Financial Regulatory Reform: The Failure to Address the Problem of Regulatory Capture

One of the real shortcomings of the financial regulatory reform bills passed by the House and the Senate is the lack of any effort to do something about the problem of “regulatory capture.”  As I have maintained, one of the contributing causes to the financial crisis was the failure of regulators to use their existing authority.  The standard explanation is that regulators, like most everyone else, did not see the crisis coming.  While the severity of the coming crisis was not seen by most people, it was obvious that some sort of shakeout was coming, since the rate of increase in the price of housing was unsustainable and subprime mortgages were recklessly being originated.  Also, there is the telling and oft-quoted remark of Charles Prince, the former head of Citigroup, in July 2007:  “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

One of the reasons for this failure of government regulators goes by the name of “regulatory capture.”  This concept is often invoked by conservatives opposed to the “regulatory state.”  For example, a recent editorial in the Wall Street Journal (subscription required) uses this concept to mock efforts to impose more regulation in either the finance or the oil drilling industries.  The editorialists at the Journal opine: “Perhaps if liberals read more conservative economists, they might understand that this is a common consequence of the regulatory state that they have so diligently constructed over the decades. It is also a main reason that many of us are skeptical of the regulatory solutions routinely offered in response to every accident or business failure.”

It is not only political conservatives though that think regulatory capture is a problem.  For example, the leftist historian Gabriel Kolko makes a similar point in his 1963 book about the progressive era at the beginning of the twentieth century.  The title of the book is The Triumph of Conservatism: A Reinterpretation of American History, 1900-1916.  More recently, Simon Johnson and James Kwak, in their book 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, discuss regulatory capture as a problem and make a favorable reference to George Stigler’s article advancing this concept published in 1971, “The Theory of Economic Regulation.” 

Moreover, not many would argue that financial institutions nor financial markets should be completely unregulated.  If regulatory capture is a problem, and it is, the answer is not that the government is just incompetent and, therefore, we should do nothing.  A more optimistic response is necessary; we need to tackle the problem.  The failure to do so is one of the great disappointments of the current regulatory effort.

Regulatory capture does not necessarily involve anything so blatant as offering regulatory staff bribes or job offers; the way it happens can be a lot more subtle than any horror stories one may hear about the Minerals Management Service.  It also does not mean that the regulator will always do what the regulated industry wants, especially when obvious problems develop.  It does mean that a regulatory agency is more sympathetic than appropriate to the industry it regulates and that this sympathy influences decisions.  What happens is that the staffs of regulators and of the regulated entities over time come to see many issues the same way.  Part of the reason for this is due to understandable social dynamics, and part of it is structural.

As for the social dynamics, regulators by necessity spend a lot of time talking to people they regulate.  It is of course not in the interest of the regulated to be nasty to the regulators nor is it usually in their interest to be blatantly misleading.   This is a continuing relationship, and trust has to be developed.  From the point of view of the regulators, if they want information about a new development or product, they naturally turn to the people they know in the regulated industry.  These people know their business and can answer questions.

Critics of the regulated industry may be listened to, but often they do not do their homework nor are as well versed as they should be in the details of the business of the regulated entities.  Whether or not a staffer at a regulatory agency personally sympathizes with critics, the errors the critics make and their sometimes tenuous command of the facts hurt their credibility.

Moreover, friendships naturally develop.  The people the regulators deal with are usually intelligent and can be personable, at least when they want to be.  Some staffers in government agencies may also be unduly impressed with the wealth and influence of top people at financial firms.  They forget the wisdom of the remark that Hemingway wrote in reaction to the observation that the rich are different from you and me: “Yes, they have more money.”

In addition, the political leadership of regulatory agencies often comes from the regulated industry or from law firms that have as clients regulated entities.  These people are usually very knowledgeable and competent, but they often bring a mindset that is similar to those in the regulated industry.  This is usually but not always the case; some political appointees may not have been happy about what they saw in the private sector.

There are no clear solutions about what to do about this sort of regulatory capture.  When it comes to pay, the premiums that staffs at financial regulatory agencies receive over others in the civil service (including, I might add, over staff at Main Treasury who get paid regular civil service salaries) is about as large as it can be.  In any case, the government cannot compete with the pay scales of the financial industry.  Where it can compete is by providing a good workplace, interesting work, good promotion possibility to enter into more responsible positions, and a sense of satisfaction which comes from working for the greater public good, as well as better job security.  Some government agencies pay attention to morale issues better than others; there are surveys done periodically about employee satisfaction at various government agencies.

