Presentation given at the seminar ‘Towards a Sustainable Financial System’ organized in Stockholm on the 12-13 September 2013 by Global Utmang, London School of Economics, and the Swedish House of Finance
Regulatory Capture and Mitigating Strategies (Stockholm)
1. Towards a More
Sustainable
Regulatory Process
Regulatory Capture and
Mitigating Strategies
Dr. Stefano Pagliari
Stefano.Pagliari.1@City.ac.uk
Seminar „Towards a Sustainable Financial System‟
Stockholm, 12-13 September 2013
2. “Is it possible at all to create
an international regime that
prevents regulatory capture?”
George Stigler (1971) & the motor trucking industry
“as a rule, regulation is acquired by the industry
and is designed and operated primarily for its
benefit”
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
Stakeholders
•Banks
•Other financial firms
•Non-financial business
groups
•Consumers, NGOs, …
Regulatory
policies
•Information
•Incentives
•Ideas
Regulators
•Rule-making
•Enforcement
•Supervision
3. When is the regulatory
process more likely to fail us?
3 Factors
Demand: Balance of
Stakeholders
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
4. 3 Factors
Demand: Balance of
Stakeholders
Supply: Institutional
Design of Regulatory
Agencies
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
When is the regulatory
process more likely to fail us?
5. 3 Factors
Demand: Balance of
Stakeholders
Supply: Institutional
Design of Regulatory
Agencies
The Broader Political-
Economic context
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
When is the regulatory
process more likely to fail us?
6. Asymmetry among
stakeholders competing
for regulatory influence
Financial Resources
$1.4 million spent daily by
financial industry to lobby
Congress during crisis
Technical Expertise and
Information Asymmetries
Collective action problem
(deposit
holders, investors, and
retail consumers)
Demand Side:
Balance of Stakeholders
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
• 1999-2008:$2.7 billion in reported federal
lobbying expenses by fin. Industry
• $1.4 million spent daily during financial crisis
7. Heavy bias towards business
Since the crisis:
Greater diversity of
stakeholders
Greater diversity within the
business community
Source: Pagliari and Young 2013
Pre-
Crisis
Post-
Crisis
%
Difference
Finance 75.1% 60.3% -19.8%
Non-financial business
groups
16.4% 24.2% +47.5%
NGOs / Cons. / Trade
Unions / Research
8.4% 15.5% +83.8%
USA EU UK
Financial business
groups
66.6% 70,6% 59.6%
Non-financial business
groups
23.2% 18.9% 28.1%
NGOs / Cons. / Trade
Unions / Research
10.2% 10.5% 12.2%
Capital Requirement Directive (CRD
IV)(2010)
Banks 43.7%
Non-bank financial groups 33%
Non-financial business groups 19.6%
NGOs / Cons. / Trade Unions / Research 3.6%
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
Demand Side:
Balance of Stakeholders
8. Balance of stakeholders
Heavy bias towards business
Since the crisis:
Greater diversity of
stakeholders
Greater diversity within the
business community
Rule-making vs.
implementation
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
9. Supply Side: Institutional
Design of Reg. Agencies
Independence of Regulators
Mandate
UK FSA mandate included to “have
regard to” the competitiveness of the
financial services industry.
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
10. Supply Side: Institutional
Design of Reg. Agencies
SEC Staff Shares
traded in US
1939 1,700 260 mln
2001 2,900 2 bln.
2009 3,584 5.4 bln.
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
Independence of Regulators
Mandate
Funding
226,400 employees - 4.5 UK FSA Staff
11. Supply Side: Institutional
Design of Reg. Agencies
Independence of
Regulators
Mandate
Funding
Staffing and Revolving
Doors
Inter-temporal conflict of
interests
Preferential Access & Inside
Knowledge
Socialization, Psychological
Biases, & Intellectual Capture “It takes a thief to catch a thief” (F.D. Roosevelt)
12. The Broader Economic and
Political Context
Capture through the political
process
Electoral weight of financial industry
Banks and the financing of the real
economy
Banks as buyers of sovereign-debt
Impact of the Eurozone crisis
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
Source: FT from ECB data
13. Cyclical Nature of Capture
SlumpSlump
Crisis Crisis
Boom
Boom
Pressures on
regulators not
to „remove the
punchbowl
from the party‟
Electoral
pressures to
re-regulate
Pressures on
regulators not to
forestall economic
recovery
“on the whole, banks [in
the UK] did not have to
lobby politicians, largely
because politicians
argued the case for them
without obvious
inducement”
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
the Bank of England as
“capital Taliban”
