Regulatory capture

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In 1913 Woodrow Wilson wrote: "If the government is to tell big business men how to run their business, then don't you see that big business men have to get closer to the government even than they are now? Don't you see that they must capture the government, in order not to be restrained too much by it? Must capture the government? They have already captured it."[1]



For public choice theorists, regulatory capture occurs because groups or individuals with a high-stakes interest in the outcome of policy or regulatory decisions can be expected to focus their resources and energies in attempting to gain the policy outcomes they prefer, while members of the public, each with only a tiny individual stake in the outcome, will ignore it altogether.

When this imbalance of focused resources devoted to a particular policy outcome is successful at "capturing" influence with the staff or commission members of a regulatory agency so that the preferred policy outcomes of the special interest are implemented, then regulatory capture has occurred.

Regulatory capture theory is a core focus of the branch of public choice referred to as the economics of regulation; economists in this specialty are critical of conceptualizations of governmental regulatory intervention as being motivated to protect public good. Two often cited articles are Laffont & Tirole (1991) and Levine & Forrence (1990).

The theory of regulatory capture is associated with Nobel laureate economist George Stigler, one of its main developers. Two other cited references are Bernstein (1955) and Huntington (1952).

“Unmet Duties in Managing Financial Safety Nets.”

Edward J. Kane, a professor of finance at Boston College and an authority on the ethical and operational aspects of regulatory failure, has some ideas about how to do this and right our damaged system in the process. He outlined them in a recent paper titled “Unmet Duties in Managing Financial Safety Nets.”

This ugly financial episode we’ve all had to live through makes clear, Mr. Kane says, that taxpayers must protect themselves against two things: the corrupting influence of bureaucratic self-interest among regulators and the political clout wielded by the large institutions they are supposed to police. Finally, he argues, taxpayers must demand that the government publicize the costs of efforts taken to save the financial system from itself.

“That authorities and financiers could so callously violate common-law duties of loyalty, competence, and care they owe taxpayers and financial-institution customers is evidence of a massive incentive breakdown in industry and government,” Mr. Kane writes. “This breakdown cannot be repaired merely by replacing the governing political party or by changing the jurisdictions and mission statements of regulatory agencies.”

It’s tough, however, to assign responsibility to regulators who routinely fend off or stymie anyone attempting to scrutinize how the cops on the beat functioned in the years preceding the financial meltdown. So everyday Americans need to kick and scream if they want some light shed on this critical epoch in our financial history.

To bring accountability to regulatory performance, Mr. Kane suggests that financial supervisors take an oath of office in which they agree to perform four duties. First is the duty of vision, under which they would promise to adapt their surveillance practices to respond to the creative ways financial institutions hide their dubious practices. Regulators must also promise to take prompt corrective action, and to perform their work efficiently. Finally, there is what Mr. Kane calls the duty of “conscientious representation,” whereby regulators swear to put the interests of the community ahead of their own.

This last promise gets to the heart of a continued erosion of trust in our system, Mr. Kane argues. “If real world supervisors were perfectly virtuous, they would make themselves politically and financially accountable for the ways in which they exercise their discretion,” he writes. “Perfectly virtuous supervisors would fearlessly bond themselves to disclose enough information about their decision making to allow the community or interested outsiders to determine whether and how badly they neglect, abuse, or mishandle their responsibilities.”

Instead, our regulators refuse to produce complete documentation and accounts of the actions they took during the crisis. And keeping taxpayers in the dark isn’t exemplary ethical behavior. Rather, it is characteristic of what Mr. Kane calls an elitist regulator, one who uses crises to cover up mistakes and expand his or her jurisdiction.

“According to this standard,” Mr. Kane writes, “Fed efforts to use the crisis as a platform for self-congratulation and for securing enlarged systemic-risk authority sidetracks, rather than promotes, effective reform.”

To ensure that regulators live up to the promises they make, Mr. Kane suggests that inspectors general at each agency be charged with regularly auditing the performance of financial overseers. A crucial component of those reviews would be exploring attempts by regulated entities to influence the officials who oversee them. That’s because in financial crises, Mr. Kane explained, crippled institutions pressure the government to rescue them and force other parties (usually the taxpayers) to share their pain.

“We’ve got a very comfortable equilibrium here where Wall Street praises the authorities and the authorities give Wall Street more or less what it wants and they hope that the public really doesn’t understand the depth of the cynicism involved,” Mr. Kane said in an interview. “You keep reading about how wonderful it is that we didn’t have a Great Depression. Well, if they can sell that point of view, then nothing will change.”

