Green Ink on the Mediocracy

Cultural capture of financial regulators

Early literature on regulatory capture by Chicago economists (Becker1 Stigler2, Posner3) suggested that all regulators are prone to capture, and that in many cases, they are actually established for the purpose of protecting the industry rather than the public interest. These analyses, focusing on regulators that had been established in the early twentieth century, tended to perceive regulation itself as the problem, and advocate deregulation as the solution.

However, what they failed to take into account was that regulators were often established in an effort to resolve problems of legislative capture, or as it was then known, political corruption. As William Novak writes4, they were not naïve and idealistic attempts to impose paternalistic policies on a public that didn't know what was good for it. Rather, they were attempts to protect the implementation of government policy from the political pressures that special interests were able to exert. That those interests should try to influence the new regulatory agencies would not have come as any surprise, but the hope was that some of the incentives that tempted politicians to favour special interests would not affect the regulator. Thus, simple deregulation will not solve the problem, and in financial regulation, since at least 2008, we have been suffering the consequences.

The most direct channels of regulatory capture are pecuniary incentives provided by the industry to the regulator itself to implement the rules in such a way that favours the industry. Other than illegal behaviour such as bribery or blackmail, examples are the ‘revolving door’ whereby regulators can solicit lucrative jobs in the industry after leaving the regulator; or regulatory arbitrage, where firms must pay fees to the regulator, and also have some choice over which agency they are regulated by, thus giving the agencies an incentive to court them with favourable implementation.5 A similar dynamic prevailed with the Credit Rating Agencies, who although not public bodies, were made responsible for risk ratings that in effect determined the official capital requirements for banks.6 Banks paid the CRAs to rate their derivative products, and could shop around for the highest rating.

Cognitive capture

Cognitive capture however occurs when a regulator comes to their own view of their duty, which, for whatever reason, coincides more closely with that of the industry than would that of an objective observer. Cognitive capture can occur even in the absence of any obvious pecuniary incentives.

So if not pecuniary, what are these corrupting incentives, and how do they capture our minds without us noticing? James Kwak7 outlines three types of cognitive bias that could tilt financial regulators in favour of the financial industry: identity; status; and relationships.

Experiments have shown that our behaviour to others is affected by whether we feel a shared identity with them. Even when we share some completely arbitrary trivial identity, we are more trusting, more trustworthy and more generous. Kwak suggests this is likely to work in favour of financial companies, because in terms of education and background, financial professionals and their regulators are likely to have a lot in common. Furthermore, the revolving door, leaving aside career incentives, has the effect that the regulator and the regulated are actually the same people, just at different stages in their careers. Kwak cites a New York Times report that over the period 2009 to mid 2010, 148 former regulators registered as lobbyists.8

Status has a similar effect to identity. Ball and Eckel9 conducted an experiment in which economics students were asked to complete a quiz and then given a random rather than a correct score of their results. They were sorted into groups who were said to have done well (“stars”) and not well (“no-stars”). Following an award ceremony in which “stars” were presented with a gold star while “no-stars” applauded, the students were then divided into pairs and asked to play an ultimatum game in which one player must divide a prize into two portions and offer one to the other player. The other player can either accept or decline. If they decline then neither player receives any of the prize. “Stars” ended up with more money. People with even this seemingly trivial type of ‘high status’ receive favourable treatment. It is not difficult to imagine the status gap between a regulator and the Wall Street ‘Masters of the Universe’. Apart from the obvious remuneration chasm, over the past 30 years the financial industry has evolved from the boring 3-6-3 model10 into attracting the top students from all the best universities to try and stay ahead in the race for financial innovation.

The relationship effect is simply that we tend to be more agreeable towards people when we can ‘put a face on them’ or when we are aware that they can put a face on us. The job of a regulator is to ensure that the public interest prevails when it comes into conflict with private interests. The public has no particular face, while private interests will go to some trouble to engage on a personal level with the regulator.

All three of these forms of cognitive bias were brought vividly to life in an episode of the radio programme This American Life.11 Carmen Segarra, an employee at the New York Fed who worked with a supervising team housed actually inside the Goldman Sachs office, was so concerned by the timidity of the Fed employees and the pressures on herself to conform to this deferential attitude that she recorded a number of internal meetings. This took place not only after the financial crisis, but also after an internal Fed report12 that had highlighted exactly these issues. On beginning work at the Goldman office, Segarra was shocked by how comfortable the Goldman executives felt with her Fed colleagues. For example, one of them said that there was a Goldman view that once clients were wealthy enough, certain consumer laws didn’t apply to them. She was even more shocked when her colleague told her to pretend she hadn’t heard it. Her colleagues frequently tried to get her to change her meeting minutes. The extraordinary lack of confidence revealed in the recordings is remarkable when one considers that this is the institution that only a few years earlier had effectively bailed out the entire world financial system.

