Figuring out how much to blame financial regulators for the financial crisis.

Commentaries on economics and technology.
Dec. 26 2010 1:06 AM

Naive, but Not Corrupt

Figuring out how much to blame financial regulators for the financial crisis.

85_ps
SEC logo.
The SEC suffers from high turnover

Relationships between London banks and their regulators are not especially warm just now. The latest rules on bonuses 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 percent 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 to 2003 (the year things began to go wrong!) as a trade association for the financial sector. In America, critics have charged that regulators—and, indeed, Congress—are 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?

Advertisement

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 streetwise. 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 local Conservative Party associations. Goldman Sachs could learn a lot from their tactics!

I have no firsthand 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 U.S. Members of Congress on the Market for Political Favors." Tahoun analyzed the relationship between stock owned by members of Congress and contributions to their political campaigns by the relevant firms, and found a powerful positive association.

In particular, Tahoun's research shows that U.S. members of Congress 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 United States, 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 our American counterparts—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 were far from benign: They could result in severe financial instability and generate serious losses for taxpayers, not to mention precipitate a global recession. That has been a grave lesson for regulators and central banks.

So the charge of intellectual capture is 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 director of the London School of Economics. His latest book is Banking on the Future: The Fall and Rise of Central Banking.

This article comes from Project Syndicate.

Like Slate on  Facebook. Follow us on  Twitter.

TODAY IN SLATE

Politics

Blacks Don’t Have a Corporal Punishment Problem

Americans do. But when blacks exhibit the same behaviors as others, it becomes part of a greater black pathology. 

I Bought the Huge iPhone. I’m Already Thinking of Returning It.

Scotland Is Just the Beginning. Expect More Political Earthquakes in Europe.

Lifetime Didn’t Think the Steubenville Rape Case Was Dramatic Enough

So they added a little self-immolation.

Two Damn Good, Very Different Movies About Soldiers Returning From War

Medical Examiner

The Most Terrifying Thing About Ebola 

The disease threatens humanity by preying on humanity.

Students Aren’t Going to College Football Games as Much Anymore, and Schools Are Getting Worried

The Good Wife Is Cynical, Thrilling, and Grown-Up. It’s Also TV’s Best Drama.

  News & Politics
Weigel
Sept. 19 2014 9:15 PM Chris Christie, Better Than Ever
  Business
Moneybox
Sept. 19 2014 6:35 PM Pabst Blue Ribbon is Being Sold to the Russians, Was So Over Anyway
  Life
Inside Higher Ed
Sept. 19 2014 1:34 PM Empty Seats, Fewer Donors? College football isn’t attracting the audience it used to.
  Double X
The XX Factor
Sept. 19 2014 4:58 PM Steubenville Gets the Lifetime Treatment (And a Cheerleader Erupts Into Flames)
  Slate Plus
Slate Picks
Sept. 19 2014 12:00 PM What Happened at Slate This Week? The Slatest editor tells us to read well-informed skepticism, media criticism, and more.
  Arts
Brow Beat
Sept. 19 2014 4:48 PM You Should Be Listening to Sbtrkt
  Technology
Future Tense
Sept. 19 2014 6:31 PM The One Big Problem With the Enormous New iPhone
  Health & Science
Medical Examiner
Sept. 19 2014 5:09 PM Did America Get Fat by Drinking Diet Soda?   A high-profile study points the finger at artificial sweeteners.
  Sports
Sports Nut
Sept. 18 2014 11:42 AM Grandmaster Clash One of the most amazing feats in chess history just happened, and no one noticed.