicopters flying over the city, dropping currency out.  (Laughter.)  There's limits of how much currency they can drop.  It's much easier to credit banks' accounts.

In supervision, the Fed is that good.  And the people are that good.  One reason for it is all of these Ph.D. economists.  When I was there, there was a least 90 of them.  I don't know if there's more or not.  And some of those would go over to the supervisory side.

And that just brings a lot of brainpower and other insight and people who do believe in -- I don't call it the free market.  I call it the somewhat free market.  I mean, in my lifetime, there hasn't been a free market.  We need to maintain that somewhat free market, and economists are the only ones who really believe in it.  I mean, businessmen don't want a free market.  They want a monopoly.  (Laughter.)  And they bring something to the table that is really worthwhile.  And so for the reason, it has -- it has done well.

A lot of the banks in trouble; the Fed doesn't really supervise major banks.  We have an issue of -- do we need this animal called a bank-holding company?  Do we need a separation of banking and commerce?  What should banks be able to invest in?  Who should be able to invest in banks?  I take a very broad view of that.  I would open up that we can invest in banks.  We have so many limitations on who the bank can lend -- what affiliates it can lend to, that sole control, that the potentials for abuse are really rather small.  So I'm not as concerned about that.  But on the whole the Fed, I think, has done a great job.

Last thought:  Internationally, if we're talking about that, I'd hate to see an international supervisor making rules for the United States and the rest of the world.  A department of supervisors committee works.  That's the G-10, which we know is 11, and their invitees.

I would change that group.  I would have some major country -- I'd make it more like the Security Council, some permanent members and rotating members so that China and India could become real members.  And they come up with expanded minimum rules, which I think are doable.  And each nation can enact them and add to it and make them harsher.  That works.  It has to be a relatively small group.  A very, very large group is not as effective.  IOSCO is okay, but nowhere as near as effective as the Basel supervisors.  And that should continue.

Colleges:  I read the G-20 report, which I thought was, I mean, so much better than the usual G-7 report.  It actually had meat on it, had timetables on it.  That -- for an institution, I can see a college of supervisors getting together.  But there's a competitive issue.  Some -- if you learn too much -- you know, some supervisors in some countries have closer relationships to their organizations than we do in the United States.  And sometimes it doesn't take long for those -- that information, which can be competitively harmful information get out.  But there's something to that.

I attended -- final thought -- the last meeting of the college of BCCI.  And I watched them.  I didn't do it; they did it.  Look -- that was, I didn't not do it; they did not do it, in terms of who is responsible for supervising BCCI.  Needs to be one supervisor, one institution, home country, whatever that is, and for them to do it well, and then coordination with others.

I have not heard of any problems in international cooperation and supervision in the credit crisis.  I've not seen anything in any country.  I mean, I hope we don't have a problem there to solve that isn't there.

GAPPER:  Okay.  Well, we've got a lot of topics there.  And clearly, it would take more than an hour to cover them all.  But we're going to squeeze ourselves in anyway.

I'd just like to, at this point, open the meeting up to questions from the floor.  And please wait for the microphone, speak into it.  Can you just say who you are and your affiliation, if you have one?  And could you just limit yourself to one question -- and by question, I mean a short sentence with a question mark at the end -- (laughter) -- so we can get as many people as possible in?

Yeah?

QUESTIONER:  Good morning.  I'm Mark Levinson.  I'm with JPMorgan Chase.  A lot of the financing done by banks and insurance companies these days is done with so-called hybrid securities, which the regulators have strongly encouraged.  These, for folks who don't know, have differing levels of subordination.  So supposedly, you have a differing chance of getting paid out in the event of failure and therefore get a different interest rate at each level.

It seems that when institutions are too big to fail, hybrid securities don't work anymore and everybody gets paid out.  Does that make any sense?  Does this kind of funding structure make any sense if the owners of all sorts of hybrid securities get treated equally?

DONALDSON:  Well, I think we are victims of so-called hybrid securities, derivatives, the infamous default swap securities and so forth.  And I think it brings into question just how we go about regulating.  You know, should there be a Food and Drug Administration approach to toxic instruments?  Should there -- should certain sorts of instruments be outlawed?

And I'm not -- that's a very controversial area, particularly in a free-market arena such as we have in this country.  But I think when we start to look at this reorganization of the regulatory mechanism, we've got to go at it with a total clean slate and forget about the way we've been regulating before and think about something as radical as the outlawing of a toxic instrument.

And that is not to say that some of these instruments don't have a purpose.  But some of them are pretty fancy.  The people that designed them really don't understand them.  And they tend to blow up.

GAPPER:  Well, that's an interesting point.  Is it simply a question of sort of leverage within the system, or is it -- (inaudible) -- inherently toxic things?

PATRIKIS:  Well, I hate the word "toxic" when I -- when I hear it.  I mean, the issue to me is is it credit-impaired instrument, market-value-impaired instrument?  Market-value-impaired instrument has to do with this crash.  There's value there.  I'd hold on to the damn thing.  At maturity, I'm going to get my money back if I have enough capital.  That's the issue.  That's long-term capital management.  That's the banking system.  That's AIG.

Bank clients -- (inaudible) -- who bought the triple-A tranches of certain instruments thought they were buying great instruments.  They didn't think enough about it.

The issue goes to, really, the buy side, the investors.  Do they understand what they're buying?  The other guy will sell anything he can sell.  They'll manufacture it.  Should I buy it, if I'm a state pension fund, or I'm whatever?  That -- I think we haven't heard enough criticism of the buy side.  I mean, these people have a responsibility -- it's fiduciary for many of them -- to ensure that they understand the products.

Should -- I don't believe in -- too much in product regulation.  I believe in fraud and dealing with fraud.  I don't think credit default swaps should be regulated.  I think the instruments did fairly well, considering everything.  I think management and supervision failed, not -- the instrument didn't fail.  The instrument did fairly well.  So I approach it from that way.

FRIEDMAN:  Yeah, I agree with Bill that everything needs to be on the table.  I would be very, very uncomfortable with bureaucrats determining which products can be used in the financial system and which not.  I mean, one of the positives of our system is we do have a great deal of creativity, and that -- we don't want to lose that.

I do think, though, that it would be totally appropriate for -- look, the same instrument in my hands may be dangerous because I have too much of it and I have too much leverage there.  In Bill's hands it may be very prudential because he is using it to hedge some other exposure.  And I just don't think the regulatory system is capable of wisely dealing with that.

I think it may be capable of saying:  Let's run those stress tests, and let's run them on the following assumptions.  For instance, in the insurance world, which is not the ultimate paradigm, but they might say:  If -- you're going to write this much and if you want to keep your rating at this level -- and they're the de facto regulators, the rating agencies -- you have to establish for us that after a one-in-a-hundred-years storm plus a one-in-250-year earthquake, you're still up and in good shape to write business.

I mean, here are the assumptions.  Here is the pros looking at the assumptions.  And you want to have that security in your books, fine.  Prove to us that you can survive a debacle.

Now the other point that the gentleman raised was the "too big to fail."  When this whole thing started, I had the utopian and -- view that the ultimate goal of the new regulatory system ought to be to make sure that no one was too big or so intertwined that we couldn't let them go under.  I mean, that's a pretty good way to concentrate people's minds:  You won't be bailed out.

