Captive Regulators Contributed to Oil and Financial Disasters

The story of regulatory failure surrounding the Deepwater Horizon oil spill is, by now, all too well known. The Minerals Management Service (MMS), the now-defunct agency that had been charged with assuring that drilling off America's coast was safe, environmentally responsible, and a reliable revenue source for the taxpayer, became the single most recognizable example of regulatory capture in the U.S.

Regulatory capture is when a regulator agency permits its judgments to be clouded by the narrow economic interests of the industry that it regulates.

It is the opposite of how regulators should work, which is to safeguard the greater and broader interests of the public health, safety and prosperity against often complex, powerful and narrowly-minded industry.

Regulatory capture can happen for a number of reasons.

First, regulatory capture can happen where the revolving door constantly shuttles individuals from the private sector to the regulator and vice versa. Regulators may be compromised by the implicit promise of lucrative employment, should they only look out for the industry during their watch.

It is this indicator of regulatory capture at MMS that the Washington Post described in such shocking detail in last week's front page story.

Seventy-Five percent of oil lobbyists formerly held jobs in the federal government. Randall Luthi, who directed MMS from 2007 to 2009, is now president of the National Ocean Industries Association, the trade association for producers, contractors, engineers and supply companies who explore and drill for oil and natural gas in offshore waters.

According to the Department of the Interior Inspector General's report, one examiner conducted safety checks at four rigs owned by one company, while at the same time negotiating a job for himself with that same company.

It also works in both directions. According to an MMS District Manager, almost all MMS inspectors had previously worked for oil companies on the same platforms they were inspecting.

As Ken Salazar testified last week before the House, he is aware of the problems caused by the revolving door and is taking steps to address it. Michael Bromwich, who directs the Bureau of Ocean Energy Management, the successor to MMS, has also pledged to beef-up "cooling-off periods," which restrict the ability of former oil regulators to seamlessly flow directly from government into a high paying industry job.

Poor funding, morale, or training for regulators also can play a role in regulatory capture. This, too, may have played a part in the ineffectiveness of MMS. During the prior administration, the workforce at MMS shrank by approximately 8%, even as offshore minerals exploration leases and acres leased increased by 10% over that same time period.

A third factor that may lead to regulatory capture is if a regulator is responsible for just one industry, such as MMS was responsible only for regulating the exploration activities of oil companies. Industry groups with a laser-like focus can lobby single-industry regulators, whereas the public's interest is likely to be much more diffuse. In addition, problems of the revolving door may be amplified for a single-industry regulator, because the regulators have relatively few options for seeking private sector employment.

Mr. Bromwich has also been quick to recognize the problems caused by having such a small and captive pool of inspectors. As he works to make the job of oil rig inspector more attractive, Congress should support these efforts as an effective way to counter regulatory capture.

Vague statutory lines drawn by Congress, as well as loose oversight, are a fourth contributor to regulatory capture because they give captive regulators plenty of room to stretch and contort the law without necessarily breaking the law or even having to explain their actions.

Finally, complex industries with large masses of proprietary data are also able to control the flow of information to regulators -- information that will form the basis of regulation and enforcement, thereby virtually precluding effective regulation.

While I have heard colleagues and commentators argue that Secretary Salazar did not do enough, fast enough, to reverse the problem of regulatory capture in time to prevent the BP disaster, these myopic criticisms ignore the deep and lasting damage done to many of our regulators by the previous administration.

During this time, a deregulatory mindset captured our regulatory agencies.

We became enamored of the view that self-regulation was adequate. That "rational" self-interest would motivate counterparties to undertake stronger and better forms of due diligence than any regulator could perform, and that market fundamentalism would lead to the best outcomes for the most people.

When the regulators themselves feel that the best regulation is no regulation at all, when a laissez faire mindset causes the regulators themselves to be deeply distrustful of curbs on any industry practice, then regulatory capture is all but ensured.

