Guest Post: Capturing the Regulatory Mothership

This guest post was contributed by Ilya Podolyako, a third-year student (for a few more days) at the Yale Law School and until recently executive editor of the Yale Journal on Regulation and co-chair, with James Kwak, of the Progressive Law and Economics reading group.

Though many economic indicators continue to look grim, the sense of crisis has largely faded from the front pages in the last few weeks. In my opinion, this is shift in demeanor of reporting is due to audience fatigue, not some fundamental change in the underlying dynamics of the economy. As the ever-prescient Onion points out, the American public has only so much tolerance for tragic stories, regardless of their source. For better or worse, however, calls for a drastic restructuring of the regulatory framework have quieted as of late. The Obama Administration has already spent a large amount of political capital on its first round of stimulus, the auto “bailouts,” and the day-to-day management of the financial sector, and will likely have to use up some more for further bank recapitalization and a possible second round of the stimulus. Unsurprisingly, in this environment, blueprints for a brand-new “systemic” financial regulator seem to have been shelved, despite a general consensus that some such entity is necessary to avoid future economic meltdowns.

This development may have some surprising upsides. For one, we have time to scrutinize the wisdom of putting enormous power into the hands of a single agency. The extant regulatory framework is certainly inadequate in many respects. Yet consolidating the exchanges, the SEC, the CFTC, the OCC, the OTS, federal housing agencies, federal consumer protection organs, a macroeconomic policy maker, a new oversight agency for derivatives, and perhaps a dedicated industrial policy manager into one body with wide-ranging authority carries enormous risks that cannot be ameliorated unless we manage to fix certain seemingly intractable underlying problems first. These include the outsize importance of the financial services sector to the U.S. economy, the permeation of government by individuals with a vested interest in preserving this status quo, and basic human fallibility and greed. Of particular concern is the possibility of regulatory capture, which takes place when a regulator begins acting for the benefit of its subjects rather than in accordance with its stated mandate of minimizing systemic risk. While any agency can theoretically be captured by concentrated and powerful individuals, a breach of the “mothership” would carry far more severe repercussions than the loss of one or two “destroyers.” Of course, only the mothership can accomplish certain tasks; in the economic context, it would exist to take on challenges of a scope that smaller bodies simply cannot handle.

The dynamics in play are thus straightforward. First, the capture of a single, large regulator could carry catastrophic consequences, whereas the capture of a smaller regulator that holds only a fraction of the mothership’s powers would be merely disastrous. Second, we want a mothership, because our current fleet doesn’t seem up to task. Third, if getting the mothership actually increases the vulnerability of the economic system over a dispersed set of regulators coordinated by the president, we should resist the temptation to get it and look elsewhere for solutions. The problem is that determining whether the third condition holds is actually quite difficult. I have been working on a game-theoretic model that could suggest an answer, but in the meantime, a smattering of observations should suffice.

Two archetypal scenarios for regulatory capture exist. The first is an underpowered, understaffed regulator working to control a wealthy, concentrated industry. In these situations, the sheer imbalance in resources means that the regulated parties can reward or punish the agency, but not vice versa. Predictably, rational bureaucrats will choose to cater their policies to the benefit of the subjects instead of suffering their wrath – recall, a regulatory job well done rarely carries any significant benefits to its engineers. The Department of Interior’s Minerals Management Service is a perfect example of a body that appears to have fallen prey to this pattern. Even a person of upstanding moral character can understand the difficulty of resisting the repeated entreaties of Exxon and the like for the sake of sticking to an unadulterated scheme of allocating oil and gas exploration rights. Someone sitting at the MMS desk may well wonder if anyone would ever notice a shift away from the prescribed approach towards one that favors the companies they deal with on a day-to-day basis. These incentives to cooperate exist even though the relationship between the regulator and the regulated parties is facially adversarial, with MMS holding rights that producers want but cannot get.

The second standard scenario for regulatory capture takes place when the same agency identifies items to source from the private sector and supervises the production of these items. The Department of Defense springs to mind as an example. The Pentagon almost certainly has the best interests of the Armed Forces in mind when it sets out its procurement goals. The combination of public (“free”) money and a desire to avoid saying one’s coworkers and superiors made a mistake, however, means that projects live on even when they go horribly wrong. Private-sector contractors benefit from bloated budgets for littoral combat ships that suffer from fundamental structural defects (the program has since been scrapped), military officers occasionally pick up a kickback, and the taxpayer ends up footing the bill. The political prominence of the Pentagon aggravates the effects of regulatory capture, since colonels know they can fight off most allegations of inefficiency by claiming that a critic is unwilling to support the troops.

