Barack Obama’s biggest second-term challenge isn’t guns or immigration. It’s saving his biggest first-term achievements, like the Dodd-Frank law, from being dismembered by lobbyists and conservative jurists in the shadowy, Byzantine “rule-making” process.
In this light, the traditional notion of “regulatory capture” doesn’t go far enough. Instead, we should think of it as “cultural capture,” writes the political scientist James Kwak. There may be no bags of cash exchanging hands, but that doesn’t matter when regulators, like many of the rest of us, have been steeped for so long in the idea that Wall Street produces the best and brightest our society has to offer. Regulators often look up to industry representatives, or know them personally, which begets “the familiar effect of relationships,” Kwak wrote in Preventing Regulatory Capture, a compilation of essays that will be published this year by Cambridge University Press in collaboration with the Tobin Project, a nonprofit research center. “You are more favorably disposed toward someone you have shared cookies with, or at least it is harder for you to take some action that harms her interests.”
Like many reformers, Connaughton points a finger at the so-called “revolving door,” which sends former bureaucrats into the private sector and vice versa, blurring the line between the regulators and the regulated. From 2006 to 2010, 219 former SEC employees filed 789 statements saying that they would be representing a lobbyist or industry group in front of the SEC, according to the Project on Government Oversight. A complex law like Dodd-Frank accelerates that cycle, Connaughton said, as industry has even more incentive to hire people directly from the agencies to help them navigate the new regulations. “Put your time in at one of these regulatory agencies while they’re doing the Dodd-Frank rule making and it’s a license to print money when you come out,” he told me.
Of course, the revolving door doesn’t explain everything. A lot of the agencies are packed with ten-, fifteen-, and twenty-year veteran rule makers, who are motivated by the esprit de corps and have no interest in leaving for industry. “Money isn’t everything. If you leave, there’s the feeling that you’re in the audience, and no longer on the public policy stage,” the former CFTC rule maker told me. “That, and at the agency you’re actually performing a public service. People recognize that. It’s a factor.”
Also, the revolving door revolves both ways. Industry leaders who are later appointed as commissioners sometimes provide a valuable asset to rule makers. In agency parlance, “they know where the bodies are buried.” In many instances, these former industry officials head agencies at the end of their careers and have no intention of returning to the private sector. CFTC Chairman Gary Gensler, for example, spent eighteen years at Goldman Sachs, eventually rising to partner, before becoming one of the most outspoken advocates in recent years for better regulation. (In 1934, President Franklin Delano Roosevelt appointed Joseph Kennedy to head the brand-new SEC for this exact reason.)
Another swinging mace in this stage of the rule-making gauntlet is what Kelleher, the head of Better Markets, calls the “Wall Street Fog Machine.” “They come at you with this jargon,” he said. “They want to make you feel like it’s too complicated for you to understand. You’re stupid, and they’re the only ones who get it—that’s the end game.” This is particularly true when it comes to financial products, like customized swaps, which traders on Wall Street have spent the last decade designing precisely in order to swindle their clients.
“That’s how you make money. You make it so complicated the clients don’t understand what it is they’re buying and selling, or how much risk they’re taking on,” said Alexis Goldstein, who worked in cash equity and equity derivatives on Wall Street for several years, first at Merrill Lynch and then at Deutsche Bank, before joining the reform movement. The more complex the product, the higher the commission you can charge, and the less likely it is that there will be copycats driving down your profit margins with increased competition, she explained. In other words, complexity “isn’t a side effect of the system—it’s how the system was designed.”
Partly as a result of that business model, the system really is complicated—extraordinarily so. But that doesn’t mean it can’t also be regulated in the right ways, reformers say. How exactly that should be done is often a bone of contention. Take those customized swaps, for example. Right now, they’re traded in the private “over the counter” market, which means that they’re contracted bilaterally, often between a single bank and a counterparty during a phone call, and they aren’t transparent. Dodd-Frank gives the CFTC the power to regulate them, and many suggest that all trades should be conducted in clearinghouses, where customers can easily compare prices and are therefore less likely to be fleeced. Banks claim they’re too complex to be traded in that way.
Kelleher says that’s “just plain false.” A customized swap is nothing more than a bundle of so-called “two-legged” swaps, he said. If you unbundle them, which the banks themselves do, for lots of reasons, like hedging, there’s no reason we can’t regulate them, he said. Just as Wall Street used the excuse of complexity to hoodwink their clients, they’re now using the excuse of complexity to hoodwink their regulators—“it’s the greatest coup they’ve managed to pull off,” Kelleher said.
Others argue that customized swaps should be regulated but clearinghouses aren’t the answer. They worry that if all such trading is moved to clearinghouses, then those institutions will balloon, leaving them vulnerable to collapse, said Peter J. Ryan, a fellow at the University of California Washington Center whose research focuses on financial services policymaking. In other words, the clearinghouses themselves could become too big to fail.
The real problem here is not that rule makers can’t understand Wall Street’s complex financial products. It’s that they often don’t have enough information about those products or the systems that govern them to see the whole picture, and therefore to choose the best possible way to regulate. As it stands, rule makers, as well as the teams of agency researchers who help them, rely to a large degree on industry to provide data about things like banks’ internal trading. For proprietary reasons, only the banks have access to much of that information, and they have no incentive to share it. When regulators request data in public comment letters, industry rarely provides it; when they do, it’s often incomplete, one-sided, or missing crucial variables. “If there’s a datum that supports their argument, they produce it. If not, they don’t—why would they?” said Naylor of Public Citizen.
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