Cultural capture

If cognitive capture is the infiltration of special interests into the individual minds of regulators, cultural capture can be seen as the occupation of the entire intellectual environment. Luigi Zingales warns of the dangers that academics can also be captured by financial firms. In a book chapter on “Preventing Economists’ Capture13, he runs through the forces that lead to regulatory capture and then explains how they can equally apply to academic economists.

As well as some of the mechanisms discussed above, Zingales explains that a proprietary data set can sometimes make the career of an academic, and that firms will not want to share data with academics unless they are confident that the resulting analysis will not threaten their interests. Specialisation can also be a factor. Someone who has dedicated their life to understanding derivatives is perhaps more likely to have a positive attitude towards their usefulness, just as a nuclear engineer is more likely to be enthusiastic about nuclear power.

Zingales then discusses the concentration of influence over economics that resides in the editors of the major economics journals. Journal editors are in very influential positions because of the particular nature of the peer-review process, where they choose the referees, and also the prohibition on simultaneous submission to different journals. While he says that he is ‘very confident that editors receive no form of direct pressure to publish articles that reflect more pro-business interests’, he says that the other causes of bias will cause the selection of editors to be skewed in favour of financial interests. This bias then becomes magnified and self-reinforcing through the editorial process.

Zingales' first recommendation, titled ‘The Power of the Media’ advocates the encouragement of news organisations to shame academics in the way that the film ‘Inside Job’ embarrassed Columbia Business School for its feeble conflict of interest policy14. He refers to an earlier paper he co-authored15, which argues that a price-competitive media will inform the public of their interests which are then reflected by their political representatives and find their way into regulation. Its central argument is that to maximise profits a media organisation must maximise its audience and this can only be done by a) presenting the news in an engaging and entertaining way, and b) appealing to the interests of those marginal consumers who because of their poverty are most likely to decide not to buy the product.

Far from being the solution to cultural capture, the power of the media is at the very heart of the problem. Firstly, in the modern media, almost all revenue comes from advertising, and advertisers are least interested in marginal consumers16. Secondly, finding an entertaining way of explaining some new loophole in derivatives regulation would seem unlikely to be the most cost-effective way of engaging these marginal consumers.

More importantly though, the forces of bias that capture news editors are an exponential function of those that pull on the editors of economic journals. Unlike academic journal editors, news editors hire all their writers. And, they most certainly do receive ‘direct pressure to publish articles that reflect more pro-business interests’. Peter Oborne wrote in his resignation letter as Chief Political Commentator at the Daily Telegraph:

“The Telegraph’s recent coverage of HSBC amounts to a form of fraud on its readers. It has been placing what it perceives to be the interests of a major international bank above its duty to bring the news to Telegraph readers.”

Analysis by the Media Standards Trust showed that there was indeed bias17.

However this kind of seemingly blatant quid pro quo between editors and advertisers is only a small part of the problem. Writing about Washington lobbying and the financial crisis, Lawrence Lessig says: “These were not stories of public officials being bribed. Indeed the most complicating and difficult fact of this transformation is how firmly and independently many of the key figures believe in deregulation as an ideal.”18 Various incentive factors skew the selection and coverage of news without any individual intention.

Bankers have always been valuable to economic policy, but in the days of Sidney Weinberg, who led Goldman Sachs from 1930 until 1969 while at the same time sitting on the boards of many of America’s largest companies, that was because of the unique perspective investment bankers had on the real economy. Weinberg was asked by successive presidents to recommend political appointments19. According to Frank Partnoy20 though, since the rise of complex OTC derivatives however, not only has the financial sector become a much larger share of the economy, but it has also become more and more opaque to people outside the system21. As a result, financial alchemists have become indispensable to anyone wanting to understand the system, including legislators, regulators and also journalists. The system is then only visible through an insider prism.