However, trying to reduce employee turnover and increasing morale, while important, does not entirely get rid of the regulatory capture problem.  One can only hope that regulatory agency employees, while reliant on the regulated businesses for information, realize the self-interest of those who are providing information and are appropriately skeptical and analytical enough to ask the right questions.  One can also hope that the top managers at the regulatory agencies recognize the benefit of employees who do not always take what they are told at face value.

While the social dynamic issues are difficult to address, there are measures that could be taken to address regulatory capture stemming from the way the government is organized to regulate the financial sector.  The structural issue that contributes to regulatory capture is the fractionated financial regulatory system, which results in blurry jurisdictional lines and competition among the regulators.  The various sectors use their regulatory agencies to win favors for themselves and to disadvantage their competitors.  The agencies are more than happy to oblige since they want to increase their turf and their importance.

One example of this is the long fight that the futures exchanges waged against the OTC derivatives market.  Whatever one thinks about the substance of the issues or the correct interpretation of the relevant statutes, the futures exchanges saw the OTC derivatives market as competition and thus made the legal argument that swaps were subject to the CEA.  The CFTC took up their battle.  While undoubtedly there were other motivations, such as concerns about the danger of the OTC derivatives market, this was really a fight between the mostly New York banks and the Chicago futures exchanges.  Both sides could come up with policy justifications.  The futures exchanges would say that the banks were essentially like unregulated bucket shops.  The banks would say that products such as interest rate, foreign exchange, and oil swaps enabled their customers to manage their risks better and help them achieve lower financing costs by providing them customized products.  They would also point out that they gave business to the futures exchanges, which they used to hedge their net exposures in their swap books.  The bank regulators took up the banks’ cause in fighting the CFTC on this issue.  The OCC, after all, had, in response to a request from a bank, issued a letter in the last half of the 1980s that said that oil swaps are part of the business of banking and thus permitted under banking law.  In this fight, the Treasury sided with the bank regulators, as did the SEC, which regulated large broker-dealers with OTC derivative affiliates.

Some readers may think that the CFTC was right in this fight because of the problems that have materialized more recently with credit default swaps (“CDS”).  It is important to remember, though, that when these fights were raging at their most fierce, CDS’s either did not exist or were insignificant.  Moreover, the difficulties with CDS are partly due to the regulatory capture of the bank regulators, which, though focused on real back-office problems with these instruments, did nothing while risk was being concentrated at AIG, rather than being dispersed.

Another example of regulatory capture leading to fighting for the industry it regulates is the OCC’s preemption of state law.  The OCC has a clear conflict of interest, since it does not operate using appropriated funds but rather relies on fee income from national banks. The more banks that choose a national charter, the more money the OCC has to spend.  While the OCC’s fight for its right to preempt state law may have sound legal justification, one has to suspect that the OCC’s enthusiastic advocacy of this in the courts and elsewhere also has something to do with making the national charter as attractive as possible.  While the OCC staff does try to do a good job, they sometimes succumb to the temptation to be advocates for the banks they regulate.

The obvious solution to these types of turf issues, where the regulated use their regulators to help their business interests, is to consolidate the regulatory functions in fewer agencies.  At a minimum, the SEC and the CFTC should be merged, and the number of bank regulators should be reduced.

The bills before the conference committee do get rid of one agency, the Office of Thrift Supervision, by consolidating it with the OCC.  That is hardly enough.  The stumbling block has been the Fed, which fights hard to preserve its authority over state-chartered member banks.  The competition between the OCC and the Fed, though, is unhealthy.  The Fed argues that it needs to be involved in banking regulation because it gives them valuable information in conducting monetary policy.  Others could say that it might create a conflict of interest.  It is worth remarking that all the Federal Reserve Banks have bank examiners on their staffs.  These examiners are not government employees but employees of the Federal Reserve bank at which they work.  (As a legal matter, each Fed bank is a separately incorporated entity, whose stock is owned by the member banks in its district.  The stock pays a dividend, and while theoretically imparting ownership, it does not give the member banks control.)  Of course, if the Fed’s responsibilities for bank examination were curtailed or eliminated, the Fed’s bank examiners could become government employees of whatever agency assumed these functions.

