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From Banking and Finance Law Daily, November 24, 2014

Are Wall Street banks “too big to regulate?”

By J. Preston Carter, J.D., LL.M.

At a Senate Financial Institutions and Consumer Protection Subcommittee hearing on regulatory capture, Chairman Sherrod Brown (D-Ohio) wondered whether the Federal Reserve Board is up to the task of regulating large and complex financial institutions, or are “these Wall Street banks simply too big to regulate?” The hearing followed media reports of secretly taped conversations between Federal Reserve Bank of New York officials disagreeing over the supervision of regulated entities.

Back to business as usual. In his opening statement, Brown said, “The financial crisis was brought on as much by timidity and capture on the part of regulators and Congress as it was greed on the part of Wall Street.” He stated that four years ago, Congress “overhauled” the country’s financial regulations and handed “a great deal of power to the Federal Reserve.” Six years after the crisis, Brown continued, and four years after the Dodd-Frank Act, “troubling reports suggest that it is back to business as usual at the Federal Reserve Bank of New York.”

Along with the report of examiners of JPMorgan and Goldman Sachs engaged in an internal “struggle,” Brown noted a new report of a New York Fed examiner “leaving to work at Goldman Sachs and then receiving confidential information from his old colleague.” Because the damage from the failure of a Wall Street bank would be felt on Main Street, Brown said, it is “important that examiners, supervisors, and all regulators remember that their job is to serve the American People, and not the banks that they oversee.”

We are not perfect. Testifying at the hearing, William C. Dudley, the New York Fed’s President and CEO, outlined three “important changes to the process of supervision” that have been made. First, the Fed now makes its most consequential supervisory decisions on a system-wide level through the Large Institution Supervision Coordinating Committee, which includes representatives across professional disciplines from several Federal Reserve banks and the Board of Governors.

Second, Dudley noted the increased application of cross-firm, horizontal review. According to Dudley, this technique enables peer-to-peer comparison of banks, facilitates a better assessment of the overall health of the financial system, and safeguards against regulatory capture by providing insight from across the Federal Reserve System.

Third, the supervision group at the New York Fed has been reorganized “in a number of ways that promote unbiased analysis and professional objectivity.”

Dudley pledged to continue to improve the supervision and regulation of financial institutions. He said, “We understand the risks of doing our job poorly and of becoming too close to the firms we supervise.” Although Dudley said the staff works hard to avoid these risks, he reiterated that “we are not perfect” (see Banking and Finance Law DailyNov. 20, 2014).

Regulatory capture. There are two forms of regulatory capture, David O. Beim, Professor of Professional Practice, Columbia Business School, explained. In the “strong form,” regulation confers an economic benefit that companies actively want, for example, by keeping prices high or restricting competition, and the regulator agrees to supply it to them. In the “weak form,” regulation is “negative” for the companies, but the regulator does not strictly enforce the rules, and fails to control company behavior in the way intended by the law.

Beim pointed to a 2009 project on systemic risk, which he chaired at Dudley’s request, and which found a great deal of the weak form of regulatory capture at the Federal Reserve Banks. He referred to it as an “obvious pattern of timidity” toward the banks being regulated: “supervisors paid excessive deference to banks and as a result they were less aggressive in finding issues or in following up on them in a forceful way…A very frequent theme in our reviews was a fear of speaking up…Ideas get vetted to death.”

Beim believes one reason this happens is because “bright regulators in mid-career all harbor some hope that they will be offered a good job with one of the regulated companies.” Also, companies being regulated know a lot more about their businesses than the regulators who are supposed to control them, Beim added. According to Beim, this “informational asymmetry” can be alleviated by upgrading staff, hiring bright and independent-minded people, giving them extensive opportunities to upgrade their skills, and providing more explicit incentives for them to act in independent ways.

However, the most important step to control regulatory capture, Beim argued, is for Congress to strengthen the “revolving door” laws by prohibiting all regulators from working in the regulated industry for three years after leaving government.

Solutions offered. Robert C. Hockett, Edward Cornell Professor of Law, Cornell Law School, and recent consultant to the New York Fed’s Legal Department, offered two suggestions to regulatory capture in his testimony.

First, institutionalize the “contrarian role.” Hockett said the New York Fed requires some permanent means of self-evaluation and self-criticism. A department or unit should be charged with this task and it should have three characteristics: (1) A deliberate, explicit, self-conscious identification on the part of the department itself, and of the New York Fed as a whole, that the department is a “mode of institutional self-evaluation and self-criticism.” (2) A sufficient number of personnel within the department or unit as to enable an “esprit de corps” to develop. (3) The leader of the group should have a status equivalent to that of other top-level New York Fed personnel.

Hockett’s second suggestion is that the Fed begin a process of considering whether it ought to “bifurcate Fed legal departments, and perhaps even the role of the General Council itself, at the regional Fed banks if not at the Fed Board itself.”

End the Fed’s regulatory authority. Finally, Dr. Norbert J. Michel, Research Fellow in Financial Regulations, Heritage Foundation, argued that the Fed’s regulatory role should end. Michel contended that the Fed “is not, and can never be, immune from the potential conflicts and capture problems that exist throughout U.S. regulatory agencies.” He maintained that the “supposedly new ‘macro-prudential’ regulations are new only in the narrowest sense, and that we should not expect them to make financial markets any safer than they were prior to the subprime crisis.” According to Michel, all reform proposals should include at least one major change to U.S. financial market regulation: transferring all regulatory authority from the Fed to the Federal Deposit Insurance Corporation and/or the Office of the Comptroller of the Currency.

Companies: Goldman Sachs; JPMorgan

MainStory: TopStory BankingOperations FederalReserveSystem FinancialStability

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