As Oxford Professor Simon Wren-Lewis says on his blog, “Because financial economists need to be good at telling stories that their clients find sympathetic, their worldview tends to be one where a smaller state is good for the economy, higher taxes on top incomes are a bad idea, markets are generally efficient and regulation is harmful.”22

Very often, the purpose of regulation is to internalise the costs of externalities on the businesses that create them. As a result, the costs of regulation are often born by a concentrated number of firms, while the costs of externalities are often widely distributed. A carbon tax for example would force businesses to pay the costs of their carbon emissions. As such, businesses are more keenly aware of the costs than the benefits of regulation. This is particularly true in financial regulation, where systemic risk (the externality) can build up as a direct result of the reduction of individual risk23, so that bankers may feel that they are helping to generally reduce risk, and that the costs of regulation are preventing them from doing as much as they would otherwise. Or as Richard Posner put it: Wall Street does “not have regard for consequences for the economy as a whole — that is not the business of business. That is the business of government.”24 Business as a whole, and finance in particular has therefore been very supportive of the politics of deregulation. There is no reason why media businesses should be any exception. And if the selection of editors of academic journals is tinted through mechanisms of implicit unconscious bias, mass media editors and journalists are often consciously selected for their political affiliations.

While a media oligopoly would wield extraordinary political power as the arbiter of all the information on which an electorate decides to vote, a financial oligopoly has extraordinary power over the financial reputation of any business, including over their share price and their credit rating. Banks are also likely to possess valuable inside information on a firms’ competitors. This of course applies to the media industry as much as any other.

Is there therefore a risk of a potential chain of influence from an overly concentrated financial sector to an overly concentrated media sector to political representatives? Lessig argues that campaign finance is at the heart of cultural capture: remove the distorting incentives of campaign finance and you will go a long way towards restoring the legislative and regulatory agenda to representing the public interest. But where is all that campaign money actually spent? It buys advertising from the media. Is there any particular reason why this money that goes from financial firms to media companies needs to go via Washington? Even if there is no such chain, there is nevertheless a confluence of interests in advocating a general platform of deregulation, against the interests of the public.

The blatant quid pro quo form of lobbying is either illegal or at least politically embarrassing. As a result, Lessig argues, what has evolved is a kind of gift economy in which reciprocation takes the form of moral obligation rather than explicit contractual exchange. These kinds of incentives result in an automatic selection process that corrupts politics towards the interests of powerful firms and away from the public.25

When an organisation grows too powerful it must be diminished. Because of free-rider and coordination problems, it is much more difficult for widely distributed industries to cooperate in lobbying and other rent-seeking activities. Zingales and Rajan advocate a "political version of antitrust law - one that prevents a firm from growing big enough to have the clout in domestic politics to eventually suppress market forces."26

It was recognised after the Great Depression that it was not plausible to pretend that if the financial system collapsed the government would step aside and watch it happen. As systemic risk has increased, the government is therefore by default underwriting the financial system, but without receiving compensation for doing so. As a result the US government effectively wrote blank cheques bailing out the largest banks in the financial crisis. Because of this government guarantee, creditors are more willing to lend to those large banks, and charge them 78 basis points less interest than they do smaller banks, earning them $34 billion in 200927. Every time the government bails out a bank because it is considered too big or interconnected to fail, the less plausible it becomes that it will not do so again, and the greater the incentives for consolidation and increased interconnection. As a result, with each financial shock, the system becomes more brittle rather than less.

The Basel III accords and the Financial Stability Board set up by the G20 agreed to implement stricter capital requirements for designated Systemically Important Financial Institutions (SIFIs). Higher capital requirements mean lower returns on equity.

There are signs that this is beginning to make an impact. GE Capital in April announced it would sell assets so as to shrink its balance sheet from $363bn to $90bn. According to the Financial Times28, this was a direct result of its SIFI status, which it hoped to have lifted. It is not yet clear, but it is likely that GE Capital is a special case, being part of a giant industrial company. To persuade banks to divest voluntarily, the cost of the extra capital buffer will need to outweigh not only the 78 basis point subsidy, but also other advantages associated with being big, including lobbying power. One idea might be a new rule that sets a target maximum size, and then automatically increases SIFI capital requirements until the target is met. A simpler one would be to simply break them all up.

For all the reasons discussed here, this is likely to be a political marathon. If the media industry is not already also far too concentrated, then it is certainly moving in that direction, certainly in the US29 and the EU30. As such it presents another giant risk to the public interest, and one that could, if it hasn’t already, combine in a particularly unhealthy alliance with the financial sector. There must therefore be much stricter limits on media ownership, and stricter public interest obligations that both create diseconomies of scale and make it harder for Media giants to abuse their power. Escalating tax bands on media companies could be structured in such a way that they were revenue neutral, but created incentives for establishing small media companies. Incentives to create diverse structures of ownership would also be beneficial if in aggregate they better reflected the public interest.

