Friday, June 11, 2010

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.

No comments:

Post a Comment