{"id":61298,"date":"2014-10-02T10:43:33","date_gmt":"2014-10-02T14:43:33","guid":{"rendered":"http:\/\/countingpips.com\/?p=61298"},"modified":"2014-10-02T10:43:33","modified_gmt":"2014-10-02T14:43:33","slug":"outside-the-box-why-the-fed-is-so-wimpy","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/forex\/2014\/10\/outside-the-box-why-the-fed-is-so-wimpy\/","title":{"rendered":"Outside the Box: Why the Fed Is So Wimpy"},"content":{"rendered":"
October 2, 2014<\/div>
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By John Mauldin<\/span><\/h4>\n
\"\"Another in what seems to be a small parade of scandals involving secretly recorded tapes of Federal Reserve regulators emerged last week. What a number of writers (including me) have written about regulatory capture over the past decade was brought out into the open, at least for a while. My brilliant young friend (40 seems young to me now) Justin Fox<\/a>, editorial director of the Harvard Business Review<\/em> and business and economic columnist for Time<\/em> magazine, published a thoughtful essay this week, outlining some of the issues surrounding the whole concept of banking regulations.<\/p>\n

Yes, the latest scandal involved Goldman Sachs, and it took place in the US, but do you really think it\u2019s much different in Europe or Japan? Actually, there are those who argue that it\u2019s worse in those places. This does not bode well for what happens during the next crisis (and there is always a next crisis, hopefully far in the future, though they do seem to come more frequently lately).<\/p>\n

Writes Justin:<\/p>\n

The point here is that if bank regulators are captives who identify with the interests of the banks they regulate, it is partly by design. This is especially true of the Federal Reserve System, which was created by Congress in 1913 more as a friend to and creature of the banks than as a watchdog. Two-thirds of the board that governs the New York Fed is chosen by local bankers. And while amendments to the Federal Reserve Act in 1933 shifted the balance of power in the Federal Reserve System from the regional Federal Reserve Banks (and the New York Fed in particular) to the political appointees on the Board of Governors in Washington, bank regulation continues to reside at the regional banks. Which means that\u00a0the bank regulators\u2019 bosses report to a board chosen by \u2026 the banks.<\/p>\n

For those who would like a bit more bearish meat, I offer you a link to John Hussman\u2019s latest piece, \u201cThe Ingredients of a Market Crash<\/a>.\u201d<\/p>\n

I\u2019m in Washington DC today at a conference sponsored by an association of endowments and foundations. They have a rather impressive roster of speakers, so I have found myself attending more sessions than I normally do at conferences. Martin Wolf and David Petraeus headline a very thoughtful group of managers and economists, accompanied by an assortment of geopolitical wizards. I\u2019ve learned a lot.<\/p>

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No follow-on note today. I need to get back to my classroom education\u2026<\/p>\n

Your loving the fall weather analyst,<\/p>\n

John Mauldin, Editor
\nOutside the Box<\/em>subscribers@mauldineconomics.com<\/a><\/p>\n

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Why the Fed Is So Wimpy<\/strong><\/span><\/h2>\n

By Justin Fox
\nHarvard Business Review HBR Blog Network<\/em><\/a>
\nSeptember 26, 2014<\/p>\n

Regulatory capture \u2013 when regulators come to act mainly in the interest of the industries they regulate \u2013 is a phenomenon that economists, political scientists, and legal scholars have been writing about for decades<\/a>.\u00a0 Bank regulators in particular have been depicted<\/a> as captives<\/a> for years, and have even taken to describing themselves<\/a> as such.<\/p>\n

Actually witnessing\u00a0capture in the wild\u00a0is different, though, and the new<\/a> This American Life<\/em> episode<\/a> with secret recordings of bank examiners at the Federal Reserve Bank of New York going about their jobs is going to focus a lot more attention on the phenomenon. It\u2019s really well done, and you should listen to it<\/a>, read the transcript<\/a>, and\/or read the story<\/a> by ProPublica reporter Jake Bernstein.<\/p>\n

Still, there is some context that\u2019s inevitably missing, and as a former banking-regulation reporter for the American Banker<\/em><\/a>, I feel called to fill some of it in. Much of it has to do with the structure of bank regulation in the U.S., which actually seems designed to encourage capture. But to start, there are a couple of revelations about Goldman Sachs in the story that are treated as smoking guns. One seems to have fired a blank, while the other may be even more explosive than it\u2019s made out to be.<\/p>\n

In the first, Carmen Segarra, the former Fed bank examiner who made the tapes, tells of a Goldman Sachs executive saying in a meeting that \u201conce clients were wealthy enough, certain consumer laws didn\u2019t apply to them.\u201d\u00a0 Far from being a shocking admission, this is actually a pretty fair summary of American securities law. According to the Securities and Exchange Commission\u2019s \u201caccredited investor<\/a>\u201d guidelines, an individual with a net worth of more than $1 million or an income of more than $200,000 is exempt from many of the investor-protection rules that apply to people with less money. That\u2019s why rich people can invest in hedge funds while, for the most part, regular folks can\u2019t. Maybe there were some incriminating details behind the Goldman executive\u2019s statement that alarmed Segarra and were left out of the story, but on the face of it there\u2019s nothing to see here.<\/p>\n