Unfortunately, the necessities of the crisis have meant we've moved in the other way and we've made people bigger and less able to fail.  I do think that there are some things, like credit derivative swaps being on a clearinghouse and other things, that need to be done so we are able to -- there are fewer and fewer institutions who are too big to fail or too intertwined to be allowed to fail.

GAPPER:  Okay.

DONALDSON:  Yeah, let me just add one thing to what Steve was saying, which is that I remember back a number of years ago when there -- and I think it was in the mid-'80s -- there was a thing called portfolio insurance, dynamic hedging.  And I can remember sitting on the board of a company where the staff came up and suggested that we engage in this.

And it depends upon there being a market there.  And one of the directors said:  Well, what happens if you can't dynamic-hedge, if a market's going down and you can't lay this product off?  That's not going to happen.

Well, it did happen.  The over-the-counter dealers in 1987 didn't answer their telephones.  Now, who would have thought of that?  What Ph.D. in economics would have thought that a segment of the market was not going to answer the telephones in a down draft in the market and therefore make dynamic hedging not work?

GAPPER:  Okay.  I'm going to go there.  Yeah.

QUESTIONER:  Stanley Arkin.  Ernie, you mentioned supervision, regulation.  You mentioned AIG.  Steve mentioned populism, maybe intensified.  Is there any role for criminal prosecution in the regulation of the markets?

PATRIKIS:  Oh, there certainly is the case of fraud.  In the case of organizations, I can't say too little about Eliot Spitzer and his threats.  And you know, to me, I've always believed that in dealing with attorney generals like that, the SEC and times at the Fed, that this is not the United States, this is not a democracy.  The issue for any major corporation is, how much do I have to pay to get out of this picture?  You can't fight.  You're not permitted to fight.

If you want to fight, they'll say, "Well, we'll indict the company."  And that's just plain wrong.  That's un-American.

But for individuals, I certainly do believe there are people who should get extended vacations, courtesy of the government, when they violate laws.  There certainly is a need for that.

FRIEDMAN:  I think there ought to be law that said anyone who is a prosecutor has to have a -- two-, three- -- you pick it -- -year waiting period before he can run for higher office.  (Laughter.)

GAPPER:  Okay.  Another question?  There.

By the way, I should say that unlike the financial markets at the moment, we've got an excess of demand and not supply in matters of time, so I'm going to -- (inaudible).

QUESTIONER:  I'm Kenneth Bialkin.  I -- we've had a perfect storm.  No one performed what they should have done.  There was a dereliction of duty at every level, whether it's in the left or the right.

But there's one area that has gotten occasional notice and goes nowhere, and that is the accounting rule by which banks and financial institutions are obliged to strip their earnings and strip their capital, mark their assets to some notional market, depleting their surplus and coming up with massive losses, all of which is the result of an accounting convention introduced in 2006 called fair value.

I wondered if you could, among the many issues that went wrong, talk about the failures of the accounting regulators -- standard regulators, the supervisory regulators, including the SEC and the Fed, as to how they let the banks get into a situation where they had to report themselves essentially being bankrupt by having to make believe there was an asset in your portfolio that if you had to sell it and you couldn't sell it, therefore you should mark it down.  I wondered if you could focus on that.  Steve might want --

DONALDSON:  You bring up an entire Pandora's box of accounting in this country.  I think that it's clear to say that we have very confused accounting rules who have become more and more obfuscated as we try and cover everything, rule after rule after rule.  There's an attitude of precision in accounting that just isn't there.  There's judgment in terms of reserving for losses, et cetera, et cetera.

It's not a precise profession, if you will.  And efforts to talk about rules versus principles-based accounting starts to get into this arena.  I believe that we need to move toward an international accounting system with some consistency to it.  And we're starting to move toward that.

Unfortunately, that movement is going to be interrupted, I believe, by the mess we're in now.  It was moving pretty rapidly, and I think it's going to be interrupted.  But we need to come down on a better way of doing accounting and recognizing the imprecision of it.

FRIEDMAN:  Can I make a comment?

GAPPER:  Yeah.

FRIEDMAN:  Kenny, I want to express my strenuous disagreement with the premise of your question.  First of all, there is no -- there is no accounting system that is remotely close to perfect.  They all -- it's like Churchill saying about democracies:  each of them is like the worst of all systems, except for anything else mankind has tried.  You know, at least fair value is.

But the alternative is banks essentially carrying something at approaching cost, and over time making a judgment:  Well, I do or don't think this is impaired.  And that, you'll remember, after Enron, was called Enron-style accounting because it was -- I think Warren Buffett's phrase -- marked to (miss ?).  And there was a substantial amount of -- there's a substantial amount of room there for self delusion as to what things are worth.

Fair value basically says it's worth what I can sell it for.  And I'm going to grant you, there's a big problem when markets freeze up.  But what fair value does is, it's like -- it gives management an early warning system.  It makes sure those lines of communication from the trading desk to the chairman's office are not blocked up by wishful thinking:  I'd like to believe this will happen, and besides, I'll get my bonus if this happens.  It's a discipline.  It's like the patient in the -- is constantly strapped to the sensors as to what's going on.

Once you get to a crisis where people are not answering their phone and you have illiquidity, none of these systems work.  And there's got to be -- in the famous level three assets, there has to be more judgment.  But I would be very nervous if we took away the warning systems.

The chairman of the Financial Accounting Standards Board, when someone made the argument you made, basically said:  Well, we have a public policy interest that we would like to have consumers out there spending, so my modest proposal -- said he, ironically -- is we'll instruct every brokerage firm, when they send you your brokerage statement, let's put in the prices for back in last June.  This will be much more cheering and won't lead to the declines in your net worth, and you'll go out and spend.  And you know, it's rumored that if he was forced to go move away from fair value, he'd retire.

He made that as a semi-joke.  Turns out, the Europeans basically said -- and some of their major banks took advantage of it -- why don't you go back and market that -- mark that to where it was on June 1st?

Now, try to imagine, if you're trying to raise money from an outside capital source, are they really going to come in and look at your numbers marked at June 1st and say, "We'll make our capital injection based on that fantasy"?  Of course not.  They're going to try to figure out what it's worth today.  So right there you're in the stage of having two sets of books:  one for Joe Public, who's buying your stock, and the other for the Mideastern sovereign wealth fund that's injecting money.

GAPPER:  Okay.  We'll try and get a couple more questions.  Yeah.

By the way, I always had a soft spot for the old German private banking accounting, where they didn't have fair value; they declared their results on the basis of what they thought their assets were worth.  And then they had hidden reserves, as well; so you really didn't know.

QUESTIONER:  I'd like to find those hidden reserves.

This is Lauren Mullen from Bank of America.  And I wanted to note that Donaldson had mentioned earlier in his talk about the impact of the Gramm-Leach-Bliley Act and how that had somehow broken down some of the barriers between the banking and the securities acts for what the banks could do, but the agencies had not really kept up; and also noted a little bit about the investor protection mandate at the SEC.

And I wondered as he was talking about that if perhaps the mandate of the SEC needs to really be expanded to focus more on a global market protection; given that the impact of the crisis we're facing now, being that it's a market-wide impact, is having much larger impact on investors than the individual order-by-order, trade-by-trade, investor-by-investor protection would have.

