Nicholas F. Brady, the investment banker who directed a study of last October's stock market collapse for President Reagan, warned Congress yesterday that the market could collapse again unless swift action is taken to reform some of its rules and practices.
Brady told members of the Senate Banking Committee that Congress should pressure the securities industry to adopt immediate reforms and needs to be ready to overhaul stock market regulation through legislation.
"We must act to prevent a reoccurrence of the events of October," said Brady, who runs Dillon, Read & Co. "We are looking down the barrel, and the gun is still loaded."
Shortly after Brady testified, the Securities and Exchange Commission released a 2 1/4-inch-thick study of the October market collapse. Its primary conclusion was that steps need to be taken to diminish volatility -- violent swings in prices.
Brady reiterated his view that the Federal Reserve Board's authority over the nation's financial markets should be expanded on key issues, including trading halts and minimum financial requirements, or margins, for investors.
But Federal Reserve Board Chairman Alan Greenspan, who testified later yesterday, disagreed, saying that if the Fed had that responsibility, it be viewed as the federal "safety net" for any securities firm that gets in trouble.
Committee Chairman William Proxmire (D-Wis.) responded to Brady's call for quick action by proposing a March 3 deadline for government agencies to report to Congress on progress in adopting reforms. But other members of the committee warned against hasty action.
Several members of the committee, led by Sens. Jake Garn (R-Utah) and Alfonse D'Amato (R-N.Y.), said Congress should study the market collapse thoroughly and move slowly. Garn said great care should be taken to avoid burdensome regulation that could encourage investors to shift their trading from U.S. to foreign markets.
Congress, Garn said, should consider the issues "carefully before deciding what action, if any, needs to be taken." Sen. Christopher Bond (R-Mo.) added that there is "no reason to rush to judgment."
Brady urged Congress to give the securities industry no more than six months to come up with a package of reforms that addresses concerns raised in his study. He said Congress should find a way to draft legislation that would take effect in the event the major stock exchanges and other securities industry regulators have not made substantial progress.
But the sharp division over what, if any, action to take is likely to slow adoption of major congressional reforms, especially in this election year. Significant opposition to certain key recommendations in the Brady study also has complicated the process.
Brady's fundamental conclusion was that the stock, options and futures markets have become so closely linked that they should be regulated on key "intermarket" issues by one regulatory body, the Federal Reserve.
In the current regulatory framework, the SEC regulates stock and options trading, the Commodity Futures Trading Commission regulates futures trading, and various exchanges have powers that Brady would strip and vest in the Fed.
Brady said the failure to set similar financial standards for investors in the stock, options and futures markets and the failure of regulators to closely coordinate trading halts and other actions contributed to the 508-point drop in the Dow Jones industrial average on Oct. 19. He said that if his recommendations had been in place last year, the stock market would have neither risen nor fallen so dramatically.
Brady also urged adoption of other reforms, such as a single system to process trading in stock, options and futures that reflect the premise that the various markets should be regulated as if they were one. He said steps by individual exchanges since October failed to address the need for coordinated policy.
"Without proper safeguards, a drop of the severity and speed of October can certainly happen again, with even more far-reaching consequences," Brady said. Because the October collapse was caused by only a handful of large institutional investors who used computer-directed trading strategies involving stocks, options and futures contracts, there is an urgent need for action to avert another market disaster, Brady said.
But Brady's recommendation that the Federal Reserve serve as the overall regulator of the nation's financial markets ran into strong opposition, not only from Greenspan but from some members of Congress as well.
If the Fed, which oversees the nation's banking system and has a reputation for saving large, failing banks, also were viewed as a lender of last resort to Wall Street, it could encourage additional risk-taking and speculation.
Greenspan suggested merging the related functions of the SEC and CFTC, or having the Fed or Treasury Department participate in a joint oversight with representatives of those two agencies.
Greenspan also opposed Brady's recommendation that the Fed set up an information-gathering system that would compile details about every trade in the stock, options and futures markets. Although Brady said that much of the information is already gathered but is not kept in one place, Greenspan said gathering the data would represent an invasion of privacy and might discourage foreign investors from investing in U.S. securities markets.
D'Amato said he opposed giving the Fed additional authority over the financial markets because "this is the agency that said everything is hunky-dory with our foreign loans." Major banks regulated by the Fed recently have reported massive losses from foreign loans.
Greenspan said the October stock market collapse did not have any long-term negative impact on the nation's banking system. "History teaches us that stock market declines that do not adversely affect the banking system have a much less serious effect on the overall economy than ones that do," he said.
Greenspan made these other points:
Portfolio insurance, a hedging device used by large institutional investors, exacerbated the stock market's plunge but worked so badly that "the pressures they could put on a future market contraction would be much diminished."
Index arbitrage, a computer-based "program trading" strategy involving stocks and futures, added to "confusion and doubt" in the markets because of breakdowns in the process. However, in normal times, Greenspan said, index arbitrage serves to keep prices of stocks and stock index futures in line with each other.
Circuit breakers -- so-called because, as suggested by Brady, they would limit the price movement of stocks, options or futures -- are not a good idea but may be necessary. Greenspan said such measures were "destabilizing" but "they may be the least bad of all the solutions."