The other smoking gun is that Segarra pushed for a tough Fed line on Goldman\u2019s lack of a substantive conflict of interest policy, and was rebuffed by her boss. This is<\/em> a big deal, and for much more than the legal\/compliance reasons discussed in the piece. That\u2019s because, for the past two decades or so, not having a substantive conflict of interest policy has been Goldman\u2019s business model. Representing both sides in mergers, betting alongside and against clients, and exploiting its informational edge wherever possible is simply how the firm makes its money<\/a>. Forcing it to sharply reduce these conflicts would be potentially devastating.<\/p>\n

Maybe, as a matter of policy, the United States government should<\/em> ban such behavior. But asking bank examiners at the New York Fed to take an action on their own that might torpedo a leading bank\u2019s profits is an awfully tall order. The regulators at the Fed and their counterparts at the Office of the Comptroller of the Currency\u00a0and\u00a0the Federal Deposit Insurance Corporation correctly see their main job as ensuring the safety and soundness of the banking system. Over the decades, consumer protections and other rules have been added to their purview, but safety and soundness have remained paramount. Profitable banks are generally safer and sounder than unprofitable ones. So bank regulators are understandably wary of doing anything that might cut into profits.<\/p>\n

The point here is that if bank regulators are captives who identify with the interests of the banks they regulate, it is partly by design. This is especially true of the Federal Reserve System, which was created by Congress in 1913 more as a friend to and creature of the banks than as a watchdog. Two-thirds of the board that governs the New York Fed<\/a> is chosen by local bankers. And while amendments to the Federal Reserve Act in 1933<\/a> shifted the balance of power in the Federal Reserve System from the regional Federal Reserve Banks (and the New York Fed in particular) to the political appointees on the Board of Governors in Washington, bank regulation continues to reside at the regional banks. Which means that\u00a0the bank regulators\u2019 bosses report to a board chosen by \u2026 the banks.<\/p>\n

Then there\u2019s the fact that Goldman Sachs is a relative newcomer to Federal Reserve supervision \u2013 it and rival Morgan Stanley only\u00a0agreed to become bank holding companies<\/a>, giving them access to New York Fed loans, at the height of the financial crisis in 2008. While it\u2019s a little hard to imagine Goldman choosing now to rejoin the ranks of mere securities firms, and even harder to see how it could leap to a different banking regulator, it is<\/em> possible that some Fed examiners are afraid of scaring it away.<\/p>\n

All this is meant not to excuse the extreme timidity apparent in the Fed tapes, but to explain why it\u2019s been so hard for the New York Fed to adopt the more aggressive, questioning approach urged by Columbia Business School Professor David Beim in a formerly confidential internal Fed report<\/a> that This American Life<\/em> and ProPublica give a lot of play to. Bank regulation springs from much different roots than, say, environmental regulation.<\/p>\n

So what is to be done? A lot of the classic regulatory capture literature<\/a> tends toward the conclusion that we should just give up \u2013 shut down the regulators and allow competitive forces to work their magic. That means letting businesses fail. But with banks more than other businesses, failures tend to be contagious. It was to counteract this risk of systemic failure that Congress created the Fed and other bank regulators in the first place, and even if you think that was a big mistake, they\u2019re really not going away.<\/p>\n

More recently, there\u2019s been a concerted effort to take a more nuanced view of regulatory capture and how to counteract it. The recent Tobin Project<\/a> book, Preventing Regulatory Capture: Special Interest Influence and How to Limit It<\/em><\/a>, <\/em>sums up much of this thinking. While I\u2019ve read parts of it before<\/a>, I only downloaded the full book an hour ago, so I\u2019m not going to pretend to be able to sum it up here. But here\u2019s a thought \u2013 maybe if banking laws and regulations were simpler and more straightforward, the bank examiners at the Fed and elsewhere wouldn\u2019t so often be in the position of\u00a0making judgment calls that favor the banks they oversee. Then again, the people who write banking laws and regulations are not exactly immune from capture themselves. This won\u2019t be an easy thing to fix.<\/p>\n

update:<\/strong> The initial version of this piece listed the Office of Thrift Supervision as one of the nation\u2019s bank regulators. As David Dayen pointed out<\/a> (and I swear I knew at some point, but had totally forgotten), it was subsumed by\u00a0the OCC in 2011<\/a>.<\/p>\n

Justin Fox is Executive Editor, New York, of the Harvard Business Review Group and author of The Myth of the Rational Market<\/em><\/a>. Follow him on Twitter @foxjust<\/a>.<\/p>\n

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The article Outside the Box: Why the Fed Is So Wimpy<\/a> was originally published at mauldineconomics.com<\/a>.<\/div>\n
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