What regulatory changes -- what are maybe the three biggest regulatory changes that you see we need to get through this crisis?

GAPPER:  Okay.  Well, let's ask the panel; three quick regulatory changes.

DONALDSON:   Well, clearly, and most immediately, I think we need to plug the hole of mortgage lending that has somehow -- that's been unregulated.

Secondly, I think we need to plug the hole of derivative responsibility, if you will.  The fallout from Gramm-Leach-Bliley was to take derivatives and make them under the jurisdiction of no one.  The CFTC has no jurisdiction, the SEC has no jurisdiction, the Federal Reserve has no jurisdiction.  That's why we got in the trouble we've gotten in.  So we're going to have to plug that hole.

I could go on and on about the holes that need to be plugged.  What agencies should do that is another question.  And that's why I think we need to relook at the whole thing.

FRIEDMAN:  Figure out how to deal with hedge funds.  There's thousands of them.  There'll be a lot fewer thousands by the end of the year, but there's thousands of them.  Figure out how to deal with them through their prime brokers or the banks that lend them.  But you're right, I don't think it would be possible to get in there to each of them.

Finalize the plans for credit derivative swaps being dealt with on clearinghouses, and setting up margin product goals.  And rationalizing this weird overlap of regulatory agencies and get it into something approaching fighting trim.

GAPPER:  Okay.  Ernie?

PATRIKIS:  Don't blame Gramm-Leach-Bliley.  Bank of America was able to make an acquisition overnight because of Gramm-Leach-Bliley.  JP Morgan/Chase was able to do it.  Morgan Stanley and Goldman Sachs were able to convert their bank holding companies overnight because of it.  We're very lucky that we had Gramm-Leach-Bliley.

All Gramm-Leach-Bliley did was level the playing field so that investment banks could do what commercial banking organizations could do.  None of them did it, though, because they're afraid of the Fed and the Bank Holding Company Act.

And they bit the bullet.  And then the question is, did they bite the bullet because of access to the window, or did they bite the bullet also because it's coming under the Fed umbrella, because internationally doing business --

GAPPER:  If that's good, what's the bad?

PATRIKIS:  Well, it's the umbrella supervisor, which -- (inaudible) -- requires, and (abroad ?) I think the Fed has more credibility in terms of supervision for it.  So I look at Gramm-Leach-Bliley and say we're very fortunate we had it in place.

GAPPER:  Okay.  Yes.  Okay.

QUESTIONER:  John Beattie (sp), from UBS.

There's been a lot of press recently on the need to regulate or better regulate the securities markets, primarily from the issuer's perspective, as opposed to focusing on the investor's perspective, which I think is a point you mentioned.  By way of example, there has been -- there's been a lot of -- despite qualitative disclosure on the risks of investing in complex products, large financial institutions nevertheless went ahead and invested, and lost lots of money.

In order to make regulation more effective from the perspective of disclosure, is there likely to be discussion on bolstering qualitative disclosure with more quantitative risk disclosure, particularly for complex products?

PATRIKIS:  I think that's pillar three of Basel II, which is disclosure.  If we believe in the market and the market as a governor, then we'll need more disclosure.  There was a program that started maybe 10 years ago in that direction, but it died, I think, because of opposition from various aspects of the financial industry.  I think we'll see that start up again.

But there is the other issue.  If you've ever read a prospectus for a plain old one- to four-family mortgage-securitized transaction, it's mind-boggling, and you really don't learn anything.  So the issue has to be the effectiveness of disclosure.  All the things I've wanted to read aren't in that prospectus, in terms of what the servicer can do and what the trustee does and all of those.  So a little rethink is needed.  Just disclosure in itself doesn't do it.  Quality disclosure.

GAPPER:  Okay.  Anyone else on the disclosure?  All right.

Okay.  This is going to be the last question.  Sir.  That gentleman there, yes.

QUESTIONER:  Hi.  I'm Andrew Rice, from Portfolio, Conde Nast Portfolio.

I have a question for Mr. Friedman.  You mentioned the congressional role, and Barney Frank has announced that he's going to take up the question of regulation in the -- early in the next Congress in a very muscular way.  And I was wondering, I mean, is that something that you're apprehensive about, or what is your attitude towards those plans?

DONALDSON:  Well, I --

FRIEDMAN:  Yes --

DONALDSON:  Oh, go on.  Go on.

FRIEDMAN:  Yeah, I am apprehensive, not because I disagree that we need muscular regulation, but because I don't think that -- and so I applaud his desire to do it.  I just think the groundwork has to be -- this is a very complex effort, and I think the groundwork needs to be set with very serious, dispassionate studies before that work is done.

Partly, it will involve some tricky political questions, but it'll also involve a lot of international questions.  And I just think a template needs to be set that they can then accept or reject, but use as a -- at least a polar setting.

GAPPER:  Okay.

DONALDSON:  I just say that I totally agree with Steve.  I think that one of the big dangers now is that we -- well, after the turn of the year, we leap into a political discussion in Congress in terms of doing a remake that needs to be done.

I think we need to have a totally dispassionate, non-political, independent group think this thing through.  Now, they can give the results of what they do to Congress and let them play around with it, if they will, politically.  But in terms of that deliberative body coming up with the sophisticated tradeoffs that are needed in a political environment, I think that's going to be very tough.

GAPPER:  Okay.  I'm going to say that I think the moderator only has one important duty, which is to end the meeting on time.  So I'm going to do that.  And I'm going to thank our panel for a fascinating discussion.

DONALDSON:  Thank you.

(Applause.)

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THIS IS A RUSH TRANSCRIPT.

New York City, New York

JOHN GAPPER:  Welcome, everybody.  I'd just like to welcome everybody.  This meeting we're having this morning is part of the McKinsey Executive Roundtable Series in International Economics.

I'd just like to remind everybody to turn off their cell phones, BlackBerrys, iPhones, whatever, because apparently they interfere with the sound system.  So please do turn them off.  And I'd just like to remind everybody this meeting is on the record.

I'm John Gapper with the Financial Times.  And we're privileged, actually, this morning to have a distinguished panel to discuss the issue of financial market regulation.

I think it's safe to say that we're actually at a historic moment.  We don't exactly know what history will say about this moment, but we do know that it will at least record it and say that it was a turning point of some kind, both in the financial sector generally and in regulation, particularly.

And to discuss that topic this morning we have with us Bill Donaldson, former chairman of the SEC, as well as co-founder of Donaldson, Lufkin & Jenrette.  And beside him, Steve Friedman, the former chairman of Goldman Sachs and also chairman of the National Economic Council, the job to which Larry Summers was appointed by President-elect Obama yesterday.  And next to him, Ernie Patrikis, a partner in White & Case, former number two at the New York Fed, and who also worked for a time with Hank Greenberg at AIG.  So you can see that we've got a panel that knows a great deal about both the public sector and the private sector in finance.

And I'd just like to start, actually, by asking Steve Friedman a question.  Everyone says now, given the extraordinary events we've been seeing, that we clearly need more regulation.  Do we need more regulation?