Congress should fund regulators

Source: The President’s Blueprint for Reforming Financial Regulation: A Critique: Part II, Richard A. Posner

"Second, it would probably be a good idea to finance the financial regulatory agencies out of congressional appropriations rather than fees paid by the regulated firms. The fee system puts the agency and the regulated firms in the approximate relation of seller to customers, and let's not forget the slogan that the customer always knows best. The particular danger is that a firm will, by configuring its structure in a particular way, bring itself under the jurisdiction of an agency that, desiring to increase its fee income, offers (implicitly of course) a softer regulatory touch. There is the further danger, when an agency is supported out of fee income, of a mismatch between the penalty function of fees and the revenue function. Fees set at the right level to deter risky practices may generate too little or too much income to finance the agency at optimal size."

Regulatory capture at the SEC

Norman Posner on SEC failure

Source: Why the SEC Failed: Regulators Against Regulation Norman S. Poser, Professor of Law Emeritus, Brooklyn Law School, Pg 9

"...Beginning in the 1980s, the SEC largely abandoned its role as an active monitor of the markets. Increasingly, it embraced the climate of deregulation that has pervaded the government. The Commission’s main focus changed from protecting investors to protecting the companies and investment firms that the SEC was required to regulate.

The SEC’s change of direction was given an air of legitimacy by Chicago-school laissez-faire scholars who argued, for example, that regulation of the markets is not needed and is even harmful because the markets are best left to regulate themselves, that mandatory corporate disclosure is unnecessary because the profit motive will give companies a sufficient incentive to make accurate disclosures,36 and that regulation of market manipulation is futile because manipulation is a myth. Others argued that the “moral hazards” that existed when commercial bankers engaged in investment banking also were a myth. The latter argument questioned the basis premise of the Glass-Steagall Act, which mandated separation of these two activities, and provided a theoretical basis for the gradual erosion of the Act and its ultimate repeal in 1999.

Wall Street and corporate America welcomed anti-regulatory theory because it gave them a justification for the unfettered pursuit of profit, unburdened by fear of guilt or government prosecution. Their attitude was famously summed up by the fictional financier Gordon Gekko in the 1987 movie Wall Street, who said “greed is good.” The catastrophic events of 2007 and 2008 have, to say the least, cast a shadow of doubt over these ideas...

...During the past decade, the SEC made important regulatory changes that weakened the regulatory system and turned out to be a disaster for investors, significantly contributing to the 2008 financial crisis. First, the SEC exempted the largest investment banking firms from the minimum capital requirements imposed on broker-dealers.

Second, the SEC repealed a rule designed to prevent manipulative short selling of securities. At the same time, the Commission’s other deregulatory actions included limiting shareholder access to the proxy voting system and repeatedly urging the Supreme Court to limit investors’ ability to recover their fraud losses by means of private lawsuits."

SEC revolving door

"The revolving door can turn swiftly at the Securities and Exchange Commission.

Steven Richards left the SEC in July 2008 as a top accountant in the enforcement division to join the global business advisory firm FTI Consulting. Five days later, he signed on to represent a client involved in a "nonpublic investigation" by his old division.

In August 2008, Andrew Dunbar left his job as an enforcement lawyer in the SEC's Los Angeles office to take a job with the law firm Sidley Austin. Eleven days later, he was tapped to help a client answer an "informal request for information" from the same office.

Mr. Dunbar didn't respond to requests for comment and Mr. Richards declined to comment, as did both of their employers.

The two ex-SEC men were among 66 former SEC employees who filed 168 letters with the SEC secretary in 2008 and the first nine months of 2009 disclosing clients or new employers they planned to represent before the agency, according to documents obtained through a public-records request. SEC regulations require such letters if a former employee represents a client before the agency within two years of leaving.

Some former employees disclosed routine matters, such as assisting clients filing SEC forms; 79 said they would be representing clients in "ongoing nonpublic investigations," including 36 who said the SEC's enforcement division was involved. Of the remaining forms, 73 gave no indication about the issues involved or which office at the SEC was handling them. The SEC redacted, or removed, the names of the clients and the titles of the matters before releasing the documents.

The employee disclosures, along with a recent report by the SEC's inspector general, demonstrate the work that agency employees do after they leave. The inspector general's report documents how a former SEC enforcement director helped Allied Capital Corp., a business-development lender, as it headed off potential fraud charges.

Treasury Secretary and Goldman Sachs

Henry Paulson, the former US Treasury Secretary, held a meeting in Moscow with Goldman Sachs’s board in which he spilt sensitive details of forthcoming government policy, a new book has alleged.

The meeting, which is certain to raise further questions about Mr Paulson’s close relations with Goldman Sachs, is described in Too Big To Fail, a heavily anticipated rundown of the months leading up to Lehman Brothers’ collapse, written by Andrew Ross Sorkin, the New York Times columnist.

