Ted Kaufman - United States Senator for Delaware

Captive Regulators Contributed to Oil and Financial Disasters

July 27, 2010

Madam President, the story of regulatory failure surrounding the Deepwater Horizon oilspill by now is all too well known. The Minerals Management Service, called 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 taxpayers, became the single most recognizable example of regulatory capture in U.S. history.

Regulatory capture is when a regulatory agency permits its judgments to be clouded by the narrow economic interests of the industry it is supposed to be regulating. It is the absolute opposite of how regulators should work, which is to safeguard the greater and broader interests of public health, safety, and prosperity against often complex, powerful, and narrowly minded industries.

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 the MMS from 2007 to 2009, is now president of the National Ocean Industries Association, the trade association for producers, contractors, engineers, and supply companies that explore and drill for oil and natural gas in offshore waters.

According to the Department of Interior inspector general's report, one examiner conducted safety checks at four rigs owned by one company, while at the same time negotiating for a job for himself with the very 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. And I know he will. Michael Bromwich, who directs the Bureau of Ocean Energy Management--the successor to the 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 can also 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 percent, even as offshore minerals exploration leases and acres leased increased by 10 percent over the same period. Leases go up by 10 percent, employees go down by 8 percent. That does not seem to make sense, but it fits into the idea of regulatory capture.

A third factor that may lead to regulatory capture is if a regulator is responsible for just one industry, such as MMS was responsible for only 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, the revolving door may be amplified for a single-industry regulator because the regulators have relatively few options for seeking private sector employment after they leave the single-industry regulator.

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

We have a business that is very complex. There is a lot of information flowing. It is more and more difficult for the regulator to keep track of the information they need to do their regulation and enforcement.

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 avert the BP disaster, these myopic criticisms ignore the deep and lasting damage that Secretary Salazar found when he arrived done by many of our regulators in the previous administration.

During the last administration, a deregulatory mindset captured our regulatory agencies. They became enamored of the view that self-regulation was adequate--that was throughout the government--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 the best regulation is no regulation at all, when a laissez faire mindset causes the regulators to be deeply distressful of curbs on any industry practice, then regulatory capture is all but ensured. During these 8 years, Congress's failure to conduct vigorous oversight was particularly damaging as well.

What we had was a situation where we basically pulled the referees off the field and did not even watch what was going on and what happened.

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 oil and mineral industries.

It is interesting that I hear colleagues on the other side of the aisle say: The government didn't do this right; the government didn't do right in the oil thing. How could they when the last administration took us completely out of the oil regulation business? How did everything happen on these sites without an inspector there to check that the batteries were working, to see that inspections were carried out.

The Federal Government was denuded of any ability to do anything once the spill developed, once the leak started because we believed the reports that were put out by the companies. No one looked at them and said: Don't worry, this will never happen. And if it does, we have a plan. Remember, that was the plan that was talking about how we were going to have to look out for the walruses. Remember?

I do not understand how one can be critical of Secretary Salazar when we saw that he came into an office where there was no regulation and where the regulators were totally, completely captured by the business. As we learned over the last 2 years, when regulators fail, it is the American people who pays the price.

When President Obama was inaugurated, therefore, he inherited executive agencies that had been weakened by 8 years of atrophy and neglect.

Another example is the Office of Thrift Supervision. It is a wonderful example of how regulatory neglect in the financial sector led us to an economic and financial crisis.

Listen to this. During the Bush administration, over 20 percent of the full-time equivalent positions at OTS were eliminated. Why did we need OTS inspectors if we did not believe we needed regulation?

This decrease in funding for OTS personnel, while striking, is not the heart of it. It does not reveal the scope of the rot in the agency. For that, one needs to examine how those regulators acted. And I suggest to everyone Senator Levin's Permanent Subcommittee on Investigations hearings that he chaired that went into detail what actually happened to the Office of Thrift Supervision.

As established in those hearings, Washington Mutual, better known as WaMu, comprised as much as 25 percent of the assets under OTS regulation. Moreover, WaMu contributed between 12 percent and 15 percent of OTS's operating revenue through the fees it paid.

Think about this. The largest institution you are regulating covers over 25 percent. Even though WaMu was the most significant and largest institution under its regulation, regulators allowed shoddy and even fraudulent lending to occur under their noses without taking remedial, corrective action or any significant enforcement measures.

