Is Regulation Really for Sale?

LONDON – Relationships between London banks and their regulators are not especially warm just now. The latest bonus rules issued by the Committee of European Banking Supervisors (soon to morph into the European Banking Authority), have left those sensitive souls on the trading floors feeling rather bruised and unloved. In the future, 70% of their bonuses will have to be deferred. Imagine living on only $3 million a year, with the other $7 million paid only if the profits you earned turn out to be real? It is a shocking turn of events. Yet, in narratives of the financial crisis, regulatory capture is often an important part of the story. Will Hutton, a prominent British commentator, has described the Financial Services Authority, which I chaired from 1997-2003 (the date things began to go wrong!) as a trade association for the financial sector. Even more aggressive criticism has been advanced about American regulators – and, indeed, about Congress – alleging that they were in the pockets of investment banks, hedge funds, and anyone else with lots of money to spend on Capitol Hill. How plausible is this argument? Can benign regulation really be bought? When I was a regulator, I would certainly have denied it. I had never worked in the financial industry, and knew few people who did. (Full disclosure: I am now an independent Director of Morgan Stanley.) My successors have all come from the financial sector, however, which, until recently, was regarded as a sign that they were street-wise. Now we are not so sure. The consultation processes on rules and regulations were highly structured, and much effort was devoted to ensuring balanced representations from providers and users of financial services. We funded research for a Consumer Panel in an effort to ensure “equality of arms.” Of course, regulatory staff had more informal links with the industry than with consumers. But that is inevitable in any country. The industry’s voice was more often heard in Parliament as well. The most effective lobbyists were Independent Financial Advisers, who seemed to be especially active in the local Conservative Party associations. Goldman Sachs could learn a lot from their tactics! I have no first-hand knowledge of the legislative process in the United States. But, as an outsider, I am amazed at the apparent intensity of lobbying, and at the amounts of money that firms and their associations spend. Is it effective? The media seem to think so, though with relations between government and industry still only a notch below open warfare, it is difficult to be sure. An intriguing sidelight on the relationship between Congress and business is provided in a study by Ahmed Tahoun of the London School of Economics on “The role of stock ownership by US members of Congress on the market for political favors.” Tahoun analyzed the relationship between stock owned by congressmen and contributions their political campaigns by the relevant firms, and found a powerful positive association. In particular, Tahoun’s research shows that US congressmen systematically invest more in firms that favor their own party, and that when they sell stock, firms stop contributing to their campaigns. Moreover, firms with more stock ownership by politicians tend to win more and bigger government contracts. The data are not from financial firms alone, and Tahoun has not disaggregated them by sector. But the results are of interest nonetheless. They suggest a less-than-healthy relationship between lawmakers’ political and pecuniary interests. Regulators are typically not subject to those temptations. They are not normally allowed to own stock in financial firms (at least in the jurisdictions that I know). But can they nonetheless be captured? I see two potential grounds for concern. The first is the revolving door between the industry and regulatory bodies. This is more prevalent in the US, where regulators’ salaries are very low, especially in the Securities and Exchange Commission and the Commodity Futures Trading Commission. Turnover among senior – and not so senior – people in these agencies is very high. The Fed folk are paid a little better, and stay rather longer. The United Kingdom pays its regulators more, but there is still a lot of “in and out” activity, and more than there used to be. Singapore and Hong Kong have a different model. Their regulators are given market-related compensation packages, and continuity of senior staff is more effectively maintained. My view is that the Asian financial centers have it right. The second concern is what one might call intellectual capture. While I would strongly argue that the FSA in my day did not favor firms unduly, it is perhaps true that we – and in this we were exactly like US regulators – were inclined to believe that markets were generally efficient. If willing buyers and willing sellers were trading claims happily, then, as long as they were “professional” investors, there was no legitimate reason to interfere in their markets. These people were “consenting adults in private,” and the state should avert its gaze. We now know that some of these market emperors had no clothes, and that their activities, far from benign, could result in severe financial instability and generate serious losses for taxpayers, not to mention precipitating a global recession. That has been a grave lesson for regulators and central banks. So intellectual capture is a charge hard to refute. But were regulators surrogate lobbyists for the financial industry? I do not think so, and to argue as much devalues the efforts of many overworked and underpaid public servants around the world. Howard Davies, former Chairman of Britain’s Financial Services Authority and a former Deputy Governor of the Bank of England, is currently Director of the London School of Economics. His latest book is Banking on the Future: The Fall and Rise of Central Banking. Ends