The Giant Revolving Door of Regulatory Hostage-Taking

The late economist George Stigler wouldn't be surprised at today's world.  

Stigler, you see, won a Nobel Prize for the concept of "regulator capture," or the idea that "regulation may be actively sought … by the industry and is designed and operated primarily for its benefit."

Sound familiar? If you've noticed a pattern of government favoring Wall Street, you've cracked an important code. One of the great confusions of the past two years is how the financial industry managed to fully wreck shop while remaining mostly untouched from the hands of regulators. After 9/11, airline security was immediately revamped from head to toe. Three years after the financial collapse began, here we are; almost nothing has changed.

Friends don't let friends turn down plutocracy
If you're trying to make sense of this, look no further than what's often called Wall Street's revolving door to Washington. In short, those whose duty it is to regulate Wall Street have a curious tendency to be elite members of … Wall Street.

We've compiled a brief list of examples:

We found hundreds of examples, but we'll stop there. You get the point.

First-class financial incest
Now, just because someone has worked in the financial industry doesn't necessarily mean they can't take on Wall Street when it's their job to do so. In spite of his former career as an investment banker, Dallas Fed president Richard Fisher argued earlier this month that "banks that are 'too big to fail' are simply 'too big.' We must cap their size or break them up." He's an independent voice who doesn't robotically hew to the interests of the financial lobby. 

But he's also a rare gem. Consider John Dugan, a former bank lobbyist who now serves as comptroller of the currency. His office (the OCC) regulates and supervises the big national banks.

You probably know where this is going. Instead of policing banks, Dugan's OCC has played the role of mama bear protector.

• The New York Times reports that of the hundreds of thousands of consumer complaints fielded over the past decade, fewer than 200 enforcement orders were issued.
• When West Virginia tried to sue Capital One (NYSE: COF) for credit card abuses, the company applied for a charter under the OCC, ostensibly seeking its infamously gentle embrace. Now a national bank under Dugan's sole purview, Capital One escaped West Virginia's  jurisdiction, and the state was politely told to pipe down and move along. The head of the Financial Crisis Inquiry Commission told Dugan, "You tied the hands of the states and then sat on your hands." And it worked magnificently.
• Under the OCC's light watch, commercial banks took on insane derivatives exposure. Untold commercial banks were backstopped by taxpayers when things turned explosive. Dugan seems content with this result: "In the end, the fact that they got the [bailout] money but took steps to fix themselves … to pay the government back quickly, will be viewed as a successful way to deal with a very difficult situation." Forget moral hazard. His friends lived.

The customer is always right (ahem)
This kind of behavior isn't restricted to Wall Street. After the BP (NYSE: BP) oil spill, the world has been appalled after learning how the Minerals Management Service (MMS) was literally in bed and snuggling with the oil companies it oversaw.

Appalling, yes. But MMS' relationship with Big Oil was juvenile compared with banks and their regulators.

OCC derives its operating budget not from Congress, not from states, but from the banks it regulates. Big deal, you say? The problem is that banks can shop around for friendlier regulators if OCC's restrictions rain on their master plan. Banks are literally regulators' paying customers, which must be kept happy for a regulator to justify its existence. Consider this profile of former Countrywide CEO Angelo Mozilo (courtesy of The New Yorker):   

Mozilo called some of the regulators' concerns "much ado about nothing." He decided that Countrywide should try to switch regulators, leaving the Fed and the O.C.C. for the weaker Office of Thrift Supervision (O.T.S.) … the O.T.S. had lobbied Countrywide to make the switch.

That's impressively stupid.

Get us out of here
What's the solution? Consolidating regulators and giving them their own operating budgets so they don't have to compete against one another for business seems like a no-brainer. But we're admittedly stumped on the issue of regulatory capture and won't pretend to have all the answers. When regulators are hiring, they can't just reject every Wall Street veteran. We want regulators who know what they're doing. We just don't want the police to coincidentally be the criminal's frat brother.

That said, here are two things we can do that would help us turn this ship around.

(1) Find ways to have less money in politics.
The financial industry spends more than $1 million a day on lobbying.  All too often that means industry sellouts are appointed as regulators.

Fixing this problem is easier said than done. Voting for politicians with backbones is probably a good start, as is demanding some kind of campaign finance reform or improved transparency of who's paying for those annoying ads.

(2)When a simple law will work, don't tinker with regulatory discretion.
Firm laws can be far superior to discretion. We shouldn't always give regulators discretion to exempt and make random subjective calls as they please.

Consider this: Currently, the Federal Reserve subsidizes Dugan's too-big-to-fail banks by allowing them to use our FDIC-insured deposits for gambling with risky derivatives -- the same ones that contributed to the 2008 financial meltdown. That's a recipe for disaster. Because there's no good reason for taxpayers to subsidize derivatives casinos, why not just end the practice and be done with it?

This is actually something that's being voted on over the next week. If you want to stop subsidizing risky derivatives casinos, click this petition:

Ilan Moscovitz and Morgan Housel don't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.