STEPHEN FRIEDMAN:  Well, I wouldn't phrase it as more, because it's an interesting irony that some of the parts of the system that blew up the earliest and really set off the conflagration were intensely regulated.  I would say we certainly need more effective regulation.  I think it would be very, very hard to make a spirited defense for the regulatory system that existed before.

I think it's now become accepted wisdom that the U.S. has a hodgepodge of regulatory structures set up that were not designed for the 21st century.  Indeed, they were -- it was some form of congressional logrolling, giving everyone something that they wanted, and it's remarkably inefficient, and it allows things to fall between the slats.  There just isn't adequate talent to go around unless you concentrate your fire more effectively.

So we need a totally rethought regulatory system in this country.  I think there's a myth that capital-markets people, of whom I am one, and a lot of people in the audience are from that, basically think that the free markets are so perfect that they will be intricate self-regulating mechanisms.

Just -- everyone in this room looks old enough to remember the events of the last 25 years.  Go back to the Latin American debt crisis, the real estate crisis and the bank crisis of the late '80s and the early '90s, Long-Term Capital, the dot-com bubble, the Asian debt crisis, and the current, which is by far the worst.  And I've probably left some out.

We have a financial system that in many ways is bipolar.  It seems to range between heights of speculative euphoria and then depths of panicky despair and the drying-up of liquidity and (co-relations ?), gravitating towards one.

And you know, that -- you don't have to be a great historian to know that's been the pattern over many, many, many centuries.  You can go back to tulip bulbs and South Sea bubbles and the railroad bust-ups in the 19th century.  So it seems to be something endemic in human nature.

And we need a regulatory system that, without taking the risk-taking and creative genius of the system out of it, substantially moderates the highs and the lows.  It needs to be completely rethought.

The last thing I would say is, it is a frightening thought to me that Congress, without immense preparation, would try to take on that job, trying to do it in a period where there would be thoughts of retribution and punishments and populism.

You know, the -- people have talked a lot about the Bretton Woods conference.  It took several years of intense study before that conference, preparation by technicians, before the movers and shakers were able to move.  And I think it would be very well advised for some kind of blue-ribbon bipartisan group to be appointed by the new president -- incoming president and Congress to study this, let a little bit of time pass and establish a template.

GAPPER:  Will Donaldson?

WILLIAM H. DONALDSON:  Yeah, I don't think it's a question of more regulation.  I think it's a question of more effective regulation.  As Steve intimated, if you go back to 1929 and the early 30s, the formation of the SEC, the Securities Acts of '33 and '34, Glass-Steagall to separate investment banking from banking, all of these regulatory -- regulations, regulatory agencies were set up in 1930.

You fast-forward, present time, the Gramm-Leach-Bliley law threw out Glass-Steagall and allowed everybody to get into everybody else's business.  And yet the regulatory organizations were organized -- the Federal Reserve to give prudent -- prudential regulation to the banking system, the SEC to be the policeman, if you will, the -- basically the investors' protector.  And what we need to do, I believe, is to totally rethink these regulatory agencies and to totally rethink what their responsibilities are going to be.

Once we get that job done, we are not an island unto ourselves here in the United States.  We're dealing on a global basis and we're going to have to figure out how we can mesh a new, more effective regulatory system with the other parts of the world.  And everybody's totally familiar with how pervasive global investing has been and how impossible it is to simply get our own house in order unless the rest of the world's house is in order.

And for those of you who've wrestled with this -- I know Steve and I have -- in terms of attempting to get the independent nations of this world to agree, regulation is almost impossible.  There's totally different ideas on what is good regulation.  There are totally different ideas on what is good accounting.  There are all sorts of ways of going about this.

I think we have pretty good enforcement regulation right now with other jurisdictions.  There's pretty good rules and regulations with agencies comparable to the SEC, sharing information on real wrongdoers.  But as far as the rules of the road, we've got a long way to go.

ERNEST T. PATRIKIS:  There's supervision; there's regulation.  They're not the same thing.  Supervision is qualitative; regulation is on-off, good-bad, yes-no.  I'm a believer in supervisor, coming out of the bank supervisory world.  It requires talented examiners to go into institutions and examine them.  The bank supervisors do that with varying skills.

So many federal agencies involved in bank supervision.  Fifty state agencies do bank supervision; 50 insurance state agencies.  Federal level, the SEC -- not too much involved on a -- (inaudible word) -- state level, a check for attorneys general.

The greatest impediment to all of this?  Congress.  Agricultural Committee has responsibility for futures.  They want to give it up to a committee?  And that has been an absolute difficulty for us.  And maybe next year -- the second half of next year, we'll start to deal with that situation.

Structurally, I look at the industries.  What we -- we're too close to it right now to appreciate what had happened -- the large number of non-banking organizations becoming bank-holding companies under the Fed's umbrella.

And that's significant.  It changes leverage.  There's a leverage ratio.  And I think it will take us a while to sort it out.  We haven't really seen them restructure.  You know, is there going to be a massive movement of assets from non-banking parts of those organizations into the bank, where those will really be megabanks?

In the long run -- I can start with the long run and work back -- I believe in universal banks.  There should be a charter.  You should be able to do whatever -- our competitors around the world, except Japan, which lags us in terms of following us, have universal banks.  The bank can decide what it wants to do.  You can be a consumer bank.  You can be an investment bank.  You can be an everything bank.  It's up to management to decide that.

Working back from that, there are difficulties with a number of agencies.  I'll go back to the short term.  People say:  Oh, CC -- Comptroller of the Currency, Office of Thrift Supervision.  Move them both together.

The Office of Thrift Supervision supervised AIG.  Now that means that it would have looked at AIG financial products.  Must have been a great job that they did.

Once we can get step one done, and if there are other parts of it, I believe the Fed should end up with 25, 35, 50 of the largest (systemic prone ?) organizations -- commercial banks, investment banks, hedge funds, private funds, whatever -- and every year, every three years, that list change, and they come in under the Fed's prudential supervision.

And we are perhaps the greatest principles-over-rules nation.  I hear all the time that the FSA in London is the -- you know, has the best rules.  Well, they have rules.  They have nine rules.  If you can't find the answer in the 10,000-page rule book, you go to the nine rules.

In bank supervision, unsafe, unsound banking practice -- New York banking law turn of the last -- last century -- all the bank examiner has to say is, "This is an unsafe, unsound practice.  Stop it."  You don't stop it, you get spanked.  That's the best rule that there is.

What's unsafe and unsound?  I know what it is.  You know what it is.

Now, the one issue that I have concern with is the quality of staff necessary to do it.  If you're going to rely on supervision as opposed to regulation, you need quality of staff.  And that becomes a matter of payment, how much you pay people.

At the New York Fed, when I was first vice president, my biggest challenge was how do I keep someone five years instead of three, how do I keep him seven years instead of five, how much good work can I throw at them, and how much money can I pay them within constraints, knowing that the private sector is much greater.

And I can list all the people who left who didn't want to leave but left because they bought a home or they had kids who wanted to go to college.

But I think part of this is a realization that those that do this work need to be paid not the private-sector level, not what they're paid today.  There's got to be something there that will keep them there.  That, (plus high ?) income, will keep them there if they have quality.

If we don't do that, then you get what you pay for, and we just continually don't expect the public sector then to be able to address the issues in the private sector and stop them, because they're not capable of doing it.  (I'll stop ?) with that.