A financial superregulator would have certain characteristics that distinguish it from the above examples. Unlike the Department of Defense, it will focus on a politically unpopular constituency – bankers – and thus be unable to deflect Congressional oversight as unpatriotic. Similarly, any good-faith attempt to create the systemic risk agency would give it power to punish the regulated parties for offensive behavior, avoiding a repeat of the MMS fiasco. These improvements do not make the would-be regulator immune from capture; they just raise the capture’s difficulty and cost.

Problematically, these same measures may increase the willingness of various parts of the financial sector to work together. In the face of reforms that could destroy the hedge fund business, for example, various players could unite in a massive lobbying effort despite the possibility that their competitors could hold out and get the benefits of laxer regulation for free. Even more worrisome is the fact that agency employees will quickly realize both their immense power to dissolve fortunes and the fact that they could benefit enormously from letting some financiers pay them not to do so. Since regulatory pressure is free and political costs of being too tough are diffuse, the only visible constraint on the regulator’s efforts will be the diminution of profits that regulated parties could spend on bribes or lobbying efforts. Currently, various entities battle each other for turf. While a company could buy out a single regulator like the OTS, there is always a threat that a different agency will come in and demand more ransom. This possibility discourages companies from trying to capture individual agencies and encourages them to try to comply with substantive rules. A single, umbrella entity, however, could actually guarantee a positive outcome in exchange for (an admittedly larger) chunk of cash. Indeed, given its ability to make or break businesses, a superregulator could demand payoffs with a previously unseen force. For the first time, industrial investment in corruption could become not just smart, but safe.

Avid readers of this blog will be rightfully skeptical of the above scenario. As the crisis has demonstrated, the current regulatory framework is fraught with issues: it encourages large companies to shop for favorable supervisors, conceals systemic risk, and diverts money from real capital investments towards administrative maneuvering. Yet good intentions alone will not prevent Congress or the Executive Branch from making the situation worse by creating one opaque and powerful agency to take the place of several opaque and powerless ones. Just think of what happened with the CIA.

By Ilya Podolyako

21 responses to “Guest Post: Capturing the Regulatory Mothership

  1. All this is just tinkering around the edges. The real problem is that a financial oligarchy is running the country. This will only change if the electorate commits to electing people who aren’t part of the oligarchy, a likely scenario only if we enter another deep depression that severely pushes everyone.

    Obama is clearly bowled over by older people with more experience than him. He has caved to the bankers, the generals, and soon will cave to the Israel lobby. It’s one of the dangers of elected a young, inexperienced person, however charismatic or brilliant he may be.

  2. This piece didn’t go into the fact that at least in recent administrations including the current one the regulators were in ideological sympathy with the regulated, and have tended to see themselves as facilitators rather than “adversarial” watchdogs watching over intrinsically dubious activities. Cognitive regulatory capture is at least as endemic as the conventional corruption.

    As long as this condition holds, that government itself is based on the dogma that what’s good for Wall St is good for America, it’s difficult to see how either of the above scenarios can be avoided.

    In particular, the imbalance of resources must existentially continue so long as the “regulated” entities are Too Big To Fail. How can a regualator ever be bigger than that. Not to mention how a regulator’s perspective and potential actions are radically constrained if the core of his mission is dogmatically defined to be preventing failure. He’s practically being ordered to let himself be captured.

    Going back to the first paragraph, I again lament how far short of his Change promises Obama has fallen. Why should there be such a sense of the “tragic” such that people should already be so weary, if Obama was leading the charge in taking back America from the forces which have bottled it up in this way?
    It’s always seemed to me that all this time he could’ve been accruing political capital rather than spending it if he were on the offensive.

    But instead he’s squandered his time and energy, thrown away his real support, all to dedicate his presidency to the continuity of the Bush agenda on the banks and on war. So it’s no mystery to me why all the early talk about a regulatory renaissance has wilted and died. The main reason Obama is not pushing a new day for regulation is that he doesn’t want to. That he hooked up with Rubin and Summers and Geithner proves that he still agrees that Wall St can self-regulate.

  3. I do not think regulators to date have been powerless so much as determined not to rock the boat, whatever their reasons might be (regulatory capture or just trying to muddle through their careers). At any rate, they chose to not exercise their authority, even for things that were clearly within their jurisdiction (as the Ponzi schemes have demonstrated), let alone things that existing law did not contemplate.

    It seems a non-issue to me whether we structure our regulatory system around the mother-of-all-regulators or as a bunch of sheriffs if the culture does not change. And the culture absolutely will not change when the pattern for addressing crises is to give the banks whatever they need to get out of trouble or otherwise want. Put yourself in the position of a regulator: what is the worst-case scenario for you upon discovering a practice with attendant systemic risk? You could step in, stake your reputation on fighting this practice, get tossed out at the end of your term and thereafter be professionally radioactive. Or you could wait until things blow up, offer the appropriate mea culpa, stand back while the federal government papers over the problem, then take a job at a bank. Which would you choose? The powers that be can tinker with organizational structure all they want, but that’s not reform.

