Friday, October 3, 2014

Regulating the powerful: regulatory capture and “too big to fail”

Regulatory capture was the topic of the most recent John Mauldin’s Outside the Box newsletter. While the article by Justin Fox, shared in the newsletter, is an interesting and provocative comment on recent Goldman Sachs scandal, it hardly scratches the surface of the problem.

Unavoidability of regulatory capture

Regulatory capture, which is nothing more but another form of corruption, is probably one of the most common problems of all modern democracies with extensive regulatory regimes (see Wikipedia page for examples from different sectors). With regulation expanding in many countries, the risk that agencies will represent anything else but public interest is also increasing.

Agencies regulating financial sector are among the most exposed to regulatory capture. Here is a list of just a few reasons why regulators of financial sector are so exposed to capture:

  • Financial sector is a big contributor to political campaigns of elected officials;
  • Staff of regulators is interested to maintain a good relation with regulated companies as an option for future career;
  • Agencies are interested in expansion of the regulated sector, as it would increase importance of the agency;
  • Industry is an important sector of knowledge for regulators, and therefore can influence agency opinions.

Complex interdependence relations between regulators and industries makes certain extent of regulatory capture unavoidable and even encouraged desperate offers to shut down regulation in multiple sectors.

Power of financial sector: special case of financial sector

By far the most important reason why regulators of financial sector are controlled by industry interests is the power of financial sector. Unlike the public, that is interested in financial sector just when something happens and is unwilling to invest time and money, financial sector companies dedicates all the attention, plentiful resources and strong dedication to achieve favorable results.

Existence of “too big to fail” institutions is a major proof of regulatory failure. If we consider that public interest is to have financial sector contributing to economic wellbeing of the country, situation where problems in one financial institution can significantly damage wellbeing of the country can be hardly called acceptable. And still too big to fail continues to exist.

As the old proverb about the banks says “If you owe the bank thousands, then the bank owns you. If you owe the bank millions, then you own the bank.” What if we transform it to “If you owe the society billions, you have to follow the rules. If you owe the society trillions, you set the rules.”

Are there any solutions?

Justin Fox says:
“But here’s a thought – maybe if banking laws and regulations were simpler and more straightforward, the bank examiners at the Fed and elsewhere wouldn’t so often be in the position of making judgment calls that favor the banks they oversee. Then again, the people who write banking laws and regulations are not exactly immune from capture themselves. This won’t be an easy thing to fix.”

While his suggestion would definitely make the regulation more transparent, it would hardly solve the problem. The only real way to return some of the agencies to the public is to limit systemic importance of the potential capturers.

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