Can Financial Regulation Be Fixed?

By James Kwak

The tragicomic events of the past few months—the London Whale (what are we up to now, $6 billion), Barclays-Libor, HSBC laundering money have prompted renewed interest in better, stronger regulation of the financial sector. Not that it’s going to go anywhere: it’s an election year, the Republicans have a blocking majority in the House and a blocking minority in the Senate, and they are only going to gain Senate seats in November.

But we’ve been here before. Remember the financial crisis? The Obama administration’s response, codified in the Dodd-Frank Act, could be summed up as “better, stronger regulation”—instead of substantive changes to the industry itself. This misses the basic problem with our regulatory structure, as described by John Kay:

“Regulation that is at once extensive and intrusive, yet ineffective and largely captured by financial sector interests.

“Such capture is sometimes crudely corrupt, as in the US where politics is in thrall to Wall Street money. The European position is better described as intellectual capture. Regulators come to see the industry through the eyes of market participants rather than the end users they exist to serve, because market participants are the only source of the detailed information and expertise this type of regulation requires. This complexity has created a financial regulation industry – an army of compliance officers, regulators, consultants and advisers – with a vested interest in the regulation industry’s expansion.”

The only thing I would disagree with is the characterization of U.S. regulators as “crudely corrupt.” Yes, many Congressmen are “in thrall to Wall Street money,” but when it comes to the staff at the regulatory agencies I think the picture is more complex and closer to the “intellectual capture” that Kay describes in Europe. (This is something we discussed briefly in 13 Bankers and that I cover in more depth in my contribution to Preventing Capture.)

Kay’s proposal is to replace today’s intricate rules, which only provide employment for loophole-seeking lawyers, with broad fiduciary duty standards. Then, for example, the ABACUS case wouldn’t have hinged on whether the fact that John Paulson was betting against the CDO was material and should have been disclosed, but on whether Goldman was acting in the best interests of its buy-side clients. In practice, the effect would be to make it easier for clients to sue their financial institutions—which might be a good thing, given how toothless the regulators have been over the past few decades.

Felix Salmon, however, builds on Kay to argue that what we really need is a financial services market where reputations matter and firms have an incentive to maintain them. That’s clearly not the world we live in today: Goldman gets a reputation for screwing its customers, but they don’t lose any business because those customers (a) figure it’s just a cost of doing business and (b) don’t have any meaningfully different choices. And to get there, Salmon continues, “we’re going to need to see today’s financial behemoths broken up into many small pieces.”

Better regulation would be great at the margin. So would more highly-paid, highly-motivated regulators. But as Salmon says, “the real problem here isn’t regulatory, and as a result there isn’t a regulatory solution.”

27 thoughts on “Can Financial Regulation Be Fixed?

  1. Kay’s proposals parallel Schiller’s theories about the effects of public incorporation on the governance of financial firms. Prior to the 1970s, most investment firms were partnerships and as directly liable owners, partners were incentivizing to act in a far more prudent manner with a greater range of subjective criteria involved in their investment decisions. Partners were not brought into the firm until they had been thoroughly vetted and had gone through an apprenceship of sorts. This also intrinsically limited the rate of growth and scope of the institution. With the advent of incorporation the personal financial risk was eliminated and the metric for corporate as well as investor success was reduced to a simple balance sheet calculation; the finance sector’s societal role as an efficient distributor of resources for worthy goals was lost.

  2. Bottom line – there are no consequences for unethical or illegal behavior. Loss of reputation? In the age of Gordon Gekko? The faster you can “rip the client’s face off” the more your reputation is burnished, among the other sharks, anyway. I’m not sure anyone on Main St. thinks these guys are anything but crooks anyway; Goddess knows they have no reason to think otherwise.
    Slamming the revolving door between the regulators and the regulated would be a big step forward, IMO.

  3. “In practice, the effect would be to make it easier for clients to sue their financial institutions—which might be a good thing, given how toothless the regulators have been over the past few decades.”

