It's Normal for Regulators to Get Captured

Regulatory capture is not some horrid aberration; it is closer to the natural state of a regulatory body.
The lure of Goldman Sachs.

I’m in Chicago this week, preparing to give a seminar on covering the policy process at the Institute for Politics. So I don’t have much time to write about the secret Fed tapes that were released by "This American Life" last week. But I do want to make one point: This is not surprising. It’s normal.

Academics call it “regulatory capture,” the process by which the regulators who are put in place to tame the wild beasts of business instead become tools of the corporations they regulate, especially large incumbents. The important thing to understand is that regulatory capture is not some horrid aberration; it is closer to the natural state of a regulatory body. There are a lot of reasons for this, but here are the highlights:

  1. The regulated industry controls the information used by the regulator. Where do you get information about the banking business? From bankers. Obviously it would be nicer to get it somewhere else, but where else would you go? The information regulators rely upon is always, always biased toward the viewpoint of the regulated. Regulators can, of course, insist that regulated industries provide extensive information, under pain of terrible penalties. What they cannot do is insist that the regulated industries provide information they would like to know but aren’t aware exists. Think of it as a giant game of hide-and-seek in which the seeker has a gun but the hider has the only accurate map of the premises.
  2. The regulated industry cares more about regulations than anyone else. As a consumer of electricity, you care a lot about lower electricity prices. But what’s your opinion about recovery of stranded costs on redundant capacity investment? If the regulator decides the wrong way about this issue, are you going to go down to the utility commission and make a fuss? What if they’re meeting on the same night as Sasha’s school play? Or the Wednesday night church potluck, when your best friend is making her amazing brownie casserole? Regulatory bodies, like other organisms, shy away from negative stimuli. That’s why the FDA tends to slow-walk the approval process unless some loud advocacy group is on their tail: A drug that could have saved lives but fails to get approval costs them little, while another thalidomide would be personally disastrous for those who approved it. It’s why OSHA nitpicks small businesses over trivia -- better millions of man-hours lost on elusive safety goals rather than one worker who managed to get dismembered on a job site without an OSHA warning registered against it. For a banking regulator, unless there’s a financial crisis, the worst negative stimuli is likely to come from angry bankers, not consumers who are outraged about the decision to let Goldman Sachs hold some Santander Brasil stock for a while. This is one big reason that agencies that start out as fierce hawks intent on putting industry in their place end up as docile partners helping the incumbents shut out new competition. Over time, whatever public outcry gave rise to the agency fades away. But the industry is still focused on the regulators with the intensity of one of those super-lasers they use to create unnatural elements, 365 days a year.
  3. The only place where a longtime regulator can get a new job is in the regulated industry. Everyone laments the revolving door. No one proposes a realistic alternative. If you enact a life ban on employment in any regulated industry, you’re essentially telling regulators that staying in their job for longer than a couple of years is the next best thing to a prison sentence. That is going to make it hard to attract good candidates, and you’ll end up with a regulatory body composed entirely of fresh-faced 20-somethings who are putting a couple of years in at the Fed before they head off to graduate school. If you don’t enact such a ban, you will find that your best people are constantly leaving for better-paid jobs in the regulated industry ... and maybe, while they’re still some of your best people, they’re thinking, “Is this really worth making a potential employer mad?” Conversely, if you try to keep industry folks out of your regulatory body, you end up with a bunch of dangerous know-nothings whose decisions amount to “Hulk smash!” And if you don’t, you end up with a regulatory body composed of people who naturally share the viewpoint of the industry they regulate. This is a big problem in any industry, but it’s especially bad in banking, because it’s hard to imagine that any government job will ever pay a fraction of what a bank does. Goldman Sachs pays many of its secretaries better than all but the top rungs of the general schedule civil-service scale. The Fed scale is higher, but not that much higher.
  4. It’s hard to stay confrontational all the time. Who do regulators see most often? The folks in the industry that they interact with. In the fantasy world of regulatory utopias, every single day, the regulators walk into an office, glare at the people they’re talking to and say, “Now why don’t you tell me the truth about these 1047-A-51Cs you just filled out, Mr. Jones?” In the real world, regulators are people, too, and people are social animals. They want to be liked. They compliment baby pictures. They call you a cab when you’re struck by a sudden attack of stomach flu in the middle of the examination. All of this subtly mutes the “attack dog” mode that we expect our regulators to maintain.
  5. Lobbying. It’s hard to adopt the Conan the Barbarian approach when you know that the boss of the folks you’re talking to is hosting a big fundraising dinner for your ultimate bosses in Congress and the White House.
  6. Making a regulator’s job easier. What’s easier to regulate -- a few staid old incumbents that you know well or a zillion upstarts who don’t know the rules, don’t have a highly competent and extensive staff of compliance officers to deal with the regulators, keep changing what they do, forcing you to figure out what that means and come up with whole new sets of rules to cover the evolving marketplace and ... I don’t really need to ask this question, do I? Over time, the interests of regulators and the interests of incumbents tend to converge upon keeping things nice and tidy by making sure that experienced players dominate the field. I’m not saying that we should be happy about regulatory capture; I’m just saying that we should expect it. Every time something goes wrong in a regulated business, someone says, “We need to create an agency that isn’t in thrall to [insert the names of industry giant here].” This is a little bit like saying, “We need to create an offensive lineman who doesn’t get hit so much”; you are acting as if the problem is the person, rather than the role. If you put an offensive lineman between your quarterback and the opposing team, he’s going to get hit. And if you put a regulatory agency between your legislators and some industry, it is going to get worked on by the companies it regulates. Inevitably, your agency will end up captured by some special interest. So think hard about how to design an agency that can do good work anyway.

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