How Important Was “Regulatory Capture” in Causing the Global Financial Crisis? Essay
The purpose of this paper is to show that the “regulatory capture” has played a role not easily measurable in causing the global financial crisis. To illustrate this, the first step will to describe the “regulatory capture” in its three possible qualifications; then, I will explain, providing some examples, how each of these categories played a possible role in posing the basis for the financial crisis. While illustrating the different forms of capture I will present some questions that leave space to different answers.
Finally, I will conclude that the regulatory capture have surely played a role in generating the crisis, but it is not possible to evaluate the effective role it had in causing it. “Regulatory capture” is not easily definable, but it can be illustrated referring to three different theories. The first theory is the Pierson & Hacker’s theory of direct influence; the second one is the structural influence developed by Strange; and the last one is the intellectual capture discussed, among many, by Turner.
The first theory refers to the direct influence over regulators achieved through lobbying, political campaign finance and through the renowned revolving doors. The Bureau of Investigative Journalism, indeed, showed, in July 2012, that in London “an extensive trawl of registries, consultations and hundreds of interviews ha(d) identified 129 organisations engaging in some form of lobbying for the finance sector, with over 800 people employed directly and at a cost of ? 2. 8m. Lobbyists include in-house bank staff, public affairs consultancies, industry body representatives, law firms and management consultants. ” Moreover, Joseph Stiglitz shows in his last book “The price of inequality” (CNBC interview, 2012) that in the USA it was banks that pushed for the 1999 repeal of the Glass-Steagall Act and that they have also been lobbying against financial reform, the single most pressing issue facing the world’s economy.
In addition to this, it must be added that, in particular, the campaign finance (the financial investment that has “really paid off”, paraphrasing Stigliz) has played a significant function in the creation of important connections between the political world and the financial one. In fact, as the Warwick Commission (2009: 28) said the financial industry gave generously to all political parties across the board, and donors one day sometimes became policy officials the next day.
Similarly the revolving doors, which in the US can take the name of “Government Sachs”, have built a solid bridge between legislators and regulators and the financial industry. However, dealing with this issue requires to face problematic questions involving public interest and “capture” itself. In particular, what should be questioned is to which degree putting experienced bankers of the major banks at the top level of regulatory agencies could represent a benefit for the society (in terms of better policies and regulation) or rather the more advanced stage of lobbying.
Indeed, the dramatically increase of complexity of financial system requires regulators who can perfectly know the sophisticated dynamics through which risk is priced and managed. For instance, to this extent, allowing ex bankers to be the regulators would represent an efficient solution. However, financial crisis has shown that facing financial innovation and regulation by an excessive “laissez faire” can be very risky because of market inefficiency. This would suggest that sometimes regulator is in charge of putting limits to financial activity.
Would ex bankers be willing or sufficiently independent to do it when necessary? This is the major source of doubt regarding the bankers-regulator solution. The second theory, as said above, is the structural influence. We can think about it as the capacity of an individual or a group to influence the circumstances in such a way that the individual or group’s influences have the priority over others’ preferences. This definition tends to be very theoretical, so some examples will be useful to grasp better its meaning.
For instance, the increased importance of networks and the rise of highly systemic banks created a system in which the banks became, on one side, too big to fail, and, on the other, too big to save. Indeed, the lesson from Lehman Brothers Chapter 11 is that letting go bankrupt a systemic player (even not one of the largest) might bring about unknown undesirable effects. The policy makers are, therefore, definitely captured because banking sector is architecture in such a way that constrains the policy makers to go through a bail-out in case of a relevant financial distress.
So which are the consequences of this behaviour? The outcomes are double: the ex-ante banks’ possibility to engage moral hazard behaviour and the ex-post debt burden on the tax payers. This creates an incentive for the banks to take more risks due to the implicit protection of the government, that rely on the tax payers to pay for the bailouts, creating a substantial problem of fairness and social equity, in which low income class has to pay for the top income class’ errors. Another example of this theory is the state dependence on taxes generated by the financial sector.
For instance, in the UK “the financial sector’s gross value added (GVA) rose over the last decade, but has declined since 2009. Its contribution to UK jobs is around 3. 6%. Trade in financial services makes up a substantial proportion of the UK’s trade surplus in services. Estimates of the sector’s contribution to Government tax revenue vary between 6% and 12%. ” (Broughton, 2012) Therefore, the current size of the financial sector is important to value how reliant the UK economy is on financial services and this rule can be applied to every country.
There is evidence that the UK and the US’ financial and insurance sector contributes a large proportion to their GVA compared to other countries and that their financial intermediation contribution to employment is high with respect to countries as shown in Broughton paper. The consequence is that the creation of a sector which must be protected because of its undoubted importance for the country’s economy generates a structural capture on the policy makers and the regulators.
The structural capture, therefore, rises the problematic question if the benefits of the financial sector are greater than the adverse consequences it can generate when the system blows up. The last theory regards the so called “intellectual capture”. This capture poses its basis in the intellectual inclination to recognise the superiority of the revival of economic market ideas. Indeed, “the tallest spires of academic finance generally, though not exclusively, supported the notion of efficient markets, reassessing the purpose of regulation and containing the ambitions of regulators.
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. ” (The Warwick Commission, 2009) In addition, intellectual capture is also related to the so called “group-think”, which is the idea that economists in the official, private or academic sphere, can reach common understandings based on shared training, practice and access to economic ideas and so be able to take expert and apolitical decisions.
To this point, a homologation problem arises, and, as suggested by the Warwick Commission, the “group-think” should be broken, in order to introduce new voices and interest to debates about financial regulation. The question is, now, if and how the intellectual capture affected the crisis and to what degree; for instance, whether the notion of efficient markets posed the basis to not adequately regulate the CDS market or not.
Putting all together, it is apparent that the regulatory capture played somehow a role in generating the crisis, but it is not easily identifiable to what extent it has contributed to that. Lobbying can be used as an example to clarify this assertion. In fact, why should the banks finance the regulatory and political sector, if there is an intellectual capture working in those sectors? So far, why the authorities have not found yet the proper way to regulate the sector after the perfect market dogma has ceased to exist, as Basel III capital requirements suggest?
One possible explanation is the presence of lobbying and pressure on regulators, but if this one is the reason, it means that we are in a vicious circle that brings us to the first question leaving unanswered both. The other explanation is that the regulators do not truly have the instruments to manage the systemic risk, which is still too little known, and if this is right the crisis can have been generated only partially by the regulatory capture. All these opened questions, therefore, make it difficult or almost impossible to tackle this issue and answer with certainty.
In conclusion, there is no doubt about the existence of capture over the regulators, but it is not clear how important the regulatory capture has been in generating the crisis. Bibliography Brougthon (2012) The financial sector’s contribution to the UK economy, House of Commons – Economic Policy and Statistics, Standard Note, SN06193. Johnson (2009) ‘The Quiet Cup’ , The Atlantic, May 2009. Mathiason & al. (2012) ‘Revealed: The ? 93m City lobby machine’, Bureau of Investigative Journalism [electronic], 9th July 2012, accessed 8 August 2012.
Available: Reinhart, Kennet & Rogoff. (2008) This time is different: A panoramic view of Eight Centuries of Financial Crises, NBER Working Paper, 13882. Safdar (2012) ‘Joseph Stiglitz: Wall Street’s Lobbying Efforts Have “Really Paid Off”’ + CNBC interview, The Huffington Post [electronic], 7th February 2012, accessed 8 August 2012. Available: The Warwick Commission on International Financial Reform (2011) The Warwick Commission on International Financial Reform: In Praise of Unlevel Playing Fields. CGI, The University of Warwick.