But Who Is Watching Regulators?

September 13, 2009
Fair Game
But Who Is Watching Regulators?
By GRETCHEN MORGENSON

NOTHING succeeds like failure, as the saying goes. And nowhere is this dismal truth more evident than in our financial regulatory system, one year after the bankruptcy filing of Lehman Brothers.

Even though calamitous lending practices laid waste to the nation’s economy, surprisingly little has changed about how the financial arena operates and is supervised. Sure, a couple of venerable brokerage firms have vanished, but many of the same players remain on the scene, in the same positions of power.

Senior regulators who stood idly by for years as financial firms built their houses of cards have been rewarded with even bigger jobs or are jockeying for increased responsibilities. The Federal Reserve Board, for example, wants to become the financial system’s uber-regulator, even though its officials did nothing as banks made deadly decisions to lend recklessly and leverage themselves to the max.

Awarding increased power to those who failed in their oversight duties flies in the face of all notions of accountability. Imagine hiring Angelo R. Mozilo, the former chief of Countrywide Financial, to run a global financial institution, or installing E. Stanley O’Neal, who presided over a disastrous period at Merrill Lynch, at the helm of a major investment firm.

Yet those in the public sector ask us to believe that regulators who snoozed during the credit bubble will be alert to emerging problems on their beats when the next mania begins.

That’s asking a lot, isn’t it?

Here’s a novel thought. Instead of creating more regulations to try to prevent this kind of mess from recurring, why not figure out how to hold regulators accountable when they perform as poorly as they did in recent years?

Edward J. Kane, a professor of finance at Boston College and an authority on the ethical and operational aspects of regulatory failure, has some ideas about how to do this and right our damaged system in the process. He outlined them in a recent paper titled “Unmet Duties in Managing Financial Safety Nets.”

This ugly financial episode we’ve all had to live through makes clear, Mr. Kane says, that taxpayers must protect themselves against two things: the corrupting influence of bureaucratic self-interest among regulators and the political clout wielded by the large institutions they are supposed to police. Finally, he argues, taxpayers must demand that the government publicize the costs of efforts taken to save the financial system from itself.

“That authorities and financiers could so callously violate common-law duties of loyalty, competence, and care they owe taxpayers and financial-institution customers is evidence of a massive incentive breakdown in industry and government,” Mr. Kane writes. “This breakdown cannot be repaired merely by replacing the governing political party or by changing the jurisdictions and mission statements of regulatory agencies.”

It’s tough, however, to assign responsibility to regulators who routinely fend off or stymie anyone attempting to scrutinize how the cops on the beat functioned in the years preceding the financial meltdown. So everyday Americans need to kick and scream if they want some light shed on this critical epoch in our financial history.

To bring accountability to regulatory performance, Mr. Kane suggests that financial supervisors take an oath of office in which they agree to perform four duties. First is the duty of vision, under which they would promise to adapt their surveillance practices to respond to the creative ways financial institutions hide their dubious practices. Regulators must also promise to take prompt corrective action, and to perform their work efficiently. Finally, there is what Mr. Kane calls the duty of “conscientious representation,” whereby regulators swear to put the interests of the community ahead of their own.

This last promise gets to the heart of a continued erosion of trust in our system, Mr. Kane argues. “If real world supervisors were perfectly virtuous, they would make themselves politically and financially accountable for the ways in which they exercise their discretion,” he writes. “Perfectly virtuous supervisors would fearlessly bond themselves to disclose enough information about their decision making to allow the community or interested outsiders to determine whether and how badly they neglect, abuse, or mishandle their responsibilities.”

Instead, our regulators refuse to produce complete documentation and accounts of the actions they took during the crisis. And keeping taxpayers in the dark isn’t exemplary ethical behavior. Rather, it is characteristic of what Mr. Kane calls an elitist regulator, one who uses crises to cover up mistakes and expand his or her jurisdiction.

“According to this standard,” Mr. Kane writes, “Fed efforts to use the crisis as a platform for self-congratulation and for securing enlarged systemic-risk authority sidetracks, rather than promotes, effective reform.”

To ensure that regulators live up to the promises they make, Mr. Kane suggests that inspectors general at each agency be charged with regularly auditing the performance of financial overseers. A crucial component of those reviews would be exploring attempts by regulated entities to influence the officials who oversee them. That’s because in financial crises, Mr. Kane explained, crippled institutions pressure the government to rescue them and force other parties (usually the taxpayers) to share their pain.

“We’ve got a very comfortable equilibrium here where Wall Street praises the authorities and the authorities give Wall Street more or less what it wants and they hope that the public really doesn’t understand the depth of the cynicism involved,” Mr. Kane said in an interview. “You keep reading about how wonderful it is that we didn’t have a Great Depression. Well, if they can sell that point of view, then nothing will change.”

Copyright 2009 The New York Times Company