14. What can we do about it?
1. Promoting greater
balance and
diversity among
stakeholders
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
15. What can we do about it?
1. Promoting greater
balance and
diversity among
stakeholders
2. Reforming the
institutional design of
regulatory agencies
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
16. What can we do about it?
1. Promoting greater
balance and
diversity among
stakeholders
2. Reforming the
institutional design of
regulatory agencies
3. External checks and
balances
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
17. 1. Promoting Greater Balance
& Diversity of Stakeholders
Breaking up large banks (S. Johnson)
Participatory Mechanisms
Tripartitism & Proxy advocates
E.g. Consumer Panels; Finance Watch
Promoting long-termism and
diversity in fin. industry lobbying
Compensation rules, fiduciary duties
of boards, ownership.
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
18. 2. Reforming the Institutional
Design of Reg. Agencies
Mandate: danger of
conflicting/ambiguous
mandates
Internal decision-making
IMF‟s IEO: „strengthen the
incentives to “speak truth to
power”‟ and „create internal
advisory boards „to
challenge and think the
unthinkable‟
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
19. 2. Reforming the Institutional
Design of Reg. Agencies
Mandate: danger of
conflicting/ambiguous mandates
Internal decision-making
Staffing & Revolving doors
Mitigating strategies: e.g.
disclosure, cooling off
periods, complement “revolvers”
and career supervisors
Promote diversity of experiences
and training (e.g. IMF)
Funding
Level
Source
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
20. Limits of existing checks
Board of Directors
Parliament
Media
3. External Checks & Balances
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
21. Public Interest Review Bodies
“The Sentinel” (Barth Caprio and
Levine 2012)
Reciprocal oversight from other
domestic regulators
Macroprudential regulators
Consumer protection bodies
Reciprocal oversight from
foreign regulators
Financial Stability Board‟s Peer
Review
Colleges of Supervisors,
IMF‟s surveillance (FSAP and ROSC)
3. External Checks & Balances
Dr. Stefano Pagliari
Towards a Sustainable
Financial System
Stockholm, 12/09/2013
22. Towards a More Sustainable
Regulatory Process
Regulatory Capture and Mitigating
Strategies
Thank you for your attention
Dr. Stefano Pagliari
Stefano.Pagliari.1@city.ac.uk
www.stefanopagliari.net
Editor's Notes
We have gone through the most extensive redesign of regulatory policies since the 1930s. We have expanded the perimeter of regulation to incorporate markets and institutiosn that were left outside. We have revised existing standards. Created new regulatory institutions.HOWEVER, not much discussion of what could be done to improve the regulatory process.In my presentation I’m taking the challenge to address one of the questions that was posed in the panel description: “Is it possible at all to create an international regime that prevents regulatory capture?” Origin of the concept:Concept is used frequently but in many different forms - to explain too much regulation, lack of regulation, or the wrong kind of regulation - different phases of the regulatory process (rule-making, supervision, enforcement and implementation)Little consensus regarding the extent of the problem and its causesHow do we prove the presence of capture? Where does the public interest resides in the presence of competing objectives (e.g. stability vs. growth)?When is a policy shift the result of the action of special interests?More groups or actors are capable to exercise an influence that knocks the regulator off its original balance (e.g. large consumers; electorally-driven politicians)Regulatory and supervisory process based on close and continuous interaction between regulators and regulated firms required to” to stay abreast of rapidly changing financial markets, to monitor the build-up of risks, to understand the impact of their regulatory policies. Proximity opens the regulatory process to the risk of unduly favoring narrow industry interests at the expense of the publicIncentivesInformationIdeas (socialization)PROBLEM OF EMPIRICAL EVIDENCEProblem of Empirical Evidence: “analysts have often inferred capture from episodes in which regulators partially relyupon firms, from patterns of regulatory advantage granted to certain groups, or simply ‘on the basis of observations of undesired regulatory outcomes, even though those outcomes might be caused by a number of things besides capture such as ‘regulators’ incompetence, inefficiency, or randomness’ (Carpenter and Moss)
Money: More relevant in the US than in Europe; More relevant vis-à-vis politicians than regulatorsInformationlimited engagement of deposit holders, investors, consumers of financial services
