REGULATORY CAPTURE

An especially touchy subject for current and former regulators is the concept of “regulatory capture.” Capture theory assumes that regulators act to serve the interests of the industries they regulate rather than the public interest.  My own view is that the extent of regulatory capture is probably overstated but not entirely a myth either.  I’ll explore what actions both regulatory leaders and individual examiners can take to reduce both perceived and actual regulatory capture.

Concerns around regulatory capture come from two directions.  On the one side are advocates of more regulation, who believe the regulators are going too easy on the regulated.  Proposed solutions usually revolve around tightening up on revolving door rules, writing more prescriptive laws, and haranguing regulators on Capitol Hill after something goes wrong.  Nobel economist George Stigler made famous a more libertarian approach to regulatory capture. Stigler viewed regulation as worse than pointless and believed the solution to regulatory capture is not to regulate at all.  The regulatory capture theory is convenient for those who already favored a pro-business, laissez faire approach.  It’s like the old Borsht Belt joke: “The food was terrible!  And such small portions.”

Funding Structures and Incentives

One unique (and crazy) feature of banking regulation is that banks get to choose their regulators.  Industry groups usually cite, in reverent tones, the “dual banking system.”  That means otherwise similar banks can be subject to different regulators.  You’re a national bank and don’t like how the OCC is treating you?  Switch to a state charter.  That option isn’t available to a deeply troubled bank, but charter switching isn’t limited to the squeaky clean.  Imagine if pharmaceutical companies could go to state FDAs to get approvals for new drugs.

The funding structure for federal banking agencies makes the situation worse.  The OCC receives its funding from assessments on the banks it regulates.  If national banks switch charters, the revenues go along with them.  The Federal Reserve delegates most of its day-to-day supervision to the District Federal Reserve Banks.  The Reserve Banks are literally owned by their members, who help elect the board of directors.  As I noted in an earlier post, the Reserve Banks’ dual roles as bankers’ banks and as regulators create the potential for conflict of interest.

The FDIC receives its funding from deposit insurance premiums.  Since nearly all regulated banks have insured deposits, this revenue stream isn’t sensitive to charter flips.  Even with a predictable revenue stream, charter changes can affect the amount of work available to examiners and could color their approach.  It’s worth noting that of the 555 bank failures and assistance transactions since 2007, 331 were state non-member banks, where the FDIC was the primary federal regulator.

There aren’t great alternatives to the current funding structure.  Congressional funding in the early 1980s meant that the banking agencies were chronically under-resourced and had trouble attracting talent.  That reality is also behind attempts to move the Consumer Financial Protection Bureau to a Congressional appropriation model.  The idea is to defang the agency by depriving it of funding and making it harder to attract talented personnel.  It’s hard to imagine any supporter of the CFPB’s mission advocating that approach.

Ethics Rules

Banking agencies place various restrictions on their employees to avoid conflicts of interest.  That means limitations on owning bank stocks or obtaining loans (with limited exceptions) from banks they regulate.  There are also post-employment restrictions, but current rules focus more on supervisors than on regulators and especially on front line examiners rather than senior agency management.  The OCC, for example, bars outgoing Large Bank Examiners-in-Charge (EICs) and Team Leads from working or from serving as a director from a bank they supervised over the previous year.  Their bosses and those involved in the rulemaking process are subject to less severe restrictions.

Confidentiality rules mean that the bank supervision process can be especially opaque, which may explain tighter restrictions on examiners.  An incident involving Riggs National Bank also spurred some of these rules. Riggs was at the center of a money laundering scandal and that bank’s EIC received an executive position at the bank.  The Treasury Inspector General eventually absolved the former EIC of wrongdoing but it was not a good look for the regulator.

Some potential for regulatory capture arises from the nature of the rulemaking process itself rather than from any employment quid pro quo.  Regulations are subject to a comment process and most comments come from trade associations and other interested parties.  Regulations shouldn’t come out of an ivory tower, but the additional “real world” perspective is often more self-interested than objective.