    Most people think we are overly litigious already. This statement made me think about that in a new light. Would stronger regulation across many, if not most, corporate endeavors alleviate the need for this form of societal regulation? Could this be what the anti-regulation crowd is actually going for? Deregulate all industries and then limit the damage the general public can do in lawsuits?

    I think I’m giving the deregulation crowd too much credit but I can certainly see a broad limit on compensatory damages a la doctors and malpractice in the future if this deregulation trend continues. Once there is no recourse, what recourse do we have?

  4. The best regulation is currently extant; it’s criminal prosecution for financial crimes, followed by draconian prison terms. This is the ONLY humane method of curbing the criminal gangsters running the financial industry. Administrative regs and regulators will always be a day late and dollar short in curtailing financial crimes.

    @ Kwak, keep hammering this.

  5. @Steve – they already have limited the amount of compensatory damages in Michigan and it’s on the books to writ into law across all 50 states. Also included in the new laws ready to go are a lot of retroactive clauses – meaning they set a date before the act took place so that the act is now retroactively not illegal.

    Recourse in the time of nihilism? You know the answer – nothing other than mano et mano brute force – and that’s where they want it to go next. It’s genocide – look up the definition.

    What was always missing in the formulaic exceptionalism of USA was a commitment to beauty in the commons – think Lady Bird Johnson and her project to plant wildflowers along the highways. Beauty that can only only be bought for the sadistic pleasure of disrespecting it as a throw away commodity by global war/slave/drug lords (private ownership) is a level below savage that could only have been dug by a “global” economy by and for the insane.

    In contrast, think about the Louvre in France – they never stopped adding to the collection – a commitment to beauty in the commons that survived as an IDEAL (as compared to a “value) since the 1200s A.D.

    Ideals are the foundation of civilized beings. Values have no value when there is no “ideal” – no truth, beauty and goodness in human nature is capable of surviving in the “isms” concocted by monkey-brains high on imagination.

    Many will not bend their knee to the global war/drug/slave lords that kill, torture, and insult at will. No matter how much FIAT $$$$ they have.

  6. @Steve: Once there is no recourse, what recourse do we have?

    Well you could always go back to the 1896 gold standard, which of course has no teeth.

  7. One dynamic that is often missed is that politicians, rather than being “in thrall” in pursuit of contributions, are instead active agents in extorting money from Wall Street and other industries. Thus, they favor complicated regulatory structures as a threat, and shake down the affected parties in exchange for carefully tailored loopholes.

    The complexity allows the dance to go on without enough people noticing, since the explanation of how it works takes longer than the attention span of most.

  8. How about co-determination (like Europe)for U.S corporations and finance . Consummer advocates on bank and finance boards, Simon Johnson and Joe Stiglitz and Ralph Nader on the boards of our biggest financial institutions.

  9. @engineer27 – very good point about the political animal dance – but then layer that serious character flaw from the get-go over the whole “commander in chief” thing – wars of choice – and we’ve got a real “moral” situation, don’t we?

  10. The commentary here sure is apocalyptic! I’m getting depressed just reading it, since, unfortunately, I agree with much of the emotional spirit of what is said. The worst part is the point about the attention span of the public and most of the news media.

    As to @engineer’s point, extortion is about getting something for nothing, i. e., the payoff is to prevent the agent from carrying out his/her threat. Your characterization, although accurate in my view, describes bribery rather than extortion. The nature of bribery in the U. S. has morphed into a far more sophisticated environment. The value of the current form of bribery is driven by the use of statistics (polls, especially) and broadcast media to influence voters (these ironies are sad, so sad). In a sense, the politician who is unwilling to accept bribes is likely to lose his/her job as a result of special interests sponsoring opponents. Why did Obama and the Democratic majorities in both houses ignore the obvious means to prevent more financial crises of the nature of 2008 crisis? Why did Larry Summers, generally a sound economist and independent thinker, conspire with Rubin, Greenspan and Geithner to squash the CFTC’s attempt to regulate derivative financial interests? Why is Sheila Bair running a non-profit instead of the FDIC? It’s like the dirty cop: once you’re on the other payroll, too, you can’t get off; if you try to stay off that payroll at the beginning, your efforts to do your job will be frustrated by your bribed colleagues (see Brooksley Born and Sheila Bair for frustration), and the sincere elected public servant is likely to have one term in office.