  4. The military analogy is an apt one, except that the focus is less on capturing the Department than on capturing individual decision makers empowered with substantial discretion.

    Kickbacks are less likely to take the form of cash bribes than as implicit guarantees of lucrative employment post military service. It becomes understood both that past helpfulness will be remembered, and that the ex-officer’s personal networking and intimate familiarity with the true nature of internal processes will be useful to the enterprise.

    Before one condemns this all as a crude form of soft-corruption, remember that it is precisely this prospect that encourages many talented officers to endure the publicly-beneficial hardships, sacrifices, and low-pay of a career in military service that releases an individual to find themselves a place in the workforce at middle-age having often been trained in a professional specialty with little application to the civilian domain.

    At any rate, this kind of post-government employment process takes place in probably every branch and agency of government where they touch the private sector or any organization that deals with the public and which has high-paying positions available for someone with the right kind of “experience”.

    If it seems clear that this would also be the case with the bureaucrats of an economic Omni-Regulator (indeed, it seems to have very much *been* the case with many high-level economic-advisory officials in the recent past) then it appears true adversarial, potentially-fortune-destroying confrontations would be minimized for fear of biting the hand that will feed you.

    More importantly, the nature of systemic risk as I understand it implies that many players in the marketplace are following similar strategies or at least vying with each other for (and thereby overpricing) the same opportunity – so an aggressive official risks alienating the entire sector and becoming essentially blacklisted from the very industry she may wish to join. It seems unlikely the effects of such considerations could be meaningfully kept under control. The more power an agency has, the less likely it becomes, just as numerous attempts to sever the military-industrial link have proven inadequate.

  5. Regulatory capture theory seems to ignore the power of the President to set the tone for the regulatory agencies. Bush came into power with the backing of many who argued that the regulators were hampering private enterprise. The heads of the various regulatory agencies were appointed by Bush and presumably held the same regulatory philosophy. Regulatory capture occurs in an environment where the Administration is either hostile to regulatory enforcement or indifferent. If an Administration believes in the enforcement aspect of the regulatory agencies’ mission and appoints agency heads that are on the same page, the subordinates will follow the lead. The now famous picture of the head of the thrift regulatory agency standing with a chainsaw over a stack of papers sent a loud and clear message to his subordinates, a message wholeheartedly endorsed by President Bush.

    The question to be answered in developing a superregulator is how to insulate that regulator from shifting missions based on who is the President.

  6. Perhaps I’m naive and ill-informed, in that I firmly believe the crash last fall provides definitive proof that a “drastic restructuring of the regulatory framework” is absolutely essential for the survival of our economy.

    I never again want to hear a Treasury Secretary tell us we need to flood the banks with vast sums of federal dollars – or else….

    What about the FDA as a model for the new regulatory agency that would oversee the financial industry? I realize that there is discussion on breaking up the FDA into a food regulatory agency and a drug regulatory agency – but even so – the FDA today oversees big pharma, one of the most highly regulated industries in America. Perhaps we can glean some lessons from their experience….

    Pharma companies have made and continue to make mistakes – but they are penalized financially for them when caught. Accountability is something desperately needed – and completely missing – in banking.

    The financial sector is vital to the health of the economy and thus, to the long range goals of consumers and businesses. A regulatory framework should be developed to prevent the utterly reckless behaviors that led to the approval of loans to people who could not pay them back and the accumulation of so many trillions of toxic assets on the books of the “too big to fail” banks.

  7. How about a Glass-Steagall type act for regulators and private sector work? You would have to choose one career path or the other…
    The same could go for appointed political types.
    There would probably be consequences that I can’t think of that might make this just as dangerous.

  8. Valerie Gagnon

    A bit too bookish but a very interesting piece nonetheless. However, like other commentaries have above mine, I would like to stress out that the cultural dimension may be at the heart of the problem here. How else, Ilya , would you explain the Canadian phenomena ? Finding the shape of the magical box is less important than making sure that people believe in it.
    It’s a bit like trying to figure out the perfect constitution. A fascinating travail maybe but let’s remember that some of the best democracies out there don’t even rely on any.

    Valerie

  9. Brooks Gracie

    I think we already have that Uber-agency, and it is called the IRS. Everyone loves to hate it, but it is clearly the least scandalous agency out there, despite the ease that a revenue agent could take very large bribes to settle cases or stop collection actions. I wonder why this agency has been so clean where all the others have become so corrupt?

    Any ideas?

  10. One serious lesson from this crisis is that the consumer did not lead us off the cliff. CDOs were very profitable and the financial services industry couldn’t get enough of them! Anyone who thinks that loan consumers who faked their “stated income” actually DROVE this crisis is delusional. Regulations on loan origniation would have prevented the subprime CDO market from ever materializing. See this post

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