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 SEITE 2 REGULATORY CAPTURE Case for Court Iron Triangle Legislature/ Government Regulatory actions, … Regulator/ Bureaucracy Regulated Industries Lobbying, Jobs, … SEITE 3 REGULATORY CAPTURE Regulatory Objectives Public Legislature/ Government Interest Regulatory actions, … Regulator/ Bureaucracy Regulated Industries Lobbying, Jobs, … SEITE 4 REGULATORY CAPTURE Regulatory Capture Legislature/ Government Regulatory actions, … Regulator/ Bureaucracy Collusion Lobbying, Jobs, … SEITE 5 REGULATORY CAPTURE 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 SEITE 6 REGULATORY CAPTURE 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 SEITE 7 REGULATORY CAPTURE An Example: Trust Preferred Securities (TPS)  Issuance of TPS relative to other types of capital SEITE 8 REGULATORY CAPTURE 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? SEITE 9 REGULATORY CAPTURE 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 SEITE 10 REGULATORY CAPTURE 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) SEITE 11 REGULATORY CAPTURE 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 SEITE 12 REGULATORY CAPTURE 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 SEITE 13 REGULATORY CAPTURE 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 SEITE 14 REGULATORY CAPTURE 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 SEITE 15 REGULATORY CAPTURE 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. SEITE 16 REGULATORY CAPTURE