And during those eight years, Congress' failure to conduct vigorous oversight was particularly damaging as well.

This deregulatory mindset, more than any other factor, explains why we have suffered so many examples of failed regulation in recent years -- especially in our financial sector and in the oil and mineral industries.

As we've learned over the last two years, when regulators fail, it is the American people who pay the price.

When President Obama was inaugurated, therefore, he inherited executive agencies that had been weakened by eight years of atrophy and neglect.

The Office of Thrift Supervision (OTS) is an example of how regulatory neglect and the deregulatory mindset allowed the financial sector to lead us into economic and financial crisis. During the Bush administration, over 20% of the full-time-equivalent positions at OTS were eliminated

This decrease in funding for OTS personnel, while striking, fails to reveal the scope of the rot at that agency. For that, one needs to examine how those regulators acted, as Senator Levin did during the in-depth Permanent Subcommittee on Investigations hearings that he chaired.

As established at those hearings, Washington Mutual (WaMu) comprised as much as 25% of the assets under OTS regulation. Moreover, WaMu contributed between 12 and 15% of OTS' operating revenue through the fees that it paid.

Even though WaMu was the most significant and largest institution under its regulation, regulators allowed shoddy and even fraudulent lending to occur under their nose without taking remedial corrective action or any significant enforcement measures.

OTS sat idly by as up to 90% of home equity loans underwritten at Washington Mutual (WaMu) were comprised of "stated income" or so-called "liar's loans." Still worse, OTS was captured to such a great degree that it lobbied other regulators to weaken nontraditional mortgage regulation.

As if to give further evidence of its capture, OTS even went so far as to thwart an investigation into WaMu by the Federal Deposit Insurance Corporation, a secondary regulator, that could have put a stop to some of WaMu's unsustainable business practices before they did so much damage.

OTS and WaMu are just the beginning of the story, however. The problem of capture spread beyond the thrifts to those responsible for regulating Wall Street, where many of the top cops during this time were either former industry insiders or committed to deregulation and self-regulation.

As the MIT economist Simon Johnson has termed it, a "financial oligarchy" had arisen that moved seamlessly between the private and public sectors, leaving an indelible mark on the financial regulatory landscape in a way that tends to enrich those very oligarchs and their friends.

The negotiation of the 2004 Basel II Capital Accord was emblematic of this cozy relationship. As part of these discussions, the Fed was a principal architect of a regulatory framework that would allow banks to determine capital requirements based on the judgment of ratings agencies and their own internal models.

By outsourcing their regulatory responsibilities to the banks that they were supposed to regulate, the Fed and other bank supervisors made an implicit admission that the size and complexity of megabanks had exceeded their comprehension.

Although the Basel II Accord was not fully implemented, it effectively was applied to large investment banks. While the SEC nominally regulated these firms, the Commission had no track record to speak of with respect to ensuring the safety and soundness of financial institutions.

The Commission allowed these investment banks to leverage a small base of capital over 40 times into asset holdings that, in some cases, exceeded $1 trillion.

When the bottom fell out of the market, the funding engine powering the investment bank business model seized up. Lehman Brothers was forced into bankruptcy and the other major investment banks faced an existential crisis.

At the end of the day, American taxpayers were left holding the bill for the costs to stabilize the financial system.

Basel II's treatment of capital adequacy standards is just one telling example of regulatory capture. Federal regulators also failed to strengthen consumer protection regulations in the lead-up to the crisis, despite the explosion of the subprime market and warnings from many quarters on the frequent incidence of predatory lending practices.

Hence, just like leverage ratios, regulators allowed underwriting standards to erode precipitously without strengthening mortgage origination regulations.

Wall Street regulation is compromised by another problem -- the utter dependence of regulators on the regulated for information.

This closed loop depends on the unrealistic assumption that industry will provide regulators with an accurate data stream, even when it is to their direct detriment. Too often, however, industry comes up short.

And without access to meaningful data, objective analyses cannot be developed by academics, consumer advocates or the media.