Senator Dodd initially proposed stripping the Fed or its regulatory authority, but retreated.  The Fed is likely to gain authority under whatever passes.  Whatever the status of the Fed in banking regulation, though, a more serious effort at reform would aim at consolidation of regulatory functions, including not only the regulation of banks but of government-sponsored enterprises, such as Fannie Mae, Freddie Mac, the Federal Home Loan Banks, and the various farm credit institutions.  (One might also think about credit unions, though this does not seem to be a pressing issue.)

The creation of a new consumer financial protection agency, whether housed in the Fed or not, will probably engender more turf fights.  But if not much is going to be done about the fractionated regulatory structure, it is probably better to create an agency with an explicit mission to counterbalance the bank regulators for whom customer protection may not be their highest priority.

The failure to deal with the balkanization of the financial regulatory structure is a big disappointment.  Apparently, the Administration decided it was not politically feasible, and they  may well be right.  This failure, though, will encourage a greater degree of regulatory capture than otherwise and result in turf fights and policy disputes among the agencies.  While this may not be an immediate danger, there could also be a repeat of agencies doing too little as the conditions for a financial crisis accumulate.

Financial Regulatory Reform: AML/CFT and Economic Sanctions

One aspect of financial regulatory reform that has not spawned much discussion is the implications for the government’s anti-money laundering (“AML”) and combating the financing of terrorism programs and the various sanctions programs administered by the Treasury Department’s Office of Foreign Assets Control (“OFAC”).  However, I suspect that Treasury officials in OFAC, the Treasury’s Office of Terrorist Financing and Financial Crimes (“TFFC”), and the Financial Crimes Enforcement Network (“FinCEN,” a Treasury bureau) are studying the legislative proposals in order to see if there are ways they can piggyback their compliance programs on anything new coming out of the legislation.

For example, the requirement that effectively spreads SEC oversight to most of the hedge fund industry and other private pools of capital by amending the Investment Advisers Act will mean that TFFC, OFAC, and FinCEN will be able to ask the SEC to examine more entities for AML/CFT and OFAC sanction compliance.  It is not a new requirement that hedge funds are required to obey the applicable laws and regulations in this area, but they may have more scrutiny of the systems they have to ensure compliance.  The derivatives provisions may also result in more entities being require to register with the CFTC, the SEC, or both.

In the past decade the compliance programs in this area have taken more prominence because of the concern about terrorism and examples, such as Riggs Bank, of what can happen if there is a violation of the money laundering laws.

If not for government pressure, these programs would probably receive less attention at financial institutions than they currently do.  These programs in effect deputize financial institutions and others to assist in implementing law enforcement and foreign policy goals.  When it comes to financial crimes, money laundering, and terrorist financing, this is probably something that most people support in general, even if it does make back office operations somewhat less efficient.  There is, however, some doubt about how effective these measures are and whether FinCEN can adequately handle the data it receives given some notable problems it has had with contractors developing their systems.  

OFAC sanctions, which are technically separate from the money laundering laws but gets lumped together with them, also cause financial institutions operational headaches.  To cite a commonly mentioned example, the former President of Liberia, Charles Taylor, is on OFAC’s list of Specially Designated Nationals (“SDNs”).  Mr. Taylor most likely knows this since the list is public, and he probably arranged his financial affairs before his arrest in a way to avoid the U.S. banking system and that of any other countries that have similar programs.  However, if a bank is running an OFAC screening program, anyone with the name of Charles Taylor with whom the bank had not previously done business might be flagged in some way for verification the person was not the individual on the SDN list.

The biggest problem with OFAC sanctions though is the Cuba program, which does not have a lot of support in financial circles (nor in many other circles).  It is also unpopular in many foreign countries, some of which have laws prohibiting cooperating with the U.S. government on Cuban embargo matters.  This can easily result in a financial institution (or other global companies such as a hotel chain) in having to decide which countries’ laws to break, since it can be a logical impossibility to obey both countries’ laws at the same time.

The Cuban embargo has likely made other countries less enthusiastic to cooperate with OFAC, even though on many issues they may agree with what OFAC is doing, especially in the terrorism area.  OFAC of course knows that the Cuba program is unpopular, and they try to emphasize their programs aimed at terrorism and narcotics trafficking.   But they are faced with the obligation to administer the Cuban embargo.

