In Michael Lewis’s latest Bloomberg column, he declares “The Ray Rice Video for the Financial Sector Has Arrived.” The reference, of course, is not to a video but a set of recordings of meetings at the New York Federal Reserve Bank taped by a former Fed examiner Carmen Segarra. The recordings, which form the basis of a recent “This American Life” episode, paint a disturbing picture of the New York Fed’s dealings with one of the firms it is charged with regulating, Goldman Sachs. The specific incidents range from the Fed’s toleration of Goldman’s cavalier attitude towards consumer protections for wealthy investors, its unwillingness to challenge an ethically-dubious transaction, and its failure to pressure Goldman to strengthen its conflict of interest policies. But the recurring theme was one of extreme Fed deference to Goldman and a willingness to reign in those Fed employees who deviated from that policy.
In many ways, Lewis’s analogy to the Ray Rice video that rocked the National Football League is entirely apt. Until the elevator security camera footage was made public, fans could only conjecture as to why an NFL star was dragging his unconscious fiance from an elevator. Before the release of the Goldman tapes, Americans could only conjecture how the Federal Reserve and other regulators had allowed the conditions that led to the financial crisis. But now we know. Both the Ray Rice video and the Goldman tapes reveal “unignorable truths.”
But unlike the Rice video where there is little room for debating what actually happened, some lessons of the Goldman tapes are somewhat less transparent. Here are what I think are the five most important take-aways.
1. The Fed is “captured,” but capture may not mean what you think it means
Although the term was developed by political scientists way back in the 1950s and appropriated by Chicago School economists in the 1970s, it has recently penetrated the public debate as a catch-all explanation for the bureaucratic and regulatory failures that precipitated the financial crisis (and other disasters such as the BP oil spill in the Gulf of Mexico). But in the public discourse, the phrase seems to connote not much more than the idea that the industry (Wall Street in this case) has too much influence over its regulators.
It would be hard to come away from listening to the Segarra’s tapes and not conclude that this broad definition of capture applied to the bank supervisors at the New York Fed. Segarra’s bosses were clearly too deferential to Goldman. But we do not see evidence of “capture” as it often appears in the popular imagination. The regulators were not plotting on how to help Goldman make money. Rather fear and intimidation seemed to drive their behavior. The most telling moment in the broadcast was the scene where Segarra’s bosses patted themselves on the back for sending a shot across Goldman’s bow just after the listeners had actually heard them roll over like lap dogs during a key meeting with Goldman on a questionable deal.
Ultimately, the key question for public policy and regulatory reform is: what were the supervisors afraid of? Was it that their bosses were themselves in cahoots with Goldman? Were they intimidated by the political and legal resources that Goldman could bring to bear in case of any adverse decisions? Were they afraid that they did not fully understand the economic consequences of saying no to Goldman? Or was it, as suggested by a Hew York Fed-commissioned study, a fear of straying from Group Think? Unfortunately, the tapes cannot answer these questions.
2. Complexity may be an important source of capture
While the tapes don’t conclusively resolve why the Fed was so soft on Goldman, it does offer several clues that suggest the importance of the complexity of the financial sector. At various junctures in the tapes, Segarra is encouraged by her bosses to cultivate a more cooperative relationship with Goldman. Their rationale was that her more aggressive posture would ultimately lead Goldman to be less transparent and forthcoming with regulators about its activities. There is undoubtedly something to this argument. Goldman is a large and complex firm that makes large and complex deals and investments in a large number of complex markets. Goldman management itself has a hard time keeping track of all that is going on. There is no way that a small examination staff, even one co-located at the bank, can do its job without the active cooperation of the bank. So it is quite possible in such a setting that aggressive regulation will be ineffective regulation.
A partial solution to this problem is to increase the number of examiners and pay the premium needed to attract talent and expertise to the Fed. But the better solution is to make banks smaller and less complex. The increase in transparency will lead to better regulation all around.
3. Our rules-based regulatory system tilts in favor of Wall Street
To vastly over-simplify, there are two approaches to regulation: rules-based and principles-based regulation. In a rules-based system such as ours, regulators promulgate very specific rules based on the authority that has been delegated to them by Congress. Ultimately, whatever is not explicitly forbidden is allowed. In a principles-based system, regulators establish broad principles of behavior and then have a fair amount of leeway in determining whether the regulated firm is complying with the underlying principle.
There are good arguments for and against both approaches. But the Goldman tapes show a clear liability of the rules-based system. As discussed in the broadcast, Goldman was working on a deal with Banco Santander to accept a temporary transfer of some of Santander’s assets so that the Spanish bank would appear to be better capitalized. The whole purpose of the transaction was to help Santander evade its regulators’ capital requirements. While the Fed supervisors felt the deal was “shady,” they felt they had no explicit legal authority to block the specific type of transaction. Perhaps under a regime that enforced a principle against regulatory arbitrage and the subversion of the banking regulations, the Fed could have acted.
4. The Revolving Door may not work the way you think it does
“This American Life” makes a big deal about the “revolving door” between the New York Fed and Goldman Sachs. The broadcast reveals that “a quick Internet search” suggests that at least seven former Fed bank examiners work for Goldman Sachs. Such facts obviously contribute to popular notion that instead of doing their jobs, regulators are primarily auditioning for Wall Street jobs.
It may be the case that examiners heard on Segarra’s tapes were auditioning. But if they were, they bombed. By being so deferential and timid, they did not come across as the assertive and confident types that a place like Goldman would presumably want to hire. Goldman would rather regulators like those to keep their day jobs.
Despite the common notion that regulators go soft on their prospective future employers, social science research has often found that the opposite seems to be true. For example, SEC attorneys that have been the most successful in prosecuting financial crime are those that are most likely to decamp for positions on Wall Street or “white-shoe” law firms.
The revolving door is a problem, but its manifests itself in a continued cycle of Wall Street undermining its own regulation by siphoning off the best and brightest.
5. Dodd-Frank did not solve our problems with financial regulation
The Dodd-Frank financial reform bill that Congress passed in 2012 put an extraordinary amount of faith in our financial regulatory system in general and the Federal Reserve in particular. Its reforms left much of the structure of the industry and the regulatory agencies intact. The guiding principle was that with a few more legal tools, additional resources, and more assertive regulators future financial crisis could be prevented or contained. In microcosm, the Dodd-Frank strategy amounted to hiring more Carmen Segarras. As the Goldman tapes make clear, that strategy failed. There is no reason to believe that it will not fail in the big picture as well. It is time to rethink the whole system.