The Tone Comes from the Top

Agency leadership can either mitigate or reinforce concerns around regulatory capture.  For example, in response to recommendations from an international peer review, OCC removed from its vision statement a goal to “maintain the ability” of the banks they regulate “to compete effectively.”  That statement made the agency sound too much like banking’s cheerleader rather than its regulator.  Such responsiveness is not always the case.  The GAO issued a report in 2019 concluding that “OCC Could Better Address Risk of Regulatory Capture,” which included nine specific recommendations.  OCC agreed to only one, which suggested a dismissive approach to regulatory capture concerns.

A casual approach to conflicts of interest can similarly reinforce notions of regulatory capture.  When banking attorney Keith Noreika became Acting Comptroller of the Currency in 2017, he was subject to 80 recusals, including for most of the largest banks under OCC supervision.  The recusals were either so extensive as to prevent Noreika from doing his job or were not taken seriously.  (Noreika was Acting Comptroller for nearly seven months.)  Similarly, Mary Jo White, who served as Chair of the SEC from 2013 to 2017 had to sit out nearly fifty cases in her first two years due to potential conflicts of interest.

Banks Aren’t Your Customers

Starting in the 1990s, “reinventing government” became a popular catchphrase for efforts to make government more efficient and effective by adopting some private sector principles.  These included greater focus on the customer.  Periodically, new agency leadership would start to emphasize the role of banks as our “customer.”  Fortunately, these initiatives received a collective eye roll from the rank and file.  While having little practical effect, the idea that the banks you regulate are your customer is counterproductive and dumb and promotes an image as a captured regulator.

Keep Front Line Examiners in the Loop

Few things examiners find more dispiriting than to have banks go over their heads to senior agency management.  Not only does it undercut the examiner’s authority, but it places the agency itself at a distinct disadvantage.  An agency leader is likely to know a lot fewer details of the issue at hand than the examiners on the ground.  Banks can and will take advantage of that lack of knowledge to spin the issue in a way favorable to the bank’s position.

Senior officials also reach out to bankers directly and may cut out some staff members who need to know.  In March 2023, Treasury Secretary Janet Yellen reached out JP Morgan CEO Jamie Dimon with a plan to provide funding to First Republic through a consortium of large banks.  The plan didn’t work – First Republic failed soon after.  More noteworthy to me was that this plan was hatched based on a private conversation between the Treasury Secretary and a regulated bank.  Yellen had apparently run the idea by the Fed’s Chair and Head of Supervision and the FDIC Chair.  There is no indication from press reports that the Acting Comptroller of the Currency, whose agency oversees most of the lending banks, had any role.  Considering that the Fed’s Head of Supervision became aware of serious problems at SVB only a month before its failure, it’s unlikely that someone as far removed from day-to-day supervision as Yellen would have any idea of potential issues with the lending banks.

Arrogance vs. Awe

Examiners of the largest and more sophisticated banks need to strike a balance between arrogance and awe.  Examiners should try not to come across as know-it-alls or attempt to micromanage the bank.  At the same time, don’t automatically defer to the bankers’ expertise since “they must know what they’re doing.”  Not necessarily.  Even bankers with impressive educational backgrounds, extensive experience, and huge compensation packages can violate Banking 101 principles.  It may be due to blind spots, miscalculations of risk, or simply the Peter Principle in action.  I’ve seen it enough to know it happens, so examiners should trust their judgment and not be intimidated.

Resist the Temptation to Extol

Effective supervisors recognize that some banks are stronger than others and adjust their approach to the circumstances at hand.  It’s all well and good to know what “effective” looks like.  Unfortunately, some go a step further and identify these banks and their leaders as role models in a public or semi-public setting, complete with fawning introductions.  Many of these have not aged well.

There’s usually some vetting of industry speakers but how far it filters down to the troops remains to be seen.  Also, as I noted in an earlier post, there can be a halo effect where a bank’s strong track record in one area, such as credit risk management, receives too much weight.  Weaknesses in, say, interest rate risk, money laundering controls, or consumer compliance may only come to light later.  Perhaps most importantly, a regulator runs the risk of lending its imprimatur to a bank’s management even as new information can come out and circumstances change.  It also reinforces the image of a captured regulator.