GAPPER:  Okay.  Well, let's just take a step back there.  I mean, it seems to me, from some of what we've talked about this morning, that this situation is hopeless, and it's hopeless in two ways.  One is, we have an extraordinarily complex system of regulation in the U.S., never mind internationally, with a lot of internal political rivalries.  So it's going to be extremely hard to shift anything in that arena.  And I'd like to come on to the specifics on that.

But before we do, I'd like -- the other area in which it appears to be hopeless is, we had Fed regulators who clearly didn't quite know what was going on.  But on the other hand in the private sector, managers clearly didn't know exactly what was going on, that the, that the much more highly paid risk managers in the private sector, who Ernie has talked about, clearly didn't have a full grasp of the risks those organizations were taking.

So I'd just like to examine that issue for a second.  How can we move to a system where we don't just inevitably have a period of excess, where there are risks taken within private sector institutions that the institution itself does not understand what it's doing, never mind the regulators?  Or are we always just going to be stuck in that cycle?

DONALDSON:  Let me try that one.

We spoke about staff being well paid.  I would say that the structural organization, of how the staff is organized, is equally important with the quality of the staff.  Again you take an institution like the SEC.  It's been organized along stovepipe lines forever; very little cross-fertilization between the different departments, if you will.  And that results in a lot of regulatory harassment, I suspect, coming out into the marketplace itself because of a lack of coordination inside, likewise underorganized, and what I would call risk management from a regulator's point of view.

One of the buzzwords at the SEC when I was there was that we've got to figure out how to look over the hill and around the corner and anticipate some of the things that are going to happen here, as opposed to arriving at the scene of the accident after it happened.  And that has to do with a risk management function within an organization like the SEC that attempts to anticipate and also attempts to educate, if you will, based on anticipation, on seeing something coming over the hill; instead of waiting till it happens and slapping somebody hard, getting out there and trying to prevent it from happening.

FRIEDMAN:  To the amazement of many, so many organizations that were highly respected have managed to implode, doing things dramatically against their interest.

I think when you look at organizations, most things are explainable in terms of three things: the quality of the people, the quality of the culture and, to some extent, the strategy which is in many ways the least important.

I think when you look at organizations that are good in terms of risk management, I think, culturally there is a sense that the people in the trading desk have a partnership mentality.  They are working for the firm.  Their interests are aligned.

Alignment is a crucial, is a crucial concept.  And that means their job is to be elevating, to their boss's level, areas that they think are getting excessively risky.  Like the classic example is the mortgage area well before it became -- obviously was in deep trouble.

When you look at organizations that have problems, you'll see, you'll see the opposite cultural artifact.  You'll see, trading desk very often appears to be playing for their own bonuses.  And you'll get a sense that the news flows upstairs to the chairman's office in a very, very tardy kind of a way.

The awareness of the risks, despite stacks of reports, are slow.  It's almost as if they're gaming the system.  I think that, I think, another culturally thing is, are the risk managers, are they as highly talented, as well paid?

Do they have as much clout and prestige in the firm as risk takers?  A sign of impending crisis is always when the risk managers are perceived as somehow subordinate in terms of prestige and authority to the risk takers.  And certainly it's a potential (death ?) when they have some reporting relationship to the risk takers.

So, culturally firms have to rethink.  Some have been quite effective, but many have not.  I think the category of people -- you know, the financial system is a little bit like an expansion baseball league; there aren't that many 300 hitters to go around.  And with 8,000 hedge funds siphoning off talent, a firm is going to have to basically say the defensive capacity is incredibly important to our survival and our business, and that's where we're going to put a lot of talents in.

Culturally I'll say this.  I think there was a huge follow-the-leader kind of an impulse.  Someone was doing well in a certain area, and other people decided to pile into it; if it was working for them, it should work for us.  But what happens is these kind of follow-the-leader impulses always bring the seeds of destruction because an area gets over-bought.  You get these giant, crowded (frays ?) that you can't get out of.

And here is a very crucial point.  At the end of the day, boards of directors who are supposed to be asking tough questions are not adequately educated to ask them.  Very few boards of directors would determine how much to pay the chief executive officer without having it expertised by some independent consultant firm, mostly to cover their own rear ends.  Well, unless they have extremely good risk managers -- and some firms do -- who are presenting to them and giving them a lot of confidence, why aren't they reaching outside for consultants who can help them ask the tough questions?  It's not necessarily that management is consciously deceiving them.  They're probably not.  Management is capable of making mistakes.

And here is -- and I'll close on this.  A friend of mine who is a retired four-star admiral has a rule -- he calls it Ellis's rule -- that amateurs, he said, study the plan; the professionals study the assumptions.  If you look at where people went astray, they had these intricate, complicated models, but the underlying assumptions they put in weren't adequately challenged by the boards of directors and senior management.

If you plug in the assumptions -- for instance, that housing prices are going to continue going up -- well, at the end of the day the model will grind out results that don't give you adequate warning.  A strange irony of our present situation is that risk management for people in the year 2010 or 2011 will be a lot more effective, for a number of reasons.  One, we've backed into the hot stove, but the second reason is, senior management will now no longer have to argue about what dire assumptions to plug into the -- to plug into the plans.  We're living it.

GAPPER:  I'd just like to ask, since we have -- I wouldn't say we've got representatives of the Fed and the SEC here, but we have people with knowledge of those institutions.  In some ways, it seems like the Fed -- and correct me if I'm wrong -- has had a good war, in the sense that it's done a lot of decisive things, and it's powers seem to be, if anything, expanding; and in some ways it seems like the SEC has had a bad war, in that it's got blamed for a lot of stuff and it's got somewhat shunted to the sidelines while the Treasury and the Fed have been stomping around doing things.  Bill, what's your perspective on the future of the Fed and the SEC and their sort of relative weight and functions for the new system?

DONALDSON:  Well, I think a couple of things.  Number one is that the Federal Reserve is a prudential regulator.  And what that means historically is the Fed has gone into the banking system, examined it.  If it finds things wrong, it corrects those things behind the scenes, but its total focus is on the system working and not being broken down by malfeasance on the part of a single bank.

The SEC's mission is totally different.  The SEC is investor protection, and it basically does that by disclosure, by assuring that accounting is clean and assuring that everything that's going on in the company is exposed to the investing public.

And I think as we move ahead what I'm fearful of and -- is that because of what's happened in the last couple of years, the role of investor protection is going to be diminished.  Much of the suggestion that has come out of -- frankly, out of -- in reaction to Sarbanes-Oxley and trying to push that regulatory pendulum back -- many of the suggestions on how this whole thing should be organized diminishes the possible role of an independent agency for investor protection.

The total suggestion has been that the CFTC and the SEC be merged together; but you look at some of these plans, and it's a diminished entity, if you will.  And I must say that during my career in -- for too many years -- the SEC has been the most respected agency in the federal government.  It is constantly getting kudos for being independent, non-political -- not loved, but honest and dispassionate.

I think that reputation has been severely damaged in the last couple of years.  And I hope when the reorganization comes about, it will not be just to make the markets work more effectively, or not to make it easier for corporate America or financial America to run their business, but that this dimension of protection will be thought of as we reorganize.

Ernie?