Mr Paulson is said to have met with the Goldman Sachs board even though he signed an ethics agreement when appointed Treasury Secretary in 2006, under which he promised not to contact Goldman Sachs, the bank for which he worked for 32 years and which he ran for seven years.

In June 2008, Mr Paulson went to Moscow to encourage Russian investment in the collapsing US economy. Goldman Sachs’s board was also in Moscow, to attend a dinner with Mikhail Gorbachev.

Mr Sorkin describes how Mr Paulson asked Jim Wilkinson, his chief of staff, to organise a social get-together for him with the board. Nervous that news of the meeting would leak, fanning the flames of conspiracy theories about Goldman Sachs’s undue influence on the Treasury, Mr Wilkinson sought permission from Bob Hoyt, the Treasury’s general counsel.

According to Mr Sorkin’s book, Mr Hoyt said that the meeting would not contravene ethics guidelines as long as it remained a “social event”.

But Mr Sorkin writes of the meeting: “Paulson regaled his old friends with stories about his time in Treasury and his prognostications about the economy. They questioned him about the possibility of another bank blowing up, like Lehman, and he talked about the need for the Government to have the power to wind down troubled firms, offering a preview of his upcoming speech.”

Ethics experts yesterday called on Congress to investigate Mr Paulson’s actions.

Melanie Sloan, executive director for Citizens for Responsibility and Ethics in Washington, a non-profit body, said: “It’s hard to imagine why [Mr Paulson] thought such a meeting would be OK. It wasn’t purely social — purely social is when you don’t discuss business. That’s basically inside information that the Goldman board received”.

A spokeswoman for Mr Paulson did not immediately respond to a request for comment.

In August, Timothy Geithner, the Treasury Secretary, denied that Mr Paulson gave special treatment to his former employer.

“We have been forced to do just extraordinary things and, frankly, offensive things to help save the economy,” he said. “I am completely confident that none of those decisions ... had anything to do with the specific interest of any individual firm, much less Goldman Sachs.”

Banking sources said that Mr Paulson has spoken several times following the March 2008 collapse of Bear Stearns, about his desire for more power to deal with failing companies.

Goldman Sachs received $10 billion during the $700 billion bailout of the biggest US banks last year, which it has since repaid.

The dog that didn't bark

"THE summitry never stops. After the G20's meeting in Pittsburgh on September 24th and 25th, the jawboning now moves to Istanbul, for the annual meetings of the International Monetary Fund and World Bank.

Policymakers seldom tire of talking about distorted incentives in the private sector--pay packages that encouraged bankers to think only about the short term, for example. But they should look in the mirror, too. The public sector is also affected by huge incentive problems, which help explain why regulators were unable to clamp down on finance during the bubble and why it is so difficult to withdraw the implicit promise of state guarantees.

Perhaps the biggest problem is something that economists call "time inconsistency". Monetary policy is the best-known example of this phenomenon. Central banks try to anchor inflationary expectations by sounding tough. But if the private sector raises wages anyway, central banks are reluctant to tighten policy and cause unemployment. The knowledge that monetary policy suffers from this inconsistency over time undermines the credibility of the initial, hawkish announcement.

The same sort of problem affects financial regulators and supervisors. They have incentives to announce a no-bail-out policy in order to encourage their charges to behave prudently. But as soon as crisis strikes, the optimal choice for policymakers differs from the pre-announced policy: the authorities will usually offer support. The banks anticipate this behaviour and run even more risks as a result.

Two other incentive distortions reinforce this bias towards bail-outs.

The first is that most supervisors--with the notable exception of America's Federal Deposit Insurance Corporation (FDIC), which both regulates deposit-taking banks and administers their insurance fund--do not put the capital of their own institution at risk. The second is that a policy of regulatory forbearance may save the supervisor as well as the bank: hiding losses in financial institutions from public scrutiny may also help conceal regulatory and supervisory failure.

The quiet coup

"...In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn’t be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn’t roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better—in a “buck stops somewhere else” sort of way—on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel.

But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector’s profits—such as Brooksley Born’s now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998—were ignored or swept aside.

The financial industry has not always enjoyed such favored treatment. But for the past 25 years or so, finance has boomed, becoming ever more powerful. The boom began with the Reagan years, and it only gained strength with the deregulatory policies of the Clinton and George W. Bush administrations. Several other factors helped fuel the financial industry’s ascent. Paul Volcker’s monetary policy in the 1980s, and the increased volatility in interest rates that accompanied it, made bond trading much more lucrative. The invention of securitization, interest-rate swaps, and credit-default swaps greatly increased the volume of transactions that bankers could make money on. And an aging and increasingly wealthy population invested more and more money in securities, helped by the invention of the IRA and the 401(k) plan. Together, these developments vastly increased the profit opportunities in financial services.

Not surprisingly, Wall Street ran with these opportunities. From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007..."


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