Confessions of a Financial Regulator

We received the following email from James Coffman in response to Bond Girl’s recent guest post, “Filling the Financial Regulatory Void.” Coffey agreed to let us publish the email. As he says below, he spent 27 years in the enforcement division of the SEC.

Bond Girl’s “Filling the Financial Regulatory Void” provided insight into human deficiencies in the current financial regulatory system. But it overplays the human failings of regulators and concludes with a proposed solution that, in all likelihood, would turn out worse than the current situation.

But first, in the interest of full disclosure, I should tell you that I retired two years ago from a management position in the enforcement division at the SEC after 27 years. So I was (and in my heart, I suppose I still am) a financial regulator. That background probably should be taken into account by anyone who reads this response.

There is no doubt that “regulatory capture” exists and is a meaningful factor in the recent failures of our regulatory system. Many of us in the enforcement division dealt with the problem regularly when we sought input from those in the agency who were responsible for regulating aspects of the securities markets. Over time, regulatory policies and practices had emerged that seemed to contradict the purpose if not the letter of the law. In other cases, over-arching issues (e.g., increases in fees charged by investment companies despite growth that should have resulted in economies of scale and decreasing fees) simply were not addressed in any meaningful way.

But the majority of regulators I worked with were critics of the problem of “capture,” not victims. Much of the problem arose from decades of deregulation dating back to the beginning of the Reagan administration. Elected deregulators appointed their own kind to head regulatory agencies and they, in turn, removed career regulators from management positions and replaced them with appointees who had worked in or represented the regulated industries.

These new managers and, in many cases, the people they recruited and promoted, advanced or adhered to a regulatory scheme that, at least with respect to the most important issues, advanced the interests of regulated.

Bond Girl is right, the industry “captured” the regulators and the regulatory system. But not in the passive sense that true regulators over time came to identify too closely with the interests of the regulated. This is not a case of financial regulators falling victim to the Stockholm syndrome. The vast majority of capture resulted from intentional efforts by the finance industry to advance their narrow interests at all costs and defeat meaningful regulation.

Unfortunately, we live in a country that can be bought from the top down and the finance industry exploited the situation very successfully. But do not blame the regulators. Career regulators are as much the victims of these events as the public’s economic welfare.

The creation of paid social entrepreneurs to perform regulatory functions will not enhance regulation nor reduce “capture”. I’ve sued too many CPA’s over the years for bad audits to believe the answer lies in creating a new class of auditors. Audit clients often “capture” their auditors. The result is bad audits resulting in uncorrected and undisclosed financial fraud. The victims are always the shareholders and the market.

Besides, using money to “incentivize” a new, private class of regulators plays directly into the hands of the finance industry. No matter what the regulatory fee structure may be, government will never be in a position to compete with the financial industry when it comes to “incentivizing” regulators-for-hire.

We need to look elsewhere for solutions to the problems that hamper our financial regulatory system.

• First, we need to look at the structure of the finance industry. Commercial banks got into trouble in large part because they warehoused (often off the books) toxic securities underwritten by their investment banking counterparts within the holding company structure. Similar abuses in the past resulted in separating investment banking from commercial banking. We should try it again. Insurance should be split off as well.
• Second, no institution should be allowed to become too big to fail. Those that have already achieved that status should be broken up.
• Third, we must put in place an effective financial consumer protection agency which can counteract the worst consumer practices of a too powerful industry.
• Fourth, investment banks should be made to eat what they kill. Public ownership of investment banks coincided with the industry’s decline into extremely reckless risk taking. Investment bankers should be required to own a significant percentage of the equity in the institutions in which they work (something approaching 50%, to pick a number). Having a significant portion of their net worth tied up in such stock would provide an incentive to carefully identify and measure risk. It should also reduce outsized compensation for investment bankers.
• Fifth, there should be greater limits placed on the ability of political appointees to oust career regulators. Make capture more difficult.
• Sixth, more financial products and firms should be subject to government registration and reporting.
• Seventh, regulators should not be forced to wear conflicting hats. One cannot promote an industry while protecting the public from it. Don’t ask regulators to be industry cheerleaders. Limits can be placed on regulators to ensure that they not act without consideration of the impact of their actions. But over-regulation is not what got us in this position. Cheerleaders purporting to be regulators did.
• Finally, the government should adopt a bonus plan for regulators, run by regulators (who would rotate off after short, fixed terms, to prevent back-scratching among board members) to provide incentives for regulators to excel at the job of regulation. Recognized, protected and incentivized regulators will resist capture.

Comments

[Tom Armistead:]

A balanced view from someone who spent a career inside the system.

Aug 17 10:32 AM

[DonH:]

I think limiting the ability of regulators to take jobs with companies that they regulate (and vice versa) is a desperate need.

While we're at it we should do the same and ban retired Congressmen and Senators from hiring on as lobbyists.

Aug 17 11:28 AM

[notsosmart:]

never happen.nothing will happen.the sheeples will keep getting fleeced.ethics is gone.lying is in.thats the way,sadly,this country is evolving.we had to pass laws to protect whistleblowers instead of rewarding them.made-off is a piker compared to all the financial scoundrels that should be in jail.thousands of rich avoiding taxes with world wide secret bank accts.these folks consider themselves heroes for outsmarting the irs.thats what weve become.all that matters is money.the more the better & how you get it means nothing.who do you trust?