AML/CFT issues are not currently getting same degree of public attention they once did when Riggs bank and others ran into trouble in this area, and the Obama Administration has a different Cuba policy than its predecessor.  Therefore, except for some hedge funds and, perhaps, derivative dealers and large derivative market participants, maybe not that much will happen in this area.  On the other hand, economic sanctions are not limited to Cuba and are not always unilateral as that one is.  New multilateral sanctions are definitely on the table.  Sanction programs, which have a mixed record, are attractive to policymakers wanting to do something more than making a diplomatic protest but less than going to war.  The financial regulatory reform legislation may, depending on how it turns out and the subsequent politics among agencies, provide the government a way to strengthen its AML/CFT and sanctions programs, though this may or may not be effective.

Word Games and the Foreign Exchange Market

French Prime Minister Francois Fillon learned a lesson yesterday about the importance of exactly how senior government officials word their comments about foreign exchange rates.  The French press quoted him as saying (in French): “Depuis des années, avec le président de la république, nous nous plaignons du fait que cette parité entre l'euro et le dollar ne correspond pas à la réalité de nos économies et handicape nos exportations. Je n'ai pas d'inquiétude quant à l'actuelle parité entre l'euro et le dollar.”

In context, the last sentence can only mean that he is not worried about the current exchange rate between the euro and the dollar.  But in English, the use of the word "parity" caused confusion, as this Daily Mail article explains.  Dow Jones also had an article about this (subscription required).

Fillon's sentence right before the two quoted above also propelled the confusion:  “J'ai déjà eu l'occasion de dire que je ne voyais que des bonnes nouvelles dans la parité entre l'euro et le dollar, je n'ai pas changé de discours.”

Peter Boone and Simon Johnson writing at The Baseline Scenario website translated this in part to say:   “I see only good news in parity between euro and the dollar.”   They characterize this statement as “a quote for the ages” and go on to say:  “Be careful what you wish for – such statements will drive the Germans crazy as they see further evidence that inflation lovers are clearly winning influence and might just gain control at the European Central Bank (ECB).”  Apparently realizing that the translation they used might have not accurately reflected what Fillon said, they later updated their post with one of the sentences quoted in French.  They then further commented:  “Saying this on a day when the euro is collapsing, [Fillon] is clearly condoning further collapse.”

Boone and Johnson may be right in their conclusion if not in their translation.  This incident reminds me, though, how sensitive markets sometime are to any change in wording when it comes to exchange rates.  For example, it seems to be a rule that Secretaries of the Treasury periodically say that they are in favor of  “a strong dollar policy," whatever that might mean, especially when the U.S. periodically complains that China should let its currency appreciate.

Joe Nocera's Column on Financial Regulatory Reform

Joe Nocera has an interesting column on financial regulatory reform in today's New York Times.  I agree with him that, even though the House and Senate bills are long and complicated, they do less than advertised to reduce systemic risk.

Near the beginning of the column, Nocera writes that "there is nothing even remotely radical about anything in these bills.  Nobody is suggesting setting up a new Securities and Exchange Commission, which reshaped Wall Street regulation when it was formed in 1934.  Nobody is talking about breaking up banks the way they did in the 1930s with the passage of the Glass-Steagall Act.  Nobody is even talking about a wholesale revamping of a regulatory system that so clearly failed in this crisis."


While responsibility for the financial crisis can be attributed widely, the failure of government regulators to do more to head off or lessen the severity of the impending crisis was not in the main due to a lack of authority but to a refusal to use it.  The argument that hardly anyone saw it coming is not convincing.  While the severity of the crisis probably surprised most people, it was obvious to that there could be a financial crisis of some sort.  That there were problems in the subprime mortgage was clear, as was a rate of increase in real estate prices that was unsustainable and had resulted in a very high ratio of house prices to rents.

Unfortunately there has been very little attempt to address the causes for this regulatory failure.  Rather, there has been highlighting of such provisions as forcing plain vanilla swaps onto trading platforms and into clearinghouses.  This is not necessarily a bad idea, but it seems to be a smokescreen for the absence of more fundamental reform.

Comments on Financial Regulatory Reform

The financial regulatory reform bill that will be going to conference is a bit of a muddle.  Some aspects of it are necessary and others not so much; some provisions are oversold; and some needed reforms are not included.

