Guest Post: Capturing the Regulatory Mothership

This guest post was contributed by Ilya Podolyako, a third-year student (for a few more days) at the Yale Law School and until recently executive editor of the Yale Journal on Regulation and co-chair, with James Kwak, of the Progressive Law and Economics reading group.
Though many economic indicators continue to look grim, the sense of crisis has largely faded from the front pages in the last few weeks. In my opinion, this is shift in demeanor of reporting is due to audience fatigue, not some fundamental change in the underlying dynamics of the economy. As the ever-prescient Onion points out, the American public has only so much tolerance for tragic stories, regardless of their source. For better or worse, however, calls for a drastic restructuring of the regulatory framework have quieted as of late. The Obama Administration has already spent a large amount of political capital on its first round of stimulus, the auto “bailouts,” and the day-to-day management of the financial sector, and will likely have to use up some more for further bank recapitalization and a possible second round of the stimulus. Unsurprisingly, in this environment, blueprints for a brand-new “systemic” financial regulator seem to have been shelved, despite a general consensus that some such entity is necessary to avoid future economic meltdowns.
This development may have some surprising upsides. For one, we have time to scrutinize the wisdom of putting enormous power into the hands of a single agency. The extant regulatory framework is certainly inadequate in many respects. Yet consolidating the exchanges, the SEC, the CFTC, the OCC, the OTS, federal housing agencies, federal consumer protection organs, a macroeconomic policy maker, a new oversight agency for derivatives, and perhaps a dedicated industrial policy manager into one body with wide-ranging authority carries enormous risks that cannot be ameliorated unless we manage to fix certain seemingly intractable underlying problems first. These include the outsize importance of the financial services sector to the U.S. economy, the permeation of government by individuals with a vested interest in preserving this status quo, and basic human fallibility and greed. Of particular concern is the possibility of regulatory capture, which takes place when a regulator begins acting for the benefit of its subjects rather than in accordance with its stated mandate of minimizing systemic risk. While any agency can theoretically be captured by concentrated and powerful individuals, a breach of the “mothership” would carry far more severe repercussions than the loss of one or two “destroyers.” Of course, only the mothership can accomplish certain tasks; in the economic context, it would exist to take on challenges of a scope that smaller bodies simply cannot handle.
The dynamics in play are thus straightforward. First, the capture of a single, large regulator could carry catastrophic consequences, whereas the capture of a smaller regulator that holds only a fraction of the mothership’s powers would be merely disastrous. Second, we want a mothership, because our current fleet doesn’t seem up to task. Third, if getting the mothership actually increases the vulnerability of the economic system over a dispersed set of regulators coordinated by the president, we should resist the temptation to get it and look elsewhere for solutions. The problem is that determining whether the third condition holds is actually quite difficult. I have been working on a game-theoretic model that could suggest an answer, but in the meantime, a smattering of observations should suffice.
Two archetypal scenarios for regulatory capture exist. The first is an underpowered, understaffed regulator working to control a wealthy, concentrated industry. In these situations, the sheer imbalance in resources means that the regulated parties can reward or punish the agency, but not vice versa. Predictably, rational bureaucrats will choose to cater their policies to the benefit of the subjects instead of suffering their wrath – recall, a regulatory job well done rarely carries any significant benefits to its engineers. The Department of Interior’s Minerals Management Service is a perfect example of a body that appears to have fallen prey to this pattern. Even a person of upstanding moral character can understand the difficulty of resisting the repeated entreaties of Exxon and the like for the sake of sticking to an unadulterated scheme of allocating oil and gas exploration rights. Someone sitting at the MMS desk may well wonder if anyone would ever notice a shift away from the prescribed approach towards one that favors the companies they deal with on a day-to-day basis. These incentives to cooperate exist even though the relationship between the regulator and the regulated parties is facially adversarial, with MMS holding rights that producers want but cannot get.
The second standard scenario for regulatory capture takes place when the same agency identifies items to source from the private sector and supervises the production of these items. The Department of Defense springs to mind as an example. The Pentagon almost certainly has the best interests of the Armed Forces in mind when it sets out its procurement goals. The combination of public (“free”) money and a desire to avoid saying one’s coworkers and superiors made a mistake, however, means that projects live on even when they go horribly wrong. Private-sector contractors benefit from bloated budgets for littoral combat ships that suffer from fundamental structural defects (the program has since been scrapped), military officers occasionally pick up a kickback, and the taxpayer ends up footing the bill. The political prominence of the Pentagon aggravates the effects of regulatory capture, since colonels know they can fight off most allegations of inefficiency by claiming that a critic is unwilling to support the troops.
A financial superregulator would have certain characteristics that distinguish it from the above examples. Unlike the Department of Defense, it will focus on a politically unpopular constituency – bankers – and thus be unable to deflect Congressional oversight as unpatriotic. Similarly, any good-faith attempt to create the systemic risk agency would give it power to punish the regulated parties for offensive behavior, avoiding a repeat of the MMS fiasco. These improvements do not make the would-be regulator immune from capture; they just raise the capture’s difficulty and cost.
Problematically, these same measures may increase the willingness of various parts of the financial sector to work together. In the face of reforms that could destroy the hedge fund business, for example, various players could unite in a massive lobbying effort despite the possibility that their competitors could hold out and get the benefits of laxer regulation for free. Even more worrisome is the fact that agency employees will quickly realize both their immense power to dissolve fortunes and the fact that they could benefit enormously from letting some financiers pay them not to do so. Since regulatory pressure is free and political costs of being too tough are diffuse, the only visible constraint on the regulator’s efforts will be the diminution of profits that regulated parties could spend on bribes or lobbying efforts. Currently, various entities battle each other for turf. While a company could buy out a single regulator like the OTS, there is always a threat that a different agency will come in and demand more ransom. This possibility discourages companies from trying to capture individual agencies and encourages them to try to comply with substantive rules. A single, umbrella entity, however, could actually guarantee a positive outcome in exchange for (an admittedly larger) chunk of cash. Indeed, given its ability to make or break businesses, a superregulator could demand payoffs with a previously unseen force. For the first time, industrial investment in corruption could become not just smart, but safe.
Avid readers of this blog will be rightfully skeptical of the above scenario. As the crisis has demonstrated, the current regulatory framework is fraught with issues: it encourages large companies to shop for favorable supervisors, conceals systemic risk, and diverts money from real capital investments towards administrative maneuvering. Yet good intentions alone will not prevent Congress or the Executive Branch from making the situation worse by creating one opaque and powerful agency to take the place of several opaque and powerless ones. Just think of what happened with the CIA.
By Ilya Podolyako