Listen to this. The Office of Thrift Supervision sat by as up to 90 percent of the home equity loans underwritten by Washington Mutual were comprised of stated income or so-called liar loans. A stated income or liar loan is where I come in for a loan, the loan officer says to me: Senator Kaufman, what do you make every year? And I say: $1.6 million. They write it down. Nobody asks for a W-2 form. Nobody asks for any further information on it. They just take my word for it.

Can you believe that an institution could make liar loans that were 90 percent of their home equity loans? Ninety percent of the loans they took, when people came in and said what their income was, they never asked for a W-2 form. They never asked for any further information.

Still worse, if that is hard to believe, OTS was captured to such a great degree that it lobbied other regulators to weaken nontraditional mortgage regulations. Not only were they not looking at their businesses, the largest thrift institutions, they were trying to stop other regulators from doing it.

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 MIT economist Simon Johnson has termed it, a ``financial oligarchy'' has arisen that moved seamlessly between the private and public sectors leaving an indelible mark on the financial industry landscape in a way that tends to enrich those very oligarch 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 the 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 normally regulated these firms, the Commission had no track record to speak of with respect to ensuring the safety and soundness of financial institutions. The Securities and Exchange 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.

The head of Bear Stearns said his biggest problem was that he was allowed to expand his capital base.

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

Lehman Brothers was forced into bankruptcy and Bear Stearns was taken over by JPMorgan Chase. At the end of the day, as we all know, the American taxpayer was left holding the bill for the cost 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--listen to this--that industry will provide regulators with an accurate data stream, even when it is the 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 of this is high-frequency trading, which has grown rapidly over the past few years free from regulatory structure. Basically, it has gone from 40 percent to 70 percent of all trades that are now done by high-frequency trading. Pending finalization of the April 14 large trader rule, the SEC hasn't been collecting meaningful data about high-frequency trading--listen to this--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 a perfect case in point of regulatory capture. Roundtables are designed to publicly air a diversity of views pertaining to potential regulations. These roundtables are supposed to be where a bunch of people get together with different views that represent all the views and talk about potential regulation. However, the panel that was set up on high-frequency trading, 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 symbolic failure of the regulators and the regulatory system.'' Look at that panel. See who was on it, and you could see regulatory capture right before your eyes. Thankfully, the SEC agreed to make some modifications to the panel but concerns still remained.

At the opening of the panel, SEC 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 discussion will not bring to light how conflicts of interest, and particular business models, may influence the various views we'll hear today.

Commissioner Aguilar, I couldn't agree with you more. To rely on those who have benefited from the status quo to point out the very regulatory imperfections that 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 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 American public.

Some commentators have looked at the record of regulatory failure and have 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. Think about that now. Regulatory capture is a fact of life, and they say we should therefore endeavor to have as little regulation as possible. Let's let the industries run it all is essentially what they are saying.

This position ignores the commonsense 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 could mandate cooling-off periods so regulators do not take proprietary information to their new employees. It seems like common sense, right?

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 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 they are not tempted to compromise their judgment in hopes of earning a lucrative industry job.

This country has a long and proud history of successful Federal regulation--a long and proud history of successful Federal regulation. In large part, the safety of our food, our roads, airspace, workplaces, and so many other things is due to successful Federal regulation. Our continued prosperity depends on continuing to have good, positive, well-done regulation, strongly and intelligently done, for the good of the public.

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 in the years to come.

Congress has a vital role in overseeing the enormous regulatory process that will now take place. I have talked about this before. Congress's role in this is key. We are talking about a lot of regulations down the road. It is up to Congress to do its oversight responsibility. This will include ensuring that the regulators have adequate resources and staff, that the 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. Already they have begun their counterattack. Daily, we hear that the economic recovery is being slowed by uncertainty about Federal regulations. This argument, which went on for a number of years, might have been plausible a few years ago. I might have stopped to listen to it. But after the massive financial failures and oilspills, it rings empty to me.

I am certainly not a fan of overregulation. I think one of the problems of not having regulation is that when we do regulate, we overregulate. We do not need 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.

How can we look at what has happened out there now; how can we look at the people unemployed and the people who have lost their homes and say we should go back to the way things were and continue with no regulation and have another incredible meltdown? Unfortunately, some in big business will always complain about having to follow the 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, we have found, 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, and the American people deserve no less.

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