Why regulatory capture

felix salmon
Sep 29, 2014 · 5 min read

is here to stay

Dan Davies has a fantastic piece on the secret Fed tapes, which helps explain why the problem of captured bank regulators is such a difficult one to solve.

The problem, as everyone who is familiar with bank supervision knows, is that there is a cultural disinclination to challenge banks on their behaviour. Supervisors have an excess of caution, a tendency to hide behind committee decisions and a reluctance to give orders to supervised institutions. And there’s a clear reason for this — career risk.

The incentives facing a career supervisor have the kind of risk distribution that Nassim Taleb could tell you about — they are long-tailed and asymmetric. If you do something, you are vulnerable to being criticised for doing so. And in a job where bonuses are relatively small and success comes only with promotion, being criticised is your major income risk. If you do nothing, however, most times you will not be criticised unless the bank in question actually collapses, and how often does that happen?

This is not exactly secret: in fact, it appears vividly in the Beim report which plays an important role in Jake Bernstein’s narrative surrounding the tapes, both in the fantastic This American Life version of the story, and in his written version. Bernstein’s tale goes something like this:

The financial crisis happened, largely as a result of banks which failed while being supervised by the Federal Reserve. This was obviously a failure of the Fed. So the Fed asked Columbia professor David Beim to ask what had gone wrong, inside the Fed, and how things could get fixed. Beim’s report — which was meant to be private, but which got made public after it made its way to Congress — concluded that at heart the problem was cultural. The Fed was too meek, too consensus-driven. It needed to start hiring people with sharper elbows, and it needed to encourage them to use those elbows. Beim’s recommendations, per the Fed’s own statement on this story, “were incorporated in a significant reform of the New York Fed’s supervision group” in 2011. When the Fed then hired Carmen Segarra to be a bank examiner, it was following the Beim playbook exactly. But ultimately the cultural failures that Beim pinpointed had not gone away, and Segarra was fired within 7 months of her arrival: the Fed is just as captured as it’s ever been.

None of this is false, exactly, but maybe it’s a little faux-naive. When Beim told the Fed that it had “a culture that is too risk-averse to respond quickly and flexibly to new challenges,” everybody involved was smart enough to know that such a thing could never change overnight. Such issues are deeply ingrained within organizations, and simply diagnosing them is the easy bit. (Beim wasn’t the first person to come to this conclusion, and equally he won’t be the last.) In Bernstein’s narrative, the Fed is guilty of bad faith: it claims to have implemented Beim’s recommendations, but, at least in Segara’s case, it clearly hasn’t. In reality, however, that kind of deep-seated cultural change takes many years at best, and might in fact be downright impossible. It’s not the kind of thing which can simply be implemented by decree.

Really, then, what Bernstein’s story shows is just that Beim was right. And that’s not going to change any time soon. Just look at the Fed’s response, which “categorically rejects” the points that Bernstein makes. The Fed admitted that it had a culture problem once, in the direct aftermath of the financial crisis — but now it no longer admits that, and its public position is that the problem, insofar as it ever existed, has been solved. Which I’m sure is cause for no little amount of gallows humor among lower-level Fed employees.

Here’s Beim, for instance. Does the Fed really believe that none of this is any longer the case?

The point here is that, as Dan says, the incentives facing Fed employees are all wrong. If you simply agree with everything your boss says, and in general take no initiative, then there’s no particular reason why you shouldn’t have a long and successful career, complete with periodic promotions.

To make matters worse, the first job of a bank examiner is to ensure that the bank being examined is financially healthy. That means, at the margin, encouraging any line of business which is profitable, especially if it carries minimal financial risks. Looked at in this way, it’s easy to see what was going on with Carmen Segarra.

Segarra encountered two big issues at Goldman Sachs: in one, the bank put together a clever piece of financial engineering to help massage Banco Santander’s capital ratios; in the other, she encountered the fact that Goldman seemed to have no firm-wide conflict of interest policy. In the first case, Goldman was getting paid at least $40 million, and possibly more, essentially to watch a suitcase. In the second, well, I’ll let Justin Fox explain:

For the past two decades or so, not having a substantive conflict of interest policy has been Goldman’s business model. Representing both sides in mergers, betting alongside and against clients, and exploiting its informational edge wherever possible is simply how the firm makes its money. Forcing it to sharply reduce these conflicts would be potentially devastating.

In both cases, then, getting tough on Goldman would involve Goldman becoming less profitable, less financially secure. It might well be the right thing to do, from a regulatory perspective. But as Justin says, “asking bank examiners at the New York Fed to take an action on their own that might torpedo a leading bank’s profits is an awfully tall order.”

So we have a situation where bank examiners have every bureaucratic incentive to do nothing, and they also have a professional incentive to do nothing, lest the banks they’re examining start becoming more financially precarious. And then, as Dan says, there’s a third structural issue at play — which is that senior bankers have much more access to senior Fed officials than junior Fed officials do. If Segarra and her team kicked up a fuss at Goldman, Lloyd Blankfein could pick up the phone at any time and complain to the president of the NY Fed. The president of the NY Fed knows and likes and respects the CEO of Goldman Sachs; he probably never even met a junior staffer like Segarra. (None of this is helped by the fact that the NY Fed is a private institution, whose shareholders include the likes of Goldman Sachs.)

So while Bernstein’s story is an eye-opening look into how regulatory capture works in practice, the people complaining about the lack of a smoking gun have missed the point. The scandal is precisely that ’twas ever thus: that the Fed was captured, is captured, and probably always will be captured by the banks it regulates. If it refuses to admit that there’s even a problem, then there’s no way that the situation is ever going to improve.

Felix Salmon is a senior editor at Fusion

Bull Market

A collection of finance and business writing by @alexisgoldstein, @delong, @dsquareddigest, @DuncanWeldon, @felixsalmon, @jamesykwak, @Mark__Buchanan, @WhelanKarl

Thanks to Alexis Goldstein

    felix salmon

    Written by

    Felix Salmon was a senior editor at Fusion

    Bull Market

    A collection of finance and business writing by @alexisgoldstein, @delong, @dsquareddigest, @DuncanWeldon, @felixsalmon, @jamesykwak, @Mark__Buchanan, @WhelanKarl

    Welcome to a place where words matter. On Medium, smart voices and original ideas take center stage - with no ads in sight. Watch
    Follow all the topics you care about, and we’ll deliver the best stories for you to your homepage and inbox. Explore
    Get unlimited access to the best stories on Medium — and support writers while you’re at it. Just $5/month. Upgrade