A good example is high frequency trading, which has grown rapidly over the last few years free from regulatory scrutiny. Pending finalization of the April 14 "large trader" rule, the SEC hasn't been collecting meaningful data about high frequency trading, including information on the identities of individual traders.

Even when implemented, the data will remain between the SEC, the trading firm, and the firm's broker-dealer, thereby eliminating the ability of any objective party to check the Commission's work to make sure it is doing its job of ensuring market credibility.

The recent SEC roundtable discussion on market structure issues is case in point. Roundtables are designed to publicly air a diversity of views pertaining to potential regulation.

This panel, however, as I said in a speech on May 27, promised to be so completely one-sided and "in favor of the entrenched money that has caused the very problems we seek to address that the panel itself stands as a symbolic failure of the regulators and regulatory system."

Though the SEC agreed to make some modifications to the panel, concerns remained.

As Commissioner Luis Aguilar noted in his opening statement: "I am disappointed that our Roundtable is not constituted to showcase the full breadth of relevant voices... And I am concerned that, as a result, today's discussions will not bring to light how conflicts of interest, and particular business models, may influence the various views we'll hear today."

To rely on those who have benefited from the status quo to point out the very regulatory imperfections that have allowed them to prosper is to doom the regulatory process from its inception.

As we emerge from this period of regulatory abdication and begin to rediscover the vital role that regulation must play in ensuring fair competition and a level playing field, it will take strong leadership and determination -- in the face of constant industry resistance -- to retake the initiative in our regulatory agencies for the good of the public.

Some commentators have looked at this record of regulatory failure and argued that all regulation is inherently prey to capture. Regulatory capture is a fact of life, they say, and we should therefore endeavor to have as little regulation as possible.

This position ignores the common sense solutions to regulatory capture, however. Open publication of regulatory data, for example, could allow academic scrutiny and mitigate the problem of the closed loop.

Strict ethics rules can mandate cooling off periods so that regulators do not take proprietary information to their new employers.

Congress can draw clear lines that empower regulators to act for the public interest and minimize vague mandates that can be exploited by shrewd companies. Vigorous congressional oversight can also hold regulators accountable before their agencies are too far gone to the problem of capture.

Agency employees should be paid fairly and treated with respect so that they are not tempted to compromise their judgment in hopes of earning a lucrative industry job.

This country has a long a proud history of successful federal regulation. In large part, the safety of our food, roads, airspace, and workplaces are due to successful federal regulation. And our continued prosperity depends on continuing to regulate, strongly and intelligently, for the public good.

The final Wall Street reform bill is a case in point. It invests enormous responsibilities and discretion into the hands of the regulators.

Its ultimate success or failure will depend on the actions and follow-through of these regulators for years to come. Congress has a vital role in overseeing the enormous regulatory process that will now take place.

This will include ensuring that the regulators have adequate resources and staff, that regulations reflect wide and objective input and that the failed experiments of deregulation and self-regulation are put to an end.

Industry and Big Business have already begun their counterattack. Daily, we hear that the economic recovery is being slowed by "uncertainty" about future regulations.

This argument might have been plausible a few years ago. I might have stopped to listen to it. But after massive financial failures and oil spills, it rings empty to me.

I am certainly not a fan of overregulation. But the complaint that we are starting down the path of overregulation is plainly overstated, to say the least -- especially after industry malfeasance and regulatory complicity cost so many Americans their jobs, their homes, and their way of life.

Unfortunately, some in big business will always complain about having to follow rules. But without effective rules, and rules that are effectively enforced, we are all certain to bear once again the cost inflicted upon us by the next industry-caused disaster.

Never again can we allow our environment and our economy to be entrusted to agencies that serve no purpose other than to provide a false sense of security. Lip service does not work.

Our leadership, the Congress and our regulatory agencies must walk the walk of enforcement while keeping regulatory capture to a minimum. Our government exists to do no less.