March/ April 2013 He Who Makes the Rules

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.

By Haley Sweetland Edwards

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.

Haley Sweetland Edwards is an editor of the Washington Monthly.


  • Anonymous on March 04, 2013 1:07 AM:

    holy crap.
    well, Democracy was a nice idea. Hopefully some other country will take the ball and run with it but it seems pretty much like a dead experiment here.

  • Rabbler on March 04, 2013 11:48 PM:

    Isn't this what happens when one's greatest accomplishments are vaguely written to enable passage? Of course that couldn't be Obama's fault even though they are his greatest accomplishments. 9 pages of excuses. Is it even possible for Obama to fail?

  • Nate on March 05, 2013 7:57 PM:

    Terrific article, thanks Ms. Edwards.

  • ctnyc on March 05, 2013 10:20 PM:

    Rabbler, most congressional bills are and always have been written somewhat vaguely because they have to be or nothing would ever be passed. The expertise and information that the agencies that must write the rules possess far outweighs the kind of expertise than individual members of Congress have about most issues, so Congress leaves it up to the agencies to decide the rule and regulations that will implement the laws. If Congress were to specify exactly how every bit of a several-hundred page law were to be enacted, it would literally take years to pass a single law. This is part of how our system works. These kinds of things are good to know, and were touched on in the article. Or you could just ignorantly blame Obama for everything.

  • Barney Frank on March 07, 2013 3:41 AM:

    Is it at all possible that some of the vast amount of rules the CFTC and SEC are writing are - how to put this - not very good?

    As an example, the article mentions the fact that the swap dealer registration threshold was raised from $100m to $8 billion (it doesn't mention that it will subsequently fall back to the $3 billion level) and says it's a bad thing to exclude all the tiny swaps users that would have been caught at the lower level.

    But is that correct? I don't know - I'm just asking the question - but given that the largest 10 dealers alone are counterparties to something like three-quarters of all trades, maybe it makes sense to catch those guys plus the 200-or-so dealers below them in the food chain, rather than, say, everyone?

  • The Thinker1958 on March 09, 2013 12:13 AM:

    Government for the current political parties is a game. They have the power. If they don't want the other party to do anything they do things like the one explain in this article. While people suffer in a daily basis Politicians keep playing their games. One day it will be enough for the millions (in the future maybe 200millions) poor people that will realize the scam the Politicians are running. Be prepare for home invasions, burning of Gov buildings, and say bye-bye to your way of life... it has happened through history, it will happen again.

  • Darryl on March 18, 2013 6:42 PM:

    Any other famous examples of brazen political word parsing besides those uncited violations committed by Cheney and Yoo? Is there anything that would come to the mind of everyone but the hackiest of hack writers?

    No? Maybe it just depends on what the meaning of "is" is.

  • Imrational on March 19, 2013 12:10 PM:

    I first learned about this kind of racket back when McCain and Kerry were trying to legalize pirate radio. The FCC found that there was plenty of radio spectrum available for public low powered broadcasters. Unfortunately, the law's intent was gutted by major media who, against all available science, said such stations would give too much interference to their stations.

    I've also dealt with "negotiations " at the municipal level. It's there too.

    It's all about people pushing their own self interest. The only solution is to push transperancy and place average Americans in places to act.

  • Dianna jacskon on March 20, 2013 11:20 AM:

    What a fabulous article. Thank you for writing it.

    What will it take? A total collapse of the system before the banksters and right wing judges and the GOP understand that what they are doing is destructive and against the will of the people? I'm just glad we cashed in securities to own the roof over our heads and buy our car. The whole system has the capacity to go up in smoke because of Wall Street. The aforementioned groups remind me of moths sitting on a carpet. They see the pieces of wool as individual pieces to be eaten but they don't see the entirety of the pattern on the rug, the big picture. All these people chipping away at the legislation in their various suits and robes don't see that by enabling the banks to do whatever the heck they want will result in another Wall St. debacle.

    One final point. This convinces me that we need publicly financed elections. Now.

  • Brian T. Raven on March 22, 2013 2:58 PM:

    A fine piece of work Ms. Edwards. Thank-you.

  • ezra abrams on March 25, 2013 12:08 PM:

    like many liberal commentators in the beltway, you are under the mistaken impression that Dodd Frank was actually *intended* to do good.
    Au contraire: the explicit purpoise of DF was to block any real reform by rule hell: DF was designed to look good, but all actuall decisions would be watered down by regualtory death

    Don't you get it ?? Frank and Dodd, sure as sin, are gonna get pay from the bankers; we already know that Frank takes trips on a hedge fund private jet.

  • rd on March 25, 2013 2:36 PM:

    You would think that even Repubicans would find the banks actions a complete perversion of their so called belief in markets - but no. They only conclusion is that they are totally bought.

  • Bruce on March 25, 2013 6:32 PM:

    ``It is in some ways a Sisyphean task. Here you have a group of rule makers' lawyers, economists, analysts, and specialists sitting around a table. On one side, they've got the language of Dodd-Frank, which requires them, by congressional mandate, to effectively regulate new, never-before-regulated products in never-before-regulated markets that change by the month.''

    These are the things that FDIC insured banks are allowed to do: a)... b) ... c) ...
    anything else is prohibited. What am I missing?

  • JC on April 10, 2013 1:22 PM:

    Incredibly well-written article. I wonder if there might be a 'reality show' in this. I mean, there is a "Hell's Kitchen", where a well-spoken and dramatic English chap, goes into a kitchen and blasts the egregious violations, laziness, and thoughtlessness of that kitchen apart.

    Can you imagine a John Stewart, or someone similar, pushing a new show, all about the 'Sausage Making Process', where this gets exposed on a daily basis, but with an aim to IMPROVE the process, so that recommendations are forecefully made? (Again, similar to Hell's Kitchen.)

    Right now, the 'good government' shows are boring as hell.

    Put in a derring-do Gordon Ramsay, write good and dramatic reality scripts, spice up the 'boring' government work, with a very interesting show about the PROCESS of goverment, in the bowels of the rule-making departments.

    It would work!! It still would be a show with small ratings, but, it could be fascinating enough, if well-written and the star interesting enough, that it would shine enough of a light, to intimidate the lobbying to scurry away back into the darkness.

  • wow'ed by this on April 11, 2013 1:34 PM:

    I think if Obama had the guts, he would have written the rule like this:

    " if your bank has asset value that is more than 0.5 percent of GDP goes bankrupt, all director and officer plus their spouse and children automatically go bankrupt".

    There would be no need to run economic models or be interpreted by lawyers. I would say this would even create smaller government.

  • wow'ed by this on April 11, 2013 1:48 PM:

    Actually I don't even think the law needs to be that draconian. It could just be:

    " If you are a director or officer of a bank with asset value greater than 0.5 percent of GDP, all your asset and your wife and your child can only consist of shares in the bank".

    You then get the incentive both ways.

  • Minz on April 20, 2013 11:19 PM:

    Instead of writing "better" laws (which will be torn apart by lawyers regardless), how about treating the problem at the root - by about banning all campaign contributions to political parties and politicians, and all outside funding of politicians (as a starter).

    Too many outside interests get in and politics is too incentivised by cash to be honest. Take away the cash as a root cause...