Regulatory Capture: Why? How Much? What to do about it?

Regulatory Capture: Why? How Much?
What to do about it?
Professor Engelbert J. Dockner
Department of Finance, Accounting and Statistics
WU Vienna University of Economics and Business
42nd Economic Conference OeNB, May 12-13, 2014.
Motivation
 Regulatory Capture of public agencies and public
policy was one of the main causal factors behind the
financial crisis of 2007–2009 [Simon (2009)]
 What is “Regulatory Capture”?
 Broad interpretation: Process through which special interests
affect state intervention in any of its forms [Dal Bo (2006)]
 Narrow interpretation: Process through which regulated
financial services firms end up manipulating the state agencies
that are supposed to control them
 Regulatory Capture is not corruption
 Regulatory Capture is not illegal actions,
such as bribes & threats
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Case for Court
Iron Triangle
Legislature/
Government
Regulatory actions, …
Regulator/
Bureaucracy
Regulated
Industries
Lobbying, Jobs, …
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Regulatory Objectives
Public
Legislature/
Government
Interest
Regulatory actions, …
Regulator/
Bureaucracy
Regulated
Industries
Lobbying, Jobs, …
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Regulatory Capture
Legislature/
Government
Regulatory actions, …
Regulator/
Bureaucracy
Collusion
Lobbying, Jobs, …
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Regulated
Industries
Why Regulatory Capture?
 Regulatory capture is pervasive because it is driven by
economic incentives [Zingales (2014)]
 Career Concerns: Regulators are offered better paid jobs
outside the regulatory arena (revolving door); regulators
are hired because of their valuable skills; industry employers
will hire former regulators who appreciate the industry;
regulator will try to signal pro industry view
 Information: Regulators depend on information provided by
the industry; in the absence of disclosure requirements firms
might “trade” information for better treatment
 Environmental Pressure (Social Identification):
Regulators need industry specific human capital; creates an
incentive to take actions that make this capital more valuable
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An Example: Trust Preferred
Securities (TPS)
 Boyson, Fahlenbrach and Stulz (2014) analyze regulatory
arbitrage over the period 1996-2007
 In October 1996 the Federal Reserve Board authorized bank
holding companies to use TPS as Tier 1 capital
 Trust Preferred Securities are hybrid capital. They are
cumulative non-perpetual preferred securities issued by
subsidiaries of bank holding companies
 In the subsidiary TPS are used to finance assets (junior
subordinated debt issued by the bank holding company)
 Boyson, Fahlenbrach and Stulz (2014) demonstrate:
 Banks constraint by capital requirements made extensive use of TPS
 Banks using TPS are riskier than other banks with equal amount of RC
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An Example: Trust Preferred
Securities (TPS)
 Issuance of TPS relative to other types of capital
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Source: Boyson, Fahlenbrach and Stulz (2014)
Use of TPS as Tier 1 Capital
Banks have
benefited from
the use of TPS
Does this imply
regulatory
capture?
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Source: Boyson, Fahlenbrach and Stulz (2014)
Mechanisms of Regulatory Capture
 Baker (2012) identifies four mechanisms that
were at work prior and post financial crisis:
 Lobbying: concentration of wealth in financial sector gave
bankers huge political weight; emergence of an American
financial oligarchy (campaign financing)
 Degree of political salience: During boom periods
general public has no interest in financial regulation
capture is relatively easy
 Institutional design/ revolving doors: Makkai &
Braithwaite (1992), Shive & Forster (2014)
 Intellectual capture: Regulators and industry experts
are educated by identical Business Schools
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Detecting and Measuring Capture
 Empirical studies of capture need a benchmark
(e.g. public interest) as a counterfactual
 Revolving doors easy to measure (example US)
Number of sample
firms and number of
ex-regulators
employed at
financial firms
Source: Shive and Forster (2014)
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Revolving Doors
 What is the role of revolving doors in the
process of regulatory capture?
 Shive ad Forster (2014) find:
 Regulated firms (especially those anticipating
enforcement action) are more than twice as likely as
other financial firms to hire ex-regulators
 Hiring announcement returns are significantly positive, especially after recent regulatory action
 Recent hire and presence of revolving door employees
at financial firms predicts increased enforcement
action by that regulator
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Capture and Social Identification
 Veltrop and Haan (2014) argue that social identification
with the financial sector is an important mechanism for
capture
 Empirical analysis with data from The Netherlands
 Two regulatory authorities De Nederlandsche Bank (DNB) and
Autoriteit Financielen Markten (AFM)
 Data: Questionnaires filled out by individual regulators
 Results:
 Social identification is negatively related to task performance
(Williams and Anderson (1991) measure)
 Prior tenure in the financial sector is positively related to social
identification with financial sector
 Effect of prior tenure on task performance runs through social
identification with financial sector
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How to Mitigate Capture?
 Baxter (2011) identifies several channels of capture
toward the common good:
 Model of “Tripartism”: regulatory policy that fosters the
participation of public interest groups in the
regulatory process
 Limit the size and hence the influence of industry
players
 Properly structured and resourced agencies (e.g.
tenure of management)
 Better institutional roles for regulators
 Transference, appearances and disclosures
 Independent reviews
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Conclusions
 Regulatory capture is the outcome of economic
incentives for regulators within the regulatory
system
 Capture can only exists if there are large vested
interests (big players with market power)
 Unequal wealth distributions might enhance
regulatory capture
 Capture is closely related to the governance
structure of the industry
 Regulatory capture can be mitigated by structural
reforms
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References

L.A. Baxter (2011),“Capture“ in financial regulation: Can we channel it toward the
common good? Cornell Journal of Law and Public Policy 21, 175-200.

A. Baker (2010), Restraining regulatory capture? Anglo-America, crisis politics
and trajectories of change in global financial governance. International Affairs 86,
647–663.

N. M. Boyson, R. Fahlenbrach, and R. M. Stulz (2014), Why do banks practice
regulatory arbitrage? Evidence from usage of trust preferred securities. WP.

E. Dal Bo (2006), Regulatory capture: A review. Oxford Review of Economic Policy
22, 203-225.

S. Johnson (2009), The quiet coup. The Atlantic, 05/2009.

S. Shive and M. Forster (2014), The revolving door for financial regulators. WP.

D. Veltrop and J. de Haan (2014), I just cannot get you out of my head:
Regulatory capture of financial sector supervisors. WP 410 De Nederlandsche
Bank

L. Zingales (2014), Preventing economists’ capture. In: D. Carpenter and D.A.
Moss (eds.) Preventing regulatory capture: Special interest influence and how to
limit it. Cambridge University Press.
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