January 31, 2012

Who Will Regulate the Regulators?

Our current regulatory woes are at the root of the financial crisis and can be remedied through a novel institution, new book argues

Guardians of FinanceThree former regulators fault the U.S. and world regulatory systems for the global economic crisis and are proposing the adoption of a new institution to thwart future systemic dangers.

In a soon to be released book called Guardians of Finance, James Barth of the Milken Institute, Gerard Caprio of Williams College and Ross Levine of Brown University argue that global financial regulators have proved to be an insignificant impediment to known or knowable problems which they failed to address on a timely basis.

The authors argue that complex financial products, which often get the rap for having triggered the crisis, cannot have been its root cause since countries like Ireland and Spain where financial innovation were not big factors have also suffered severely through inadequate oversight of their financial industries.

Making the case that a weak regulatory system is key to the crisis, the authors ask: “Why, for example, did U.S. regulators not react to the alarming increases in leverage at financial institutions, or the shift of trillions of dollars of assets from banks’ balance sheets that were packaged into complex securities? Why were Irish regulators willing to sit around for two-and-a-half years waiting for a reply to a letter they sent to the Anglo Irish Bank expressing concerns about its meteoric (and unsustainable) growth? Why did U.K. regulators give the Northern Rock bank a blue ribbon for risk management, and allow it to increase dividends just three months before it failed?”

Yet the authors also decry the standard approach to regulatory lapses of adding further layers of regulations and new bureaucracies to enforce them. Instead, the book, which is excerpted in the current issue of the Milken Institute Review, calls for a novel institution the authors call the Sentinel “to provide expert, independent assessments of financial regulation.”

The problems the Sentinel is designed to overcome include political interference, closeness to regulated business interests, access to information and the expertise to analyze it, and the clout to be taken seriously. For example, the authors cite the lengths to which even the respected Federal Reserve Bank has stymied access to information, thus thwarting the regulatory oversight the public requires:

“In May 2008, Bloomberg News filed a Freedom of Information Act request for Fed documents on its lending to banks. The Fed said it would respond in June, but did not. Bloomberg News sued, and in August 2009, a federal court ruled that the Fed must release the documents. The Fed appealed, and in March 2010, an appellate panel unanimously sided with the lower court. At that point, the Senate called on the Federal Reserve to identify the banks and other financial institutions that received loans. The Supreme Court eventually ordered the Fed to comply. The Fed then released the thousands of documents in a nonsearchable PDF form, making it difficult for the public or the press to examine them.”

Industry influence peddling and the tendency of regulators to feel a sense of community with those they regulate (or to see financial companies as their future employers) are well-known problems, to the extent that “the industry effectively shapes the design of financial-sector policies.” The authors add that “regulators are very aware that they can raise their salaries by a factor of ten by moving to private firms. But the industry’s role is even more direct, influencing regulators by selecting them. For example, the banks regulated by the Fed have a strong voice in choosing the executives running the 12 regional Federal Reserve banks.”

They also lament the speed of the revolving door, citing as an example the U.S. Treasury team that oversaw the Troubled Asset Relief Program: “Treasury’s former chief of staff, deputy assistant for financial institution policy, associate secretary for financial institution policy, undersecretary of domestic finance, adviser to the secretary on the financial crisis, assistant secretary for international affairs, undersecretary for international affairs and associate secretary for legislative affairs have all moved to the financial institutions over which they had just been shaping national policies.”

Recent reform efforts are inadequate to correct these sorts of problems. For example, the authors say the vagueness of Dodd-Frank leaves ample room for business interests to undermine implementation and they claim the law’s enactment a decade earlier would not have prevented the current crisis.

That is why the authors see the need for a new institution, the Sentinel, which would have just one power and one formal responsibility. It would have the power to access any information needed to evaluate financial regulation, and it would have the duty to deliver an annual report to the president and Congress about the soundness of banks, securities firms, insurance companies and ratings agencies as well as issues such as executive compensation. The Sentinel’s senior staff would include financial economists, forensic accountants and the like–at high compensation rates–and they would be barred from financial services industry

jobs for five or more years after leaving their government jobs.

The authors postulate that just knowing that such a body was watching would improve the performance of regulators, though casting a spotlight on industry problems would the Sentinel's primary impact: “What would have happened had a Sentinel highlighted the FBI’s 2004 fraud report in mortgage finance, and the lack of response from the Fed?… What would have happened if an Irish Sentinel had highlighted the dangers to the national banking system in giving out mortgages with virtually no down payments–mortgages that sometimes exceeded borrowers’ incomes tenfold?”

No current institutions have the independence, powers or proper mandate to ensure proper regulation, and because of its independence, the Sentinel would not be hamstrung by a bureaucratic tendency regulators have to cover up past mistakes. Regulators have consistently “created and maintained policies that increased the fragility of the financial system,” the authors lament, and they conclude the public needs an institution with the right knowledge and competence to be watching.

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