Monday, June 28, 2010

The Dangers of Regulatory Capture

Adam12 makes a very important point in a comment on the previous post. In response to frequently made calls for increased or better regulation of banks and other private interests, he writes:

People recognize that increased regulation or state control of banking, however well-meaning, is not the answer. The track record of American regulators is not inspiring. See the SEC's mishandling of Bernie Madoff as an example. Wall Street has found ways to circumvent regulations for decades and isn't going to stop now.

What Adam12 is getting at is the concept of regulatory capture, a longstanding problem of government that has been studied for decades by political scientists and economists. Regulatory capture occurs when an agency charged with protecting the public interest by regulating the activities of private entities becomes a tool of the entities it is supposed to regulate. In turn, the private entities become embedded in the state and exercise unwarranted power over the policymaking process concerning the industry or activity in question. As the Wikipedia entry for regulatory capture explains:

The idea of regulatory capture has an obvious economic basis in that vested interests in an industry have the greatest financial stake in regulatory activity and are more likely to be motivated to influence the regulatory body than dispersed individual consumers, each of whom has little particular incentive to try to influence regulators. As well, we would expect that when regulators form expert bodies to examine policy, this will invariably feature current or former industry members, or at the very least, individuals with contacts in the industry.

An article in today's New York Times shows how this problem will likely affect the new financial reform bill:

The bill, completed early Friday and expected to come up for a final vote this week, is basically a 2,000-page missive to federal agencies, instructing regulators to address subjects ranging from derivatives trading to document retention. But it is notably short on specifics, giving regulators significant power to determine its impact — and giving partisans on both sides a second chance to influence the outcome...

...Regulators are charged with deciding how much money banks have to set aside against unexpected losses, so the Financial Services Roundtable, which represents large financial companies, and other banking groups have been making a case to the regulators that squeezing too hard would hurt the economy.

Consumer groups, meanwhile, are mobilizing to make sure that regulators deliver on promised protections for borrowers and investors. They worry that the shift from Capitol Hill to the offices of regulators could put the groups at a disadvantage.

“It’s out of the public eye, so a natural advantage that we benefit from — public outrage — we lose that a little,” said Cristina Martin Firvida, a lobbyist for AARP, which advocates for older Americans. “We know there’s still a lot here left to do.”

The ongoing fiasco of the BP oil spill in the Gulf of Mexico is another powerful example of the dangers of regulatory capture. Minerals Management Service (MMS), the agency supposedly in charge of regulating companies engaged in deepwater drilling, was completely captured by the industry. The New Orleans Times-Picayune reports that an MMS office in Louisiana accepted gifts from oil companies and let oil company employees write up inspection reports, all against a backdrop of general corruption and mismanagement within the agency.

Such considerations raise a very important question: is the effective regulation of massive private corporations by the state possible, or is regulatory capture an inevitability in a capitalist political economy?


Adam12 said...

It may be theoretically possible to regulate adequately and avoid regulatory capture, but it would require the regulatory body to find a sufficient number of resources knowledgeable in the relevant field yet can remain free of seduction by the industry and be incorruptible. Can you compensate such people adequately, especially in industries where expertise can bring one unimaginable wealth? That's incredibly difficult! Look at former Congressman Michael Oxley, of Sarbanes-Oxley fame. He authored a landmark reform bill and is now doing consulting work helping people deal with its regulations. If he did it, how can you expect civil servants not to peddle their knowledge to the private sector and exploit their connections to the agencies that they once served?

Larry M. said...

How about regulatory neglect? When enforcement is neutered by deliberate underfunding, even well-designed regulations will not have the desired effect. I think that is similar to regulatory capture in the end result, and in a way attributable to the same factor - acquiescence to the industry under regulation, just by a different mechanism.

Adam12 said...

The SEC was ill-equipped to deal with the growing financial crisis. The staff did not have the knowledge or training needed to understand that Bernie Madoff was inventing his asset returns even after an outraged investor informed them that Madoff's claimed returns were statistically impossible. Robert Rubin, Alan Greenspan and company prevented the regulation of derivatives in 1999. It turned out that even the senior managers of investment banks did not fully understand the complexity of the financial products that their firms were creating. What confidence can we have that the government will be able to design sufficient regulations and enforce them given this history?

Larry M. said...

It's better to enact bright-line laws like Glass-Steagall than to rely on laws with blurrier lines that depend upon creating and enforcing complex regulations.

Adam12 said...

Our legislative process can't produce simple laws any more. The same forces that cause regulatory capture operate to add complexity and loopholes to placate powerful groups that would be hurt by the rules. The financial reform bill was blunted by lobbyists from the financial industry.

Larry M. said...

I just saw that the SEC got a $500 million settlement out of Goldman Sachs. See;_ylt=AlemZRsQdZwWo1_BuUjUMhCs0NUE;_ylu=X3oDMTNmbW9tZ2hxBGFzc2V0A2FwLzIwMTAwNzE1L3VzX3NlY19nb2xkbWFuBGNjb2RlA21vc3Rwb3B1bGFyBGNwb3MDMwRwb3MDMTEEcHQDaG9tZV9jb2tlBHNlYwN5bl90b3Bfc3RvcnkEc2xrA2dvbGRtYW50b3BheQ--. Let's see if they are able to build on this.

Anonymous said...

hi, new to the site, thanks.