Aug 17 03:23 PM

[zorrow:]

Reinstate Glass Stegall. Enforce Oxley Sarbanes by having a required fraud audit, similar to a bank examination, but run by trained SEC personnel. (No subcontracting to Arthur Anderson types).

Individual criminal penalties could be sought against corporate officers who signed off on fraudulent records.Relegate the compromised ineffective private auditors to prettying up annual reports.

Aug 17 06:28 PM

[Tony Petroski:]

From the "Baseline Scenario" (whatever that is): "Unfortunately, we live in a country that can be bought from the top down..."

Baseline. You have some good ideas here.

Are you writing of the USA? Bought from the top down? You may be right, but what country would you propose we relocate to?

Aug 17 10:26 PM

[PainfullyAware:]

On Aug 17 10:26 PM Tony Petroski wrote:

> From the "Baseline Scenario" (whatever that is): "Unfortunately,
> we live in a country that can be bought from the top down..."
>
> Baseline. You have some good ideas here.
>
> Are you writing of the USA? Bought from the top down? You may be
> right, but what country would you propose we relocate to?

Yes, he is talking about the USA.

I do not propose that we "Search For A Better Place To Relocate"; I suggest that we "Resist Subjugation" and attempt to "Stem The Tide" by Enacting Amendment 10 Legislation - Not So Much As "Secession" But More As "Reinstating The Limits Of Federal Power". This is a legitimate avenue for "Bloodless Revolution".

The American Experiment Is Unique Within The World.

Aug 18 04:51 AM

[PainfullyAware:]

On Aug 17 03:23 PM notsosmart wrote:

> never happen.nothing will happen.the sheeples will keep getting fleeced.ethics
> is gone.lying is in.thats the way,sadly,this country is evolving.we
> had to pass laws to protect whistleblowers instead of rewarding them.made-off
> is a piker compared to all the financial scoundrels that should be
> in jail.thousands of rich avoiding taxes with world wide secret bank
> accts.these folks consider themselves heroes for outsmarting the
> irs.thats what weve become.all that matters is money.the more the
> better & how you get it means nothing.who do you trust?

It can be overwhelming - Yet Nothing Lasts Forever. Chaos And Order Are Forever Dynamic. The Only Constant In The Universe Is "Change".

The Natives Are Restless. The Circus Continues But The Bread Is Almost Gone.

Aug 18 04:58 AM

[BRUCE E. W.:]

baselinescenario.com/2... = CHECK THIS OUT!
There is an extensive and very interesting discussion in the commentaries that followed the posting of this article by Baseline Scenario on their own web. It is definitely worth checking, and perhaps we can get more of the same constructive attention in this following. My first posting of 3 on the earlier threaded stream is added here:
Mr. Coffman makes a point about the difference between the mercenary regulator for hire and the authentic regulator that is attempting to maintain principles of stability and order. Internal coherance goes first. This is true in every model of corruption from small town police and judges, through third world sham political machines to the crony politics of market influence in complex potical circles of major cities all the way up through the centers of consolidated power politics at national and international levels. In turn, financing has always been necessary to capture and maintain power whether it is to build a war chest for a standing army or supply the resources to the production of a political military machine. Power corrupts and absolute power corrupts absolutely…so what is it that is new? Well the problem is that se think the system is static. It then becomes easy to hold it constant and act as if it failed to stop a flailing system. But the idea of “regulatory capture” (as I understand it) is a product of Chicago School Economic theory which created a blueprint for subverting the regulatory system and actually rubber stamped it as idealistic capitalism. Maximizing profits and optimizing advantages under rational choice theory codeified this practice as sanctimonious idealism reinforced by pseudo science and laced with Swiss financed Nobel prize stature for legitimation. What Mr. Coffey has demonstrated with his honest testimonial is that the regulators didn’t fail, the flailing business centers rigged the system itself just like every organized crime syndicate would do. They just went a step farther. They not only captured the decision making positions and neutralized the operative regulators, but they also neutralized the very laws that provided the regulators some tools to work with and do their job. People like Mr. Coffman have something to teach us all, the least of which is how to repair the actual process and make it work. I doubt if one brow beaten regulator is going to have the answer, but I think there should be a careful polling of the rank and file to find the pool of potential directions needed. For one I would say there needs to be a central reulating body of carefully selected Governorship that is elected for life (no swithching between interests). For a second it is pretty clear that we need an internal affairs unit with prosecuting power to regulate the regulators and give the honest ones a mode of corrective action. Thirdly there needs to be a review board open to scrutiny by a free press to publish open assessments and critical opinion. Finally, conflicts of interest can not be the rule of order. In concluding, however, it seems to me that the Bond Girl attitude of regulators “mettling” in the affairs of the Financial Service Sector; on the presumption of some degree of relative honesty being impinged on unfairly;…on the commercially successful indoctrination that we all agree that the financial capital is loaded down with