PATRIKIS:  Well, I think the SEC fell down in the prudential supervision of broker-dealers.  It's not the nature of the agency.  It's a great enforcement agency.  It does a great job on disclosure, on fraud, market manipulation, all of those issues.  That should continue.  And if it's with the CFTC, which does market manipulation, that, to me, all -- all make sense.

I remember Commissioner Atkins saying (in 2007 ?) the SEC did fewer enforcement actions because the examination staff had come up with all of these remedial actions that should be taken that went to the enforcement staff, and they spent all their time doing it.  That told me that the examination staff wasn't spending time on prudential supervision.  It was regarded as the feeder for enforcement.

In bank supervision, it's the other way around.  The major effort is on prudential supervision of the institution, financial integrity of the institution.  C-A-M-E-L-S:  capital, earnings, management, effort -- management, earnings, liquidity, sensitivity -- CAMELS, very easy, very simple.  That's what bank examiners do.  So I would strip from the SEC the prudential supervision, at least of major organizations -- (inaudible) -- 25 or 50, saying they're just not up to it.  And I think that the Fed is up to it.

As to the Fed's role, we set monetary policy aside, and I think the Fed, once it figured out there was gridlock in the market, took a little time.  When the European Central Bank did the first study of liquidity, I said to myself:  Gee, look at them.  They're trying to show how great they are, et cetera.  How showboat.

And then the Fed a little while later followed.  And I now say:  By God, they had it right.  They got it right first time.  They saw it.  They understood it.

And I think it took too long for us to realize that the wholesale financial markets had just totally freezed up.  And I wish we had been a little faster on that.  So I don't give the Fed on "A" on that.  Once the Fed got on it, I give the Fed an "A" in terms of doing everything it can.  The only thing left is helicopters flying over the city, dropping currency out.  (Laughter.)  There's limits of how much currency they can drop.  It's much easier to credit banks' accounts.

In supervision, the Fed is that good.  And the people are that good.  One reason for it is all of these Ph.D. economists.  When I was there, there was a least 90 of them.  I don't know if there's more or not.  And some of those would go over to the supervisory side.

And that just brings a lot of brainpower and other insight and people who do believe in -- I don't call it the free market.  I call it the somewhat free market.  I mean, in my lifetime, there hasn't been a free market.  We need to maintain that somewhat free market, and economists are the only ones who really believe in it.  I mean, businessmen don't want a free market.  They want a monopoly.  (Laughter.)  And they bring something to the table that is really worthwhile.  And so for the reason, it has -- it has done well.

A lot of the banks in trouble; the Fed doesn't really supervise major banks.  We have an issue of -- do we need this animal called a bank-holding company?  Do we need a separation of banking and commerce?  What should banks be able to invest in?  Who should be able to invest in banks?  I take a very broad view of that.  I would open up that we can invest in banks.  We have so many limitations on who the bank can lend -- what affiliates it can lend to, that sole control, that the potentials for abuse are really rather small.  So I'm not as concerned about that.  But on the whole the Fed, I think, has done a great job.

Last thought:  Internationally, if we're talking about that, I'd hate to see an international supervisor making rules for the United States and the rest of the world.  A department of supervisors committee works.  That's the G-10, which we know is 11, and their invitees.

I would change that group.  I would have some major country -- I'd make it more like the Security Council, some permanent members and rotating members so that China and India could become real members.  And they come up with expanded minimum rules, which I think are doable.  And each nation can enact them and add to it and make them harsher.  That works.  It has to be a relatively small group.  A very, very large group is not as effective.  IOSCO is okay, but nowhere as near as effective as the Basel supervisors.  And that should continue.

Colleges:  I read the G-20 report, which I thought was, I mean, so much better than the usual G-7 report.  It actually had meat on it, had timetables on it.  That -- for an institution, I can see a college of supervisors getting together.  But there's a competitive issue.  Some -- if you learn too much -- you know, some supervisors in some countries have closer relationships to their organizations than we do in the United States.  And sometimes it doesn't take long for those -- that information, which can be competitively harmful information get out.  But there's something to that.

I attended -- final thought -- the last meeting of the college of BCCI.  And I watched them.  I didn't do it; they did it.  Look -- that was, I didn't not do it; they did not do it, in terms of who is responsible for supervising BCCI.  Needs to be one supervisor, one institution, home country, whatever that is, and for them to do it well, and then coordination with others.

I have not heard of any problems in international cooperation and supervision in the credit crisis.  I've not seen anything in any country.  I mean, I hope we don't have a problem there to solve that isn't there.

GAPPER:  Okay.  Well, we've got a lot of topics there.  And clearly, it would take more than an hour to cover them all.  But we're going to squeeze ourselves in anyway.

I'd just like to, at this point, open the meeting up to questions from the floor.  And please wait for the microphone, speak into it.  Can you just say who you are and your affiliation, if you have one?  And could you just limit yourself to one question -- and by question, I mean a short sentence with a question mark at the end -- (laughter) -- so we can get as many people as possible in?

Yeah?

QUESTIONER:  Good morning.  I'm Mark Levinson.  I'm with JPMorgan Chase.  A lot of the financing done by banks and insurance companies these days is done with so-called hybrid securities, which the regulators have strongly encouraged.  These, for folks who don't know, have differing levels of subordination.  So supposedly, you have a differing chance of getting paid out in the event of failure and therefore get a different interest rate at each level.

It seems that when institutions are too big to fail, hybrid securities don't work anymore and everybody gets paid out.  Does that make any sense?  Does this kind of funding structure make any sense if the owners of all sorts of hybrid securities get treated equally?

DONALDSON:  Well, I think we are victims of so-called hybrid securities, derivatives, the infamous default swap securities and so forth.  And I think it brings into question just how we go about regulating.  You know, should there be a Food and Drug Administration approach to toxic instruments?  Should there -- should certain sorts of instruments be outlawed?

And I'm not -- that's a very controversial area, particularly in a free-market arena such as we have in this country.  But I think when we start to look at this reorganization of the regulatory mechanism, we've got to go at it with a total clean slate and forget about the way we've been regulating before and think about something as radical as the outlawing of a toxic instrument.

And that is not to say that some of these instruments don't have a purpose.  But some of them are pretty fancy.  The people that designed them really don't understand them.  And they tend to blow up.

GAPPER:  Well, that's an interesting point.  Is it simply a question of sort of leverage within the system, or is it -- (inaudible) -- inherently toxic things?

PATRIKIS:  Well, I hate the word "toxic" when I -- when I hear it.  I mean, the issue to me is is it credit-impaired instrument, market-value-impaired instrument?  Market-value-impaired instrument has to do with this crash.  There's value there.  I'd hold on to the damn thing.  At maturity, I'm going to get my money back if I have enough capital.  That's the issue.  That's long-term capital management.  That's the banking system.  That's AIG.

Bank clients -- (inaudible) -- who bought the triple-A tranches of certain instruments thought they were buying great instruments.  They didn't think enough about it.

The issue goes to, really, the buy side, the investors.  Do they understand what they're buying?  The other guy will sell anything he can sell.  They'll manufacture it.  Should I buy it, if I'm a state pension fund, or I'm whatever?  That -- I think we haven't heard enough criticism of the buy side.  I mean, these people have a responsibility -- it's fiduciary for many of them -- to ensure that they understand the products.

