Banking tail often wags the Fed’s regulatory dog

There are high hopes that the new head of the Fed, Janet Yellen, will change the culture at the central bank and the lenders it regulates. IMF/Flickr via CC BY-NC-ND, CC BY-NC-ND

Federal Reserve Chair Janet Yellen has her work cut out for her if she hopes to change the culture at the world’s most important central bank. Media reports abound with evidence that the financial industry has its government overseers in its pocket.

The revolving doors between the public and private sectors keep spinning as regulators find the banks’ big bucks hard to resist. The largest firms get preferential access to top officials. The Federal Reserve, perhaps the US’ most important banking regulator, recently dismissed an employee who refused to water down her criticism of lapses in Goldman Sachs’ conflict of interest policy. And former SEC employees are complaining about that venerated agency’s refusals to act in the face of strong evidence of wrongdoing.

These examples make it very difficult to draw any other conclusion but that the banks have “captured” their regulators, a situation in which agencies designed to act in the public interest instead advance those of the companies they oversee.

Although banks are not the biggest lobbyists in Washington – try the pharmaceuticals, telecommunications and insurance sectors on for size – whichever way one looks at it, financial regulation is an area in which some kind of undue industry influence is likely to always be in the air.

Recent media reports suggested the Federal Reserve is a victim of regulatory capture, a situation in which an agency advocates the interests of the banks it oversees rather than that of the public. Adam Fagen/Flickr via CC BY-SA-NC, CC BY-NC-SA

A system designed for capture

The whole system is set up and operates in a way almost certain to promote some form of industry capture. Unlike most other industries, banks have always operated in very close partnership with government. They are essential to the government’s efforts to finance itself by acting as primary dealers in US Treasury sales. Banks are the principal means by which the Fed sets interest rates through its monetary policy, famously dubbed its “transmission belts.” And big banks act as bailout agents in times of financial crisis: they take over failing institutions the government has little hope of liquidating directly.

Perhaps less well recognized is that the ever-changing nature of modern financial markets requires not only that banks be regulated within a broad framework of rules but that they also be continuously supervised. Private banks and government regulators, examiners and supervisors can – indeed must – develop a close and ongoing relationship to match and share expertise. In this respect, bankers and financial regulators belong to one “financial class.” Almost inevitably, this makes a certain degree of cultural capture unavoidable.

This special relationship fosters empathy on the part of regulators for the “problems” banks face. Regulators must learn from banks. The close association and mutual dependency creates the danger that the firms will unduly influence regulatory views so that bankers’ interests receive more favorable treatment than those of their customers or the public.

And it sets the stage for the “revolving door,” through which pass many regulators and bankers as they pursue more highly paid careers. Bankers also rotate through as the government seeks experts to help it make informed decisions. In a world in which we necessarily depend on the constant exercise of discretion by regulators, this back and forth means the odds are high that it will favor banks at others’ expense.

Beauty in complexity?

Nevertheless, there are ways to mitigate the problem. Regulatory capture in the financial world demands a realistic, multi-pronged approach.

First, while regulation is difficult and simpler rules are always preferable, there are virtues to some institutional complexity when it comes to overseeing financial firms. A functional framework of regulators has emerged, each with different missions and interests.

In the US, the Fed provides umbrella supervision for financial conglomerates and their impact on the stability of the financial system. The Comptroller of the Currency and state banking commissioners (together with the FDIC) focus primarily on the safety and soundness of individual institutions. Meanwhile the Securities and Exchange Commission and at least two other agencies police the conduct of financial institutions in the marketplace.

In the UK, the Bank of England, like the Fed, is primarily concerned with the financial stability of the banking system as a whole. The Financial Conduct Authority monitors how financial institutions conduct themselves as market participants. And the Prudential Regulatory Authority supervises the soundness of individual banks and other financial institutions.

Each of these regulators can and often does disagree with one or more of the others. Many observers believe these systems to be chaotic and too expensive. Yet the diversity leads to a richer policy formation and makes capture of “the bank regulators” that much harder.

Transparency and proper funding

Second, transparency is key to holding regulators accountable to their missions. It empowers legislative oversight committees, new cadres of expert public interest groups and the media. In a system of adversarial politics, public policy is best served by the informed competition of ideas.

The traditional penchant among bank regulators for secrecy, while important in certain (very rare) situations, has been an obstacle to good regulatory policy. Greater openness – some of which we have seen in recent years – can only improve the process.

Of course, greater transparency involves a delicate balancing act: regulators have to be careful that they do not set off panics regarding the banks about whom they have concerns. In recent years, greater transparency has not generated the concerns that were anticipated. Rather, half-informed rumors – aka, the “word on the street” – are much more likely to cause damage and are not going to be prevented anyway.

Finally, we need properly funded regulators who are kept from getting too cozy with their subjects. If Congress is too shortsighted to provide the resources to match the power and expertise of the banks, there remains a lot that regulators can do to increase their effectiveness.

For example, to help reduce the likelihood that empathy can become sympathetic bias – that is, regulation by gullible chumps – it is possible to move employees from one institution to another. Indeed, this has become an official policy at the Office of the Comptroller and is simply good management.

Having said this, no measures will be successful without effective leadership and careful implementation. And moving employees too frequently can leave an agency bereft of experience.

It was apparently the rotation and removal of expert regulators that left both the UK’s Office of the Comptroller of the Currency and the New York Fed asleep at the switch as JP Morgan’s London Whale escalated into a major financial problem. Rotation brought about as a result of budget cuts are not a good thing. Rotation based on carefully planned transitions, on the other hand, would nourish the supervisory process and help promote regulatory independence from those they regulate.

Efforts at reform

Cultural change offers the best hope of long-term reform. Bringing about cultural change requires determination and support from many quarters and both corporate leadership and regulatory expectations. Some examples of efforts in this direction are the apparent campaigns by the UK’s Comptroller of the Currency and senior Fed regulators to alter the cultures at big banks.

Yellen’s confirmation to lead the Federal Reserve has given some observers confidence that she would take a more hands-on approach to bank regulation than her predecessor. She has also displayed greater sensitivity to the problem of wealth distribution. Dare one hope that she will use the latest interest-rate meeting as an opportunity to reinforce the message expressed by her colleagues last week that bank culture must change? If so, it must begin at the Fed itself.