(endency to aggregate figures regarding the participation of different financial interest groups and the money spent by these groups to lobby policymakers often masks the fact that the interests and demands of different financial groups frequently diverge)debates surrounding financial regulatory policies do not always present the sort of frontal and asymmetrical clash between competing producers’ and consumers’ interests described by some regulatory capture theorists
(endency to aggregate figures regarding the participation of different financial interest groups and the money spent by these groups to lobby policymakers often masks the fact that the interests and demands of different financial groups frequently diverge)debates surrounding financial regulatory policies do not always present the sort of frontal and asymmetrical clash between competing producers’ and consumers’ interests described by some regulatory capture theorists
While the delegation of regulatory functions to independent agencies has been an attempt to protect the regulatory process from short-term pressures of politically influential stakeholders, the institutional design of independent regulatory agencies may still tilt the playing field in favour of certain stakeholders. FUNDINGForinstance, while from 1939–2009 the number of SEC employees haslittle more than doubled, the number of shares trading hands each day in the US has increased more than twenty times.126 Also, therecent investigation in the UK into the failure of the Royal Bank of Scotland has raised concerns regarding the inadequacy of thefunding of regulatory agencies, as the task of supervising a bank with a presence in over 50 countries and employing 226,400 peoplewas fulfilled at the beginning of the crisis by a team comprising onlyfour-and-a-half membersINTELLECTUAL CAPTURE:Lord Turner talksed about Capture through the intellectural zeitgeistAccording to Kwak, thepotential for this sort of capture increases with the complexity of theproblem: ‘faced with uncertainty deciding between competingtheories of the world and the public interest, people are more likely to fall back on the signals communicated by identity, status, orrelationships’.
While the delegation of regulatory functions to independent agencies has been an attempt to protect the regulatory process from short-term pressures of politically influential stakeholders, the institutional design of independent regulatory agencies may still tilt the playing field in favour of certain stakeholders. FUNDINGForinstance, while from 1939–2009 the number of SEC employees haslittle more than doubled, the number of shares trading hands each day in the US has increased more than twenty times.126 Also, therecent investigation in the UK into the failure of the Royal Bank of Scotland has raised concerns regarding the inadequacy of thefunding of regulatory agencies, as the task of supervising a bank with a presence in over 50 countries and employing 226,400 peoplewas fulfilled at the beginning of the crisis by a team comprising onlyfour-and-a-half membersINTELLECTUAL CAPTURE:Lord Turner talksed about Capture through the intellectural zeitgeistAccording to Kwak, thepotential for this sort of capture increases with the complexity of theproblem: ‘faced with uncertainty deciding between competingtheories of the world and the public interest, people are more likely to fall back on the signals communicated by identity, status, orrelationships’.
While the delegation of regulatory functions to independent agencies has been an attempt to protect the regulatory process from short-term pressures of politically influential stakeholders, the institutional design of independent regulatory agencies may still tilt the playing field in favour of certain stakeholders. FUNDINGForinstance, while from 1939–2009 the number of SEC employees haslittle more than doubled, the number of shares trading hands each day in the US has increased more than twenty times.126 Also, therecent investigation in the UK into the failure of the Royal Bank of Scotland has raised concerns regarding the inadequacy of thefunding of regulatory agencies, as the task of supervising a bank with a presence in over 50 countries and employing 226,400 peoplewas fulfilled at the beginning of the crisis by a team comprising onlyfour-and-a-half membersINTELLECTUAL CAPTURE:Lord Turner talksed about Capture through the intellectural zeitgeistAccording to Kwak, thepotential for this sort of capture increases with the complexity of theproblem: ‘faced with uncertainty deciding between competingtheories of the world and the public interest, people are more likely to fall back on the signals communicated by identity, status, orrelationships’.