    We’re starting to look like Nigeria, among other countries: stupid, tribal, ignorant…:(.

    Frankly, I’m at a loss as to what to do. The options are not attractive: vote (for whom)? write? cry? march? telephone? move to…well, Germany or Canada(the weather in both cases sucks)? Even the commentary on this blog has changed qualitatively. Four years ago, the discussions were (largely) earnest and hopeful. Today, well, they’re more like rants (sorry; some are still pretty good).

  11. Trickle-down Morality

    If the largest banks are routinely screwing their customers, gee…. what are the chances that those customers are inclined to screw their customers, and that those customers screw their customers, etc.?

    Fix what again? And who is suppose to do the fixing? This isn’t about a few bad apples, this is about a (reasonably) free society as a whole ‘breaking bad’ – this isn’t going to end well.

    But I did enjoy the (blog) post.


  12. Okay, I believe that the OWS crowd is willing and able to do the heavy lifting when it comes to getting the life-maintenance commerce currency up and running. There’s no point to explaining to the 99% the cosmic insanity of the obsessive-compulsive, detailed, micro-management, lalaland algorithms-meet-god-particle math being run by evil AI computers in the Division of Death Star Derivatives, is there?

    Daily life is about chopping wood and carrying water and you know who is doing that in the ‘hood). Documentary attached when there’s nothing good on TV :-))

    I like the song that begins at around 10 minutes 37 seconds:!home/BlankPage_0

  13. This is all going to end with Realization, Rage, Resolve, Revolution, Recovery. These stages will be worked through by Banking/Governing class in time to regain the “full faith and credit” of both the population and the markets or the ride will be taken by everyone. Everything will fine until it isn’t.

  14. Part of what has gone wrong in the last forty years is that the cost of running for office has skyrocketed. I think the breginning point must be campaign finance reform: preferably public financing as in Canada. . Notwithstanding Citizens United, Senator McCain’s basic idea was correct.

  15. While I don’t always agree with your posts I always appreciate your writing. I really keyed off your statement that higher paid regulators would help. I would note that there is lower-hanging fruit there that won’t cost you anything (or less than you think):

    If you’ve ever attempted to apply for a regulator position the first 15 pages of the infinite application are focused on how long you’ve worked for that regulatory body or how long you’ve worked for some other government organization. Almost none of it has to do with your ability within the specific discipline. I was astonished by this when I was 25, coming out of a long/short hedge fund as a bank analyst, and actually considered going to go work for the OTS to “do some good”. Turns out they weren’t interested in my kind; I’d been in the private sector too long. In all sincerety regulators may be under-paid — but the structure that recruits them inherently insures that they’ll also be less than capable. I’m not sure paying incompotence more would help that unless you also use those dollars to get people with real experience in the sectors you’re looking to regulate. Hedge funds are certainly smart enough to hire ex-regulators on as compliance staff — why doesn’t the government get it?!

  16. Greenspam chased Brooksley Born out of town with pitchfiorks and fireballs….and what about Elizabeth Warren?….and Borofsky just wrote the “Bailout” book, c’mon, people….

  17. @Charles_Broming:
    Re: the bribery/extortion dichotomy — not so easy to tell. Here is techdirt summarizing a This American Life episode (linked within).

    And Re; apocalypticalism, yes there pretty much is no hope. Despite the influence and sheer quantities of money involved, people can and do still vote on their own. I’m left to conclude that we have the government that, generally speaking, we want. Scary.

  18. @engineer27 – everyone knows that algorithms are counting the votes. If anything, people are wondering who actually DOES vote in people like Christy since no one actually admits to having voted for him.

  19. Wow – a new level of “breaking bad”? More “complex”? Have to do a turn-your-pard’ner combo of bribery, extortion, fraud AND then the theft to make the theft not officially “illegal”?

