Nassim Nicholas Taleb has an intriguing piece at Huffington Post, “The Regulator Franchise, or the Alan Blinder Problem,” with a juicy anecdote at its core. It highlights a critical issue: how we’ve come to accept what other eras would view as dubious conduct as business as usual. Note that Taleb does a particularly artful job of writing in this piece, so I suggest you read it in full.
Here’s the trigger: last year at Davos, Blinder interrupts Taleb’s conversation with a third party to pitch a savings product, one that allows high net worth individuals to arb FDIC insurance regs by allowing them to put funds in a single account, which would then be split up among banks so that the investor would circumvent regulations that limit FDIC insurance (Taleb recalls as $100,000 per account, actually $250,00).
Now it’s already a bit unseemly for a former Fed vice chairman to be peddling investment products personally, particularly since, per Taleb:
….it would allow the super-rich to scam taxpayers by getting free government sponsored insurance. Yes, scam taxpayers. Legally. With the help of former civil servants who have an insider edge.
I blurted out: “isn’t this unethical?” I was told in response, “We have plenty of former regulators on the staff,” implying that what was legal was ethical.
Taleb then goes on to stress why this matters:
Alan Blinder is certainly not the worst violation of my sense of ethics; he probably irritated me because of the prominence of his previous public position and due to the context of the Davos conversation, which was meant to save the world….
Tell me if you understand the problem in its full simplicity: former regulators and public officials who were employed by the citizens to represent their best interests can use the expertise and contacts acquired on the job to benefit from glitches in the system upon joining private employment — law firms, etc.
Think about it a bit further: the more complex the regulation, the more bureaucratic the network, the more a regulator who knows the loops and glitches would benefit from it later, as his regulator edge would be a convex function of his differential knowledge. This is a franchise. (Note that this franchise is not limited to finance; the car company Toyota hired former U.S. regulators and used their “expertise” to handle investigations of its car defects).
Yves again. This may all seem to be so “dog bites man” in America so as to no longer elicit any outrage. The famed regulatory revolving door, and all the benefits that former officials and their new private sector masters gain from a legally permitted but socially destructive form of trading of insider know how is now considered business as usual in the US.
It’s remarkable to see how quickly conditions have decayed in the US. One of my colleagues, Amar Bhide, wrote a Harvard Business Review story in 1994 that was completely sincere (and would have been seen as accurate then) in describing one of the critical advantages of the US capital markets was that they weren’t simply the deepest, but also the cleanest in the world, with sound regulations, best investor investor protection, the most wide ranging disclosure.
Yet it is also clear that sound regulations can confer competitive advantage. When Singapore exited the British empire, the prospects for the island nation were poor: no manufacturing base, no commodities to exploit. Yet Lee Kwan Yew developed and executed what amounted to a national strategy, with two foundations. First was making sure the public was exceptionally well educated by Asian/emerging market standards, on the assumption that all he had was human capital. Second was the recognition that corruption was endemic to developing nations, and that having clean government would confer advantage. Yew set out to create a bureaucracy that would be hard to corrupt, and that rested on creating good incentives. Top bureaucrats were and are paid at the same level as private sector professionals (think top law firm partner). There’s little incentive to trade on your office if you don’t have much to gain. Tough internal audit was another critical aspect of this program.
But legalistic regulatory evasion has also become so commonplace as to blunt most people’s sense of where to draw the lines. One of the unacknowledged problems of the crisis is that the financial system has too little equity precisely because banks and their regulator enablers pursued securitization. The effect was to de equitize huge swathes of the credit markets (the growth of the an $8 trillion, give or take a couple of trillion, shadow banking system with pretty much no equity behind it, is the end product of this development). Regulators, financiers, and academics all touted the virtues of securitization, and its cost savings. Bullshit. The process has more moving parts, more parties ripping up front fees out of the deals. So where to the vaunted cost savings come from? De equitization, from reducing risk buffers for lending that had been deemed necessary provisions against losses. The “you’ll be on this bus or under the bus” charts McKinsey would show to clients in the 1980s explaining why securitization was inherently cheaper than on balance sheet lending showed two, and only two, big sources of expense savings: the elimination of bank equity and FDIC insurance costs.
So the “innovation” that regulators, academics, consultants, and banks were all advocating more than 20 years ago was regulatory arbitrage, pure and simple. When you have regulators undermining the rules and depicting it as virtuous, behavior like Blinder’s is simply more of the same.