Should -- I don't believe in -- too much in product regulation.  I believe in fraud and dealing with fraud.  I don't think credit default swaps should be regulated.  I think the instruments did fairly well, considering everything.  I think management and supervision failed, not -- the instrument didn't fail.  The instrument did fairly well.  So I approach it from that way.

FRIEDMAN:  Yeah, I agree with Bill that everything needs to be on the table.  I would be very, very uncomfortable with bureaucrats determining which products can be used in the financial system and which not.  I mean, one of the positives of our system is we do have a great deal of creativity, and that -- we don't want to lose that.

I do think, though, that it would be totally appropriate for -- look, the same instrument in my hands may be dangerous because I have too much of it and I have too much leverage there.  In Bill's hands it may be very prudential because he is using it to hedge some other exposure.  And I just don't think the regulatory system is capable of wisely dealing with that.

I think it may be capable of saying:  Let's run those stress tests, and let's run them on the following assumptions.  For instance, in the insurance world, which is not the ultimate paradigm, but they might say:  If -- you're going to write this much and if you want to keep your rating at this level -- and they're the de facto regulators, the rating agencies -- you have to establish for us that after a one-in-a-hundred-years storm plus a one-in-250-year earthquake, you're still up and in good shape to write business.

I mean, here are the assumptions.  Here is the pros looking at the assumptions.  And you want to have that security in your books, fine.  Prove to us that you can survive a debacle.

Now the other point that the gentleman raised was the "too big to fail."  When this whole thing started, I had the utopian and -- view that the ultimate goal of the new regulatory system ought to be to make sure that no one was too big or so intertwined that we couldn't let them go under.  I mean, that's a pretty good way to concentrate people's minds:  You won't be bailed out.

Unfortunately, the necessities of the crisis have meant we've moved in the other way and we've made people bigger and less able to fail.  I do think that there are some things, like credit derivative swaps being on a clearinghouse and other things, that need to be done so we are able to -- there are fewer and fewer institutions who are too big to fail or too intertwined to be allowed to fail.

GAPPER:  Okay.

DONALDSON:  Yeah, let me just add one thing to what Steve was saying, which is that I remember back a number of years ago when there -- and I think it was in the mid-'80s -- there was a thing called portfolio insurance, dynamic hedging.  And I can remember sitting on the board of a company where the staff came up and suggested that we engage in this.

And it depends upon there being a market there.  And one of the directors said:  Well, what happens if you can't dynamic-hedge, if a market's going down and you can't lay this product off?  That's not going to happen.

Well, it did happen.  The over-the-counter dealers in 1987 didn't answer their telephones.  Now, who would have thought of that?  What Ph.D. in economics would have thought that a segment of the market was not going to answer the telephones in a down draft in the market and therefore make dynamic hedging not work?

GAPPER:  Okay.  I'm going to go there.  Yeah.

QUESTIONER:  Stanley Arkin.  Ernie, you mentioned supervision, regulation.  You mentioned AIG.  Steve mentioned populism, maybe intensified.  Is there any role for criminal prosecution in the regulation of the markets?

PATRIKIS:  Oh, there certainly is the case of fraud.  In the case of organizations, I can't say too little about Eliot Spitzer and his threats.  And you know, to me, I've always believed that in dealing with attorney generals like that, the SEC and times at the Fed, that this is not the United States, this is not a democracy.  The issue for any major corporation is, how much do I have to pay to get out of this picture?  You can't fight.  You're not permitted to fight.

If you want to fight, they'll say, "Well, we'll indict the company."  And that's just plain wrong.  That's un-American.

But for individuals, I certainly do believe there are people who should get extended vacations, courtesy of the government, when they violate laws.  There certainly is a need for that.

FRIEDMAN:  I think there ought to be law that said anyone who is a prosecutor has to have a -- two-, three- -- you pick it -- -year waiting period before he can run for higher office.  (Laughter.)

GAPPER:  Okay.  Another question?  There.

By the way, I should say that unlike the financial markets at the moment, we've got an excess of demand and not supply in matters of time, so I'm going to -- (inaudible).

QUESTIONER:  I'm Kenneth Bialkin.  I -- we've had a perfect storm.  No one performed what they should have done.  There was a dereliction of duty at every level, whether it's in the left or the right.

But there's one area that has gotten occasional notice and goes nowhere, and that is the accounting rule by which banks and financial institutions are obliged to strip their earnings and strip their capital, mark their assets to some notional market, depleting their surplus and coming up with massive losses, all of which is the result of an accounting convention introduced in 2006 called fair value.

I wondered if you could, among the many issues that went wrong, talk about the failures of the accounting regulators -- standard regulators, the supervisory regulators, including the SEC and the Fed, as to how they let the banks get into a situation where they had to report themselves essentially being bankrupt by having to make believe there was an asset in your portfolio that if you had to sell it and you couldn't sell it, therefore you should mark it down.  I wondered if you could focus on that.  Steve might want --

DONALDSON:  You bring up an entire Pandora's box of accounting in this country.  I think that it's clear to say that we have very confused accounting rules who have become more and more obfuscated as we try and cover everything, rule after rule after rule.  There's an attitude of precision in accounting that just isn't there.  There's judgment in terms of reserving for losses, et cetera, et cetera.

It's not a precise profession, if you will.  And efforts to talk about rules versus principles-based accounting starts to get into this arena.  I believe that we need to move toward an international accounting system with some consistency to it.  And we're starting to move toward that.

Unfortunately, that movement is going to be interrupted, I believe, by the mess we're in now.  It was moving pretty rapidly, and I think it's going to be interrupted.  But we need to come down on a better way of doing accounting and recognizing the imprecision of it.

FRIEDMAN:  Can I make a comment?

GAPPER:  Yeah.

FRIEDMAN:  Kenny, I want to express my strenuous disagreement with the premise of your question.  First of all, there is no -- there is no accounting system that is remotely close to perfect.  They all -- it's like Churchill saying about democracies:  each of them is like the worst of all systems, except for anything else mankind has tried.  You know, at least fair value is.

But the alternative is banks essentially carrying something at approaching cost, and over time making a judgment:  Well, I do or don't think this is impaired.  And that, you'll remember, after Enron, was called Enron-style accounting because it was -- I think Warren Buffett's phrase -- marked to (miss ?).  And there was a substantial amount of -- there's a substantial amount of room there for self delusion as to what things are worth.

Fair value basically says it's worth what I can sell it for.  And I'm going to grant you, there's a big problem when markets freeze up.  But what fair value does is, it's like -- it gives management an early warning system.  It makes sure those lines of communication from the trading desk to the chairman's office are not blocked up by wishful thinking:  I'd like to believe this will happen, and besides, I'll get my bonus if this happens.  It's a discipline.  It's like the patient in the -- is constantly strapped to the sensors as to what's going on.

Once you get to a crisis where people are not answering their phone and you have illiquidity, none of these systems work.  And there's got to be -- in the famous level three assets, there has to be more judgment.  But I would be very nervous if we took away the warning systems.