    So much booty, so little time….sigh

    More misery for others = More $$$$ for ME ME ME

  20. I took the “trouble” (often I enjoy reading these type things) to read all of Mr. Kwak’s paper/chapter for the Tobin Project book. I’m a slow reader, took me about 90 minutes while darting my eyes back and forth to the Olympic opening ceremony (which I thought was stupendous, my personal fav was Kenneth Branagh reading Shakespeare, and Branagh is also awesome in PBS’s Wallander if you can catch that).

    Although usually I like Mr. Kwak’s analysis and positive contributions to the general dialogue. I think Mr. Kwak is an intelligent and insightful man. That being said….. I found the paper to be 85% a gob of milquetoast (and since I like Mr. Kwak, I’m withholding other more vulgar descriptions which entered my mind when reading it).

    I cannot believe someone who has watched closely as the TBTF bank events unfolded over the last roughly 5 years, can give such a tepid solution (even if only prescribed as a partial solution). I don’t see “cultural capture” as even 5% of the problem with regulators, and I think it takes extreme naivete to see addressing “cultural capture” as anything more than taking an icepick to a 2,000 square mile iceberg. And this is why political conservatives laugh at liberals, because we (“we” liberals, of which I am one) come up with these academic phrases like “soft money” and “cultural capture” to describe things that require much more concrete solutions.

    The real answer to this problem is separating investment banks from retail banks and therefor separating CDS, CDO, and derivatives gambling from depositors/savers bank accounts. That same derivatives gambling allowed by Jamie Dimon (who openly LIES as he mislabels it “hedging” in an attempt to play a 9 year old’s level of semantics.

    Markets: “I told you not to gamble the lunch money Mom gave you.”

    Jamie Dimon: “I wasn’t gambling Mom’s money, I gave it to my friend Bruno Iksil and told him to gamble it. So, as you can see, it had nothing to do with me, I’m just a helpless CEO. Don’t worry, if we lost the game Bruno and me call it a “hedge” and then go bully the other kids for more money. I checked, if you call it a ‘hedge’ then it becomes magically k.osher.”

    The only positive thing I would say comes from Professor Kwak’s paper is it highlights large banks/corporations one-sided access to agencies and regulators. Here from Professor Kwak’s paper quoting Gary Gensler and continuing on:
    “Early in 2011, CFTC chair Gary Gensler said, ‘Large institutions have a great deal more resources than the investor advocates. If you looked at those 475 meetings [in the past five months] . . . 90-plus percent are probably larger institutions or corporations’ (Protess and Bishop 2011).” This is an outstanding point which deserves deeper consideration from a policy standpoint, made from an otherwise largely milquetoast paper.

    So here is my idea, in politics there is a rule called “Equal-time rule” for media access:
    Now one could argue that time should be split (Office meeting time for government agencies/regulators to be specific) 50%–50% between investor advocates/consumer advocates on one side and industry representatives/industry lobbyists on the other. But I would make it more flexible, it would be like a 60/40 type rule. That would mean that there would be some “slack on the leash” for the amount of time the regulator could choose. But for any one side, it would be no less than 40% and for any one side no more than 60%. That gives the regulator some prerogative or a judgement call, but makes it much less one-sided, as it is currently.

    I would love to know and have some input in this comments section from Professor James Kwak himself, and other consumers/investors/bankdepositors and even I would pray some thought from policymakers on what they think of my idea immediately above.

  21. Answer: 60/40

    Pres. Carter – the only one to get a lasting treaty in the ME – go figure…

  22. “So long as all goes well and there is nothing to regulate, then you can do your job of regulation really well. As soon as something goes wrong, however, then, simply by exercising your regulatory responsibilities, you run the horrible risk of precipitating the calamity you were hired to avert.

    And hence: the fatal flaw of capitalism is that it is fundamentally beyond regulation.”

    from Mole in the Ground: Stress Tests, Regulatory Capture, and the Fatal Flaw of Capitalism (

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