Nicholas Dorn, Erasmus University Rotterdam – Erasmus School of Law, Ponzi Finance, Regulatory Capture and the Credit Crunch:
The unfolding financial market instability provokes questions about the safety of all financial investments and, in doing so, reveals some large investment frauds, which can flourish only in buoyant markets. More broadly, as is now recognized by market regulators, there has been insufficient attention to fraudulent practices, conflicts of interest and evasion of regulatory controls, notably in relation to promotion of sub-prime mortgages, the role of ratings agencies, the packaging and selling on of the resulting debt instruments to investors worldwide, and circumvention of risk controls. So, where were the regulators? This paper proposes that institutional capture of the regulators by the market – in terms of adoption by the regulators of technical assumptions, ‘models’ and data defined as relevant by the private sector – provides a narrative on ‘what went wrong’. Moving towards a vision of the way forward for regulatory reform, the paper argues against the exclusionary notion of regulation that makes it a matter of coordination between those possessing technical expertise, separated off from moral questions, public politics and debate amongst citizens. The literature on security governance and ‘public goods’ is explored as one way of opening up the debate on financial regulation, reversing regulatory capture.
Daniel C. Hardy, Monetary and Financial Systems Department, International Monetary Fund, Regulatory Capture in Banking:
Banks will want to influence the bank regulator to favor their interests, and they typically have the means to do so. It is shown that such “regulatory capture” in banking does not imply ineffectual regulation; a “captured” regulator may impose very tight, costly prudential requirements to reduce negative spillovers of risk-taking by weaker banks. In these circumstances, differences in the regulatory regime across jurisdictions may persist because each adapts its regulations to suit its dominant incumbent institutions.
The Report of the Second Warwick Commission, The Warwick Commission on International Financial Reform: In Praise of Unlevel Playing Fields:
Capture was helped by the emergent view that public agencies ought to be independent of politics. As part of this process, a policy role for the private sector was legitimised. Intellectual capture, in turn, also relates to the ‘group-think’ that has taken hold in the making of financial policy. Regulatory and supervisory arrangements are discussed and agreed in expert and apolitical terms, bringing like-minded individuals who, whether in the official, private or academic sphere, can reach common understandings based on shared training, practice and access to economic ideas. Both in the national arena and, increasingly, in the international fora around the Basel process, such networks are technocratic, informal, politically unaccountable and have a narrowly defined understanding of financial policy. They are also often de-coupled from other economic considerations or broader questions about the role of finance.
It is important to break ‘group-think’ and introduce new voices and interests to debates about financial regulation.
Independent Evaluation Office of the International Monetary Fund, IMF Performance in the Run-Up to the Financial and Economic Crisis IMF Surveillance in 2004–07:
On the other side, the report ultimately ascribes the failure to warn about the crisis to “groupthink,” which is as much a description as an explanation. The report could have looked more at the extent to which staff considered contrarian views (arguably, they did) and how they judged these positions against the much larger evidence marshaled by the mainstream (clearly, they judged incorrectly). This also speaks to the IEO recommendation to increase financial expertise and staff diversity—which undoubtedly is correct, and indeed a goal of the institution, but does not follow from the pre-crisis experience: the vast majority of financial experts, from a diversity of countries and backgrounds, also failed to see the crisis coming. (Ironically, the prescient individuals cited by the report are from remarkably undiverse backgrounds—i.e., macroeconomists with PhDs from U.S.-U.K. universities.) That said, the recommendation to access thoughtful and diverse opinion is a very important one, and one that we return to below.
[…] that the publication of a dissenting vote with a brief note of explanation. Arse-kissers and group-thinkers thrive in an environment in which they are explicitly expected to agree with the loudest voice in […]