The Securities and Exchange Commission spotted weaknesses at the large investment banks it supervised and employed “escalation procedures” to address them, according to Erik Sirri, director of the agency’s division of trading and markets. But, he added, “looking back, we probably should have done more.”

Sirri’s comments came at a Senate banking subcommittee hearing, where he sought to explain the failure of the SEC’s consolidated supervised entities (CSE) program. Abandoned in September, the voluntary CSE regime was started in 2004 to oversee Goldman Sachs, Merrill Lynch & Co., Morgan Stanley, Lehman Brothers and Bear Stearns--entities with large securities subsidiaries.

Calling the current turmoil “unprecedented,” Sirri said that the committee “has always recognized that capital is not synonymous with liquidity. The CSE program required stress-testing liquidity, but it did not anticipate the possibility that secured funding would become unavailable.”

At the March 18 hearing, Sen. Jack Reed, chairman of the securities, insurance and investment subcommittee, cited a new report from the Government Accountability Office (GAO) that says regulators failed to understand the magnitude of risk management weaknesses at firms they supervised. And problems they did discover were not effectively addressed, according to the GAO.

One lesson that has emerged from the debacle, said Sirri, is that there needs to be “a supervisory focus on the concentration of illiquid assets that must drill down on their relative quality. Any regulator must have the ability to get information about the holding company and other affiliates.”

“The whole point of the GAO report is that … suspicions about deficiencies in risk management did not produce a timely, ready response,” countered Reed, D-R.I., adding that “major regulatory reform is coming.”

Sirri said the SEC focused on financial and operational risk controls at the broker-dealer and holding company. “We were limited in part,” he said. “Firms would provide information,” but in terms of integrated enterprise risk management, that information “was not what it should be.”

“A trading firm does not take deposits,” noted Sirri. “Our thought was always, if you as a firm gave someone a T-bill, you would get funding. When firms got into trouble, other funding firms would not take Treasuries to fund, and that is something we had never seen before.” The lesson, he said, is that brokers can be affected by external entities. “You don’t hold derivatives in a broker-dealer,” he said. “Illiquid instruments imperil the broker-dealer.”

When asked by Reed about the cause of the run on the bank, Sirri responded: “In the case of the broker-dealer, it was funding through repo markets. The instruments suffered. Valuations became questionable. In a situation like that, people become wary about funding, and that causes a situation that can cause a run on the bank. Risks that pertained to something other than the broker-dealer were not our charge.”

However, there were tools available to the SEC, said Sirri. For example, he said, regarding a price verification group, the agency could ask how the valuations are struck. “Who validates the model?” he said. “How do you resolve disputes? Does the ‘after-action’ report go to the board of directors?”

Timothy Long, senior deputy comptroller in the Office of the Comptroller of the Currency, told the subcommittee that from 2004 to 2007, all the regulators became aware of the accumulation of risk. Still, he said, “we did not rein in the excesses driven by the markets. Looking horizontally across the system is something we all need to do.”

The concept of the regulators as “the last line of defense” may need to be revisited, suggested ranking subcommittee member Jim Bunning, R-Ky. “The system needs to be robust enough to handle the failure of individual firms--to take control and shut them down through some kind of orderly bankruptcy.”