Taleb describes why this behavior has become hard to root out:
First, the more complicated the regulation, the more prone to arbitrages by insiders. So 2,300 pages of regulation will be a gold mine for former regulators. The incentive of a regulator is to have complex regulation.
Second, the difference between letter and spirit of regulation is harder to detect in a complex system. The point is technical, but complex environments with nonlinearities are easier to game than linear ones with a small number of variables. The same applies to the gap between legal and ethical.
Third, regulation, like drugs, has side effects, and like drugs, it can harm the patient — something in my work I call the iatrogenics (harm done by the healer). People do not mention that regulation helped promote the Value-at-Risk method of risk measurement in replacement to age-tested heuristics — these methods blew up banks.
Fourth, we need a more severe monitoring of the activities of public officials and a solution to the following conflict. In African countries, government officials get explicit bribes. In the United States they have the implicit, never mentioned, promise to go work for a bank at a later date with a sinecure offering, say $5 million a year, if they are seen favorably by the industry. And the “regulations” of such activities are easily skirted.
Fifth, and more philosophically: during the lunch with Arianna, the conversation kept sliding into the ethical basin of attraction, the compatibility of some professions and service of the public. The Greeks had respect for the banausoi, those who had to make a living in the professions, but many argued against trusting them in running the affairs of the city on grounds that “a funeral goods merchant would not be trusted to wish for the good health of his fellow citizens.” The point has been debated through the ages, from Xenophon to Seneca (who took the opposing point), but it is even starker today in the age of lobbyists and a shift in middle class values that tolerates the “everyone needs to make a living” even when the means to “make a living” are harmful to society.
These accumulated moral hazards have blown up banks and will keep blowing up the system.
Yves here. Unfortunately, the Obama administration had the opportunity execute more fundamental reform at the outset. Worse, Obama himself recognized it; he was reading biographies and speeches of FDR as president elect, yet chose to pass on an historical opportunity.
Although I have not read Depression era politics extensively, it appears two critical elements are missing now. One is that despite the chicanery of the Roaring Twenties, ideas like character and public service still meant a great deal. Those values are pretty much dead now. Second was that Roosevelt was not cowed by bankers or businessmen. For instance, when he told his economic advisers (rather out of the blue) that he was going off the gold standard (which the US had done as an expedient, but the assumption was it would go back soon) he was met with a firestorm of criticism which he airly brushed aside. I can’t imagine any senior politician now having the confidence now to defy the will of the banking industry. And it isn’t simply due to the role of corporate funding in campaigning; the roots are deeper. Being in office now is all about winning, about keeping one’s hold on power, so it isn’t surprising that everyone has a price.
Update 2:00 PM: Some readers have objected to this post, pointing out that while Taleb is correct in general, his attack on Blinder is misguided. If nothing else, this issue reveals the considerable change is what is considered to be acceptable conduct. In the 1960s, it would have been unheard of for a former senior regulator to solicit interest in a financial product, irrespective of what one thought of the fact that it exists solely to make it easier for customers to work around inconvenient regulations. And the FDIC itself sends mixed signals (this link is from a few years ago, but there is little reason to think the underlying stance has changed much):
Deposit insurance has a simple, but important purpose: to provide a safe place for depositors to keep their money, as a way to prevent bank runs and maintain the stability of the banking and financial system.
Since 1934, the basic coverage amount has increased five times, from $5,000 to $100,000. Most of the increases more or less reflected cost-of-living adjustments, but the most recent increase is an exception. The 1980 jump from $40,000 to $100,000 had more to do with attracting deposits to insured institutions in a competitive market of very high interest rates. Today, 20 years later, $100,000 of deposit insurance has lost about half its value, based on the Consumer Price Index.
The next several decades will be a time in which the population is aging, retirement costs are increasing, and the supply of federally-backed investment vehicles, such as Treasury notes and bonds, may decline. Thus, a long-term perspective may argue for allowing for the coverage limit to keep up with changes in the price level, household wealth, or other measures relevant to households.
However, there are trade-offs to consider. Higher coverage limits can increase moral hazard. The 1980 increase is widely viewed as contributing to the high cost of the savings and loan crisis. Also, the impact of higher coverage limits on insured deposit growth is difficult to predict, and the likely distribution of benefits is subject to debate.
So….FDIC insurance is to prevent bank runs. No mention of the reason for the ceiling (to reduce overall cost? Because big investors can take care of themselves and can buy risk free investments like Tbills directly?). A clear indication that deposit ceilings were increased in 1980 to allow banks to compete more effectively with money market funds, and that had adverse consequences.