Consumer Protection

On the plus side of the ledger, setting up a consumer financial protection agency, whether nominally housed in the Fed or fully “independent,” is an important provision.  The financial crisis began with a housing bubble, which would not have happened to the extent it did without inappropriate mortgages being offered to prospective house buyers.  The Federal Reserve failed in its consumer protection role, and other regulatory agencies did not get at this problem from the other side, safety and soundness.  In the absence of consolidating the regulatory agencies, this new agency should both serve to protect consumers and help to reduce systemic risk by preventing the large scale offering of loans individuals cannot afford unless everything goes right.  That is, it will do this if it is not overrun by the other regulatory agencies in the turf wars the new legislation is likely to encourage.  Also, for political reasons, it seems consumers will be less protected when it comes to auto loans offered by dealers.

Derivatives

Some of the derivatives provisions seem to be unnecessary and how meritorious they are can be debated.  They do broaden the turf of the CFTC and the SEC, which may be a good thing but could turn out badly if vicious turf wars develop.

Among the likely legislative outcomes is forcing standardized derivatives, such as interest rate swaps, to be traded on a central platform of some sort and to be submitted to a clearinghouse.  More complicated, customized derivatives, such as credit default swaps on particular securities, will probably not be subject to these requirements, since their lack of liquidity and customization make it too difficult to impose such requirements without in effect making these types of contracts illegal (which is probably the agenda of some participants in the debate).  The CFTC and the SEC will have new authority, though, to regulate customized derivatives, which will probably put these agencies in conflict with the bank regulators and perhaps with each other in cases where the jurisdictional lines between the two agencies is less than clear.

It is peculiar that the likely outcome is to impose more regulation on the plain vanilla derivatives, which have not been a source of major problems, than on more complicated, customized derivatives, which in the case of credit default swaps exacerbated the financial crisis.  The trading platform requirement for standardized derivatives may serve to improve transparency, though price information is available to those with the appropriate terminals, such as provided by Bloomberg.  One can argue both ways the merits of concentrating risk in a clearinghouse.  As for a provision that the U.S. government will never, ever bailout a derivatives clearinghouse, this lacks credibility for large, systemically important ones.  In a crisis, the government will find a way, if necessary by passing statutes, to do what it believes necessary.  Our recent experience demonstrates that.

It is also strange that the Treasury is apparently acquiescing in having the CFTC have a role in the OTC market for foreign exchange, including apparently options, unless the Secretary of the Treasury formally exempts them in writing.  It is not clear how regulation would work in an international market.  Moreover, dating back to the 1973 legislation creating the CFTC, the Treasury has consistently opposed the CFTC applying the Commodity Exchange Act ("CEA") to the wholesale OTC foreign exchange market, including options, and was able to get a provision in the 1973 statute known as the “Treasury Amendment” to attempt to attempt to accomplish this.  (In 1997, the Supreme Court decided in the Dunn case that the Treasury Amendment exclusion from the CEA included FX options.)

Resolution Authority

With respect to resolution authority for systemically important financial institutions, this is a useful authority for the government to have.  As it stands, the Bankruptcy Code process in certain situations is not ideal.  In the Long-Term Capital Management situation, the New York Fed successfully persuaded major Wall Street firms to fund a workout outside of bankruptcy in order to provide for an orderly wind down of the fund.  The Lehman bankruptcy caused market panic.  The provisions for close-out netting for certain types of financial contracts, including “swaps,” which provide an exemption from the Code’s automatic stay, were supposed to mitigate systemic risk.  In certain situations, though, these provisions may exacerbate it.  The problem is that, if a large institution fails, its counterparties may all rush to sell the underlying collateral for eligible contracts at the same time, thus causing a market problem.

It is, however, not clear how the resolution authority would work for large institutions which are failing and which have significant foreign operations subject to the laws and regulations of different countries.  It is also not clear in a financial crisis with more than one failing institution how long it would take for the FDIC to staff up sufficiently to handle multiple “resolutions.”  Improvisation, as we have witnessed, may be resorted to once again.

Whether improvisation is a “bail-out” depend on what one means by this inexact term.  Stockholders would almost certainly be wiped out, as they, to a large extent, have been for some of the large financial institutions, such as Citigroup.  Some uninsured creditors would likely fare better than others.  What happens to existing management is also a question.  It is not, though, credible to say that the government will never step in with funds or guarantees in a financial crisis.

What the legislation does not do is address the problem of regulatory capture and turf wars.  This is a serious problem about which I will have more to say.