Finally, while the different faces of capture described above pertain to the interaction between regulators and the regulated firms, different commentators have broadened this analysis to account for the role of the politicians, governments and legislative bodies who define the responsibilities that independent regulatory agencies need to follow and grant them the resources and powers to perform these tasks. n particular, in those circumstances where an apparent trade-off exists between the mandate of regulatory agencies to bolster financial stability and the goal of promoting economic growth (such as in defining appropriate capital requirements for banking institutions), then political incumbents as well as a number of societal stakeholders are more likely to support financial industry groups in demanding a watering down of the regulatory measures introduced in the middle of the crisis.68
Finally, while the different faces of capture described above pertain to the interaction between regulators and the regulated firms, different commentators have broadened this analysis to account for the role of the politicians, governments and legislative bodies who define the responsibilities that independent regulatory agencies need to follow and grant them the resources and powers to perform these tasks. n particular, in those circumstances where an apparent trade-off exists between the mandate of regulatory agencies to bolster financial stability and the goal of promoting economic growth (such as in defining appropriate capital requirements for banking institutions), then political incumbents as well as a number of societal stakeholders are more likely to support financial industry groups in demanding a watering down of the regulatory measures introduced in the middle of the crisis.68
Important to reduce the risks that regulators find themselves exposed to one-sided evidence from the regulated financial industry. Limit the risk of groupthink and intellectual capture Competition among groups is beneficialLower risk of intellectual capture and groupthinParticipatory mechanismspublic consultationsby themselves are unlikely to be sufficient to ensure that a plurality ofstakeholders will be capable of having their share of the input into theregulatory processa highlytechnical area such as financial regulation, the financial industrygroups with the greatest technical expertise continue to be bestpositioned to take advantage of these mechanismsTripartitisme.g. regulatory agencies granting access to the information available to them (e.g. internal data and analysis) in order to compensate the information advantage of industry insiders‘form of affirmative action’ on the part of regulators to strengthen thevoice of those real economy interests whose representation is morefragmentedTripartitism & Proxy AdvocatesGranting less-funded groups full access to the data and analyses of regulators and privileged position at the negotiating tableSubsiding the creation of “public interest” voices (e.g. creation of Finance Watch by the European Parliament)Creating directroutes for designated consumer groups to present complaints towhich regulators need to respond within a defined timeframeProxy Advocatescapacity of these bodies to truly represent consumerperspectives in the regulatory process is constrained by differentfactors such a limit to the resources allocated to such bodies, as wellas their location within the organizationPROBLEM OF THESE STRATEGIESWhile the strategies described above seek to mitigate capture byincreasing the capacity of consumers of financial services and othernon-financial parties to act as counterweights to the producers’interests, this strategy is less applicable to the case of those marketswhere the counterparties are not retail consumers but rather otherfinancial groups, such as in the case of wholesale markets.
Important to reduce the risks that regulators find themselves exposed to one-sided evidence from the regulated financial industry. Limit the risk of groupthink and intellectual capture "Centralising the supervisory and systemic roles within the BoE may improve information flow, co-ordination, and a shared sense of purpose. On the other hand, such an arrangement increases the potential of creating a 'group-think' mentality, particularly since a large scope of responsibility is vested in a small number of senior executives,Independence is a pre-requisite but not enoughMANDATEit is likely that ‘industry pressure anda focus on short-term economic concerns that are easily monitoredwill trump the long-term effects on the public that are harder toassess’.95Hiring Practices - Two competing views
Important to reduce the risks that regulators find themselves exposed to one-sided evidence from the regulated financial industry. Limit the risk of groupthink and intellectual capture Independence is a pre-requisite but not enoughMANDATEit is likely that ‘industry pressure anda focus on short-term economic concerns that are easily monitoredwill trump the long-term effects on the public that are harder toassess’.95Hiring Practices - Two competing views
Important to reduce the risks that regulators find themselves exposed to one-sided evidence from the regulated financial industry. Limit the risk of groupthink and intellectual captureSENTINEL-, Barth, Caprio, and Levine have called for the creation ofan independent institution called the “Sentinel” whose unique powerwould be to acquire information required to assess financialregulation and to provide an expert and independent assessment offinancial policies, thus allowing an informed debate Problems:Where do we finance these bodies?To Whatextent the highly political task of actually defining “public interest” ona given regulatory issue can be ‘entrusted to a group of disinterested“wise men”’.
Important to reduce the risks that regulators find themselves exposed to one-sided evidence from the regulated financial industry. Limit the risk of groupthink and intellectual captureSENTINEL-, Barth, Caprio, and Levine have called for the creation ofan independent institution called the “Sentinel” whose unique powerwould be to acquire information required to assess financialregulation and to provide an expert and independent assessment offinancial policies, thus allowing an informed debate Problems:Where do we finance these bodies?To Whatextent the highly political task of actually defining “public interest” ona given regulatory issue can be ‘entrusted to a group of disinterested“wise men”’.