The chairman of the Financial Accounting Standards Board, when someone made the argument you made, basically said:  Well, we have a public policy interest that we would like to have consumers out there spending, so my modest proposal -- said he, ironically -- is we'll instruct every brokerage firm, when they send you your brokerage statement, let's put in the prices for back in last June.  This will be much more cheering and won't lead to the declines in your net worth, and you'll go out and spend.  And you know, it's rumored that if he was forced to go move away from fair value, he'd retire.

He made that as a semi-joke.  Turns out, the Europeans basically said -- and some of their major banks took advantage of it -- why don't you go back and market that -- mark that to where it was on June 1st?

Now, try to imagine, if you're trying to raise money from an outside capital source, are they really going to come in and look at your numbers marked at June 1st and say, "We'll make our capital injection based on that fantasy"?  Of course not.  They're going to try to figure out what it's worth today.  So right there you're in the stage of having two sets of books:  one for Joe Public, who's buying your stock, and the other for the Mideastern sovereign wealth fund that's injecting money.

GAPPER:  Okay.  We'll try and get a couple more questions.  Yeah.

By the way, I always had a soft spot for the old German private banking accounting, where they didn't have fair value; they declared their results on the basis of what they thought their assets were worth.  And then they had hidden reserves, as well; so you really didn't know.

QUESTIONER:  I'd like to find those hidden reserves.

This is Lauren Mullen from Bank of America.  And I wanted to note that Donaldson had mentioned earlier in his talk about the impact of the Gramm-Leach-Bliley Act and how that had somehow broken down some of the barriers between the banking and the securities acts for what the banks could do, but the agencies had not really kept up; and also noted a little bit about the investor protection mandate at the SEC.

And I wondered as he was talking about that if perhaps the mandate of the SEC needs to really be expanded to focus more on a global market protection; given that the impact of the crisis we're facing now, being that it's a market-wide impact, is having much larger impact on investors than the individual order-by-order, trade-by-trade, investor-by-investor protection would have.

What regulatory changes -- what are maybe the three biggest regulatory changes that you see we need to get through this crisis?

GAPPER:  Okay.  Well, let's ask the panel; three quick regulatory changes.

DONALDSON:   Well, clearly, and most immediately, I think we need to plug the hole of mortgage lending that has somehow -- that's been unregulated.

Secondly, I think we need to plug the hole of derivative responsibility, if you will.  The fallout from Gramm-Leach-Bliley was to take derivatives and make them under the jurisdiction of no one.  The CFTC has no jurisdiction, the SEC has no jurisdiction, the Federal Reserve has no jurisdiction.  That's why we got in the trouble we've gotten in.  So we're going to have to plug that hole.

I could go on and on about the holes that need to be plugged.  What agencies should do that is another question.  And that's why I think we need to relook at the whole thing.

FRIEDMAN:  Figure out how to deal with hedge funds.  There's thousands of them.  There'll be a lot fewer thousands by the end of the year, but there's thousands of them.  Figure out how to deal with them through their prime brokers or the banks that lend them.  But you're right, I don't think it would be possible to get in there to each of them.

Finalize the plans for credit derivative swaps being dealt with on clearinghouses, and setting up margin product goals.  And rationalizing this weird overlap of regulatory agencies and get it into something approaching fighting trim.

GAPPER:  Okay.  Ernie?

PATRIKIS:  Don't blame Gramm-Leach-Bliley.  Bank of America was able to make an acquisition overnight because of Gramm-Leach-Bliley.  JP Morgan/Chase was able to do it.  Morgan Stanley and Goldman Sachs were able to convert their bank holding companies overnight because of it.  We're very lucky that we had Gramm-Leach-Bliley.

All Gramm-Leach-Bliley did was level the playing field so that investment banks could do what commercial banking organizations could do.  None of them did it, though, because they're afraid of the Fed and the Bank Holding Company Act.

And they bit the bullet.  And then the question is, did they bite the bullet because of access to the window, or did they bite the bullet also because it's coming under the Fed umbrella, because internationally doing business --

GAPPER:  If that's good, what's the bad?

PATRIKIS:  Well, it's the umbrella supervisor, which -- (inaudible) -- requires, and (abroad ?) I think the Fed has more credibility in terms of supervision for it.  So I look at Gramm-Leach-Bliley and say we're very fortunate we had it in place.

GAPPER:  Okay.  Yes.  Okay.

QUESTIONER:  John Beattie (sp), from UBS.

There's been a lot of press recently on the need to regulate or better regulate the securities markets, primarily from the issuer's perspective, as opposed to focusing on the investor's perspective, which I think is a point you mentioned.  By way of example, there has been -- there's been a lot of -- despite qualitative disclosure on the risks of investing in complex products, large financial institutions nevertheless went ahead and invested, and lost lots of money.

In order to make regulation more effective from the perspective of disclosure, is there likely to be discussion on bolstering qualitative disclosure with more quantitative risk disclosure, particularly for complex products?

PATRIKIS:  I think that's pillar three of Basel II, which is disclosure.  If we believe in the market and the market as a governor, then we'll need more disclosure.  There was a program that started maybe 10 years ago in that direction, but it died, I think, because of opposition from various aspects of the financial industry.  I think we'll see that start up again.

But there is the other issue.  If you've ever read a prospectus for a plain old one- to four-family mortgage-securitized transaction, it's mind-boggling, and you really don't learn anything.  So the issue has to be the effectiveness of disclosure.  All the things I've wanted to read aren't in that prospectus, in terms of what the servicer can do and what the trustee does and all of those.  So a little rethink is needed.  Just disclosure in itself doesn't do it.  Quality disclosure.

GAPPER:  Okay.  Anyone else on the disclosure?  All right.

Okay.  This is going to be the last question.  Sir.  That gentleman there, yes.

QUESTIONER:  Hi.  I'm Andrew Rice, from Portfolio, Conde Nast Portfolio.

I have a question for Mr. Friedman.  You mentioned the congressional role, and Barney Frank has announced that he's going to take up the question of regulation in the -- early in the next Congress in a very muscular way.  And I was wondering, I mean, is that something that you're apprehensive about, or what is your attitude towards those plans?

DONALDSON:  Well, I --

FRIEDMAN:  Yes --

DONALDSON:  Oh, go on.  Go on.

FRIEDMAN:  Yeah, I am apprehensive, not because I disagree that we need muscular regulation, but because I don't think that -- and so I applaud his desire to do it.  I just think the groundwork has to be -- this is a very complex effort, and I think the groundwork needs to be set with very serious, dispassionate studies before that work is done.

Partly, it will involve some tricky political questions, but it'll also involve a lot of international questions.  And I just think a template needs to be set that they can then accept or reject, but use as a -- at least a polar setting.

GAPPER:  Okay.

DONALDSON:  I just say that I totally agree with Steve.  I think that one of the big dangers now is that we -- well, after the turn of the year, we leap into a political discussion in Congress in terms of doing a remake that needs to be done.

I think we need to have a totally dispassionate, non-political, independent group think this thing through.  Now, they can give the results of what they do to Congress and let them play around with it, if they will, politically.  But in terms of that deliberative body coming up with the sophisticated tradeoffs that are needed in a political environment, I think that's going to be very tough.

GAPPER:  Okay.  I'm going to say that I think the moderator only has one important duty, which is to end the meeting on time.  So I'm going to do that.  And I'm going to thank our panel for a fascinating discussion.

DONALDSON:  Thank you.

(Applause.)

.STX

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