Sunday, September 20, 2009

Capture of regulatory and policy-making instruments?

The debate on financial market regulation proposals have focussed attention on procedural and structural issues like capital adequacy requirements, systemic risk regulation, caps on executive compensation, and so on. However, the equally important role of personal conflicts of interests inherent in policy makers and market regulators appears to have been confined to the sidelines.

The back and forth movement of bankers and financial market actors to prominent policy making and regulatory positions is widely acknowledged and the numerous instances of very strong and immediate conflicts of interests, at the very highest levels of decision making, has been adequately documented. It is surprising that a political and administrative system like that in the US which pays attention to disclosure requirements and potential conflicts of interests, has virtually ignored these massive moral hazard generating situations. Even more surprising has been the lack of public indignation and outrage at this serious problem.

Imagine the public outcry it would have generated in India if Vijay Mallaya was made our Civil Aviation Minister or Chanda Kochar was made the RBI Governor or any of the Ambani brothers were made the Petroleum Minister! Given the overarching role of the financial markets in the overall American economy, it is no stretch to compare the aforementioned Indian scenarios with the elevation of the likes of Robert Rubin, Hank Paulson and Co to important public policy making positions.

In an excellent op-ed in the Times, Simon Johnson and Peter Boone examine this issue and writes,

"Since our top regulators are political appointees, it should be no surprise that, in the face of heavy lobbying by the financial sector, they often turn out to be regulatory doves. We’ve permitted our mid- and high-level regulators to revolve between jobs in finance and officialdom. To name just two examples, during the Clinton administration, Robert Rubin left Goldman Sachs to become secretary of the Treasury, then returned to the industry to take an oversight role at Citigroup, while Henry Paulson, the secretary of the Treasury during the last years of the George W. Bush administration, came straight to government from Goldman Sachs.

A high-level position at the Federal Reserve, the Treasury, the White House National Economic Council or at a Congressional committee overseeing banking can be a ticket to riches when public service is done. The result is that our main regulatory bodies, including the Fed, are deeply compromised. Rather than act as the tough overseers of the public purse that we need — and that we had before 1980 — they have become cheerleaders for the financial sector. These cheerleaders, in turn, generate financial cycles by letting our financial system grow too fast, with far too little capital for the risks it takes."

And they write on the need to prohibit such movements of personnel and favor the development of career regulators to man such important positions,

"We should prohibit companies and senior managers in regulated financial industries from making donations to political campaigns. We should also restrict public employees involved in regulatory policy from working in those industries for five years after they leave office. And we should prohibit people who move to government from the finance sector from making policy decisions on bailout and regulatory-related matters for a minimum of five years.

Our regulators need to be smart people who understand finance, but they don’t need to be drawn from the upper echelons of the financial industry. There are many proven, dedicated professionals in our regulatory agencies today, and we should support the development of an even stronger cadre of career regulators. It should be up to the financial sector to make its practices clear and simple enough for these professionals to understand, and any that are too complex should not be approved."

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