In the words of Louis Brandeis, one of the great trust-busters of the early 20th Century, “We must make our choice. We may have democracy, or we may have wealth concentrated in the hands of the few, but we can’t have both.”

1 Gary Becker “Competition and Democracy” 1958

2 George Stigler 1971 “The Theory of Economic Regulation”

3 Richard A Posner 1974 “Theories of Economic Regulation”

4 William J Novak “A Revisionist History of Regulatory Capture” in “Preventing Regulatory Capture” (Cambridge 2014) eds D Carpenter, D Moss

5 “In 2005, the giant mortgage lender Countrywide, then regulated by the OCC, met with the OTS to discuss switching regulators. According to The Washington Post, “Senior executives at Countrywide who participated in the meetings said OTS pitched itself as a more natural, less antagonistic regulator than OCC and that [Countrywide CEO Angelo] Mozilo preferred that. Government officials outside OTS who were familiar with the negotiations provided a similar description.”In March 2007, the OTS approved Countrywide’s application to convert itself from a bank holding company into a savings and loan holding company in order to fall under the OTS’s regulation.” 13 Bankers Simon Johnson and James Kwak 2010

6 ibid p222

7 James Kwak “Cultural Capture and the Financial Crisis” in “Preventing Regulatory Capture” 2014 eds D Carpenter, D Moss

8 “Ex-Regulators Get Set to Lobby on New Financial Rules” Erich Lichtblau New York Times JULY 27, 2010

9 The economic value of status Sheryl Ball, Catherine C. Eckel The Journal of Socio-Economics Volume 27, Issue 4, 1998, Pages 495–514

10 "borrow at 3% lend at 6% and play golf at 3pm"

11 This American Life #536 Sept. 26, 2014: The Secret Recordings of Carmen Segarra

12 Federal Reserve Bank of New York Report on Systemic Risk and Bank Supervision Confidential Discussion Draft: August 18, 2009

13 Luigi Zingales “Preventing Economists’ Capture” in “Preventing Regulatory Capture” (Cambridge 2014) eds D Carpenter, D Moss

14 Inside Job 2010

15 Media Versus Special Interests Alexander Dyck, David Moss, Luigi Zingales Working Paper 14360

16 Dyck et al do concede that “the decline of muckraking journalism in the 1910s can be attributed at least in part to the relevant publications’ increased reliance on advertising income.” ibid

17 Was Peter Oborne right about the Telegraph’s coverage of the HSBC scandal? February 18 2015

18 Lawrence Lessig Republic, Lost (Twelve 2011) chapter 8

19 W D Cohan "Money and Power: How Goldman Sachs Came to Rule the World" (Random House 2011) Ch. 3

20 Lessig ibid p76 quoting Frank Partnoy (George E. Barrett Professor of Law and Finance at the University of San Diego School of Law)

21 It is also worth noting that according to Partnoy, since derivatives can be designed to mimic any actual security, and since they were entirely unregulated, they became a way of investing without the costs of regulation. Some of the profits from circumventing the law in this way could be used to lobby against efforts to close the loophole. Frank Partnoy Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Profile Books 2003) p46

22 Prof. S. Wren-Lewis, (Merton College Oxford)

23 JP Zigrand: Systems and Systemic Risk in Finance and Economics Jan 2014 p38

24 Richard Posner The Crisis of Capitalist Democracy (Harvard University Press 2010) p193

25 Lessig ibid p108

26 Raghuram R. Rajan and Luigi Zingales Saving Capitalism from the Capitalists (Crown Business, 2003) p230

27 Dean Baker and Travis McArthur, “The Value of the ‘Too Big to Fail’ Big Bank Subsidy,” September 2009

28 GE Capital succumbs to changing regulatory climate. Financial Times April 13 2015

29 Obar, Jonathan A.(2009)"Beyond Cynicism: A Review of the FCC's Reasoning for Modifying the Newspaper/Broadcast Cross-Ownership Rule",Communication Law and Policy,14:4,479 — 525

30 A Mapping Study Of Media Concentration And Ownership In Ten European Countries David Ward with Oliver Carsten Fueg and Alessandro D’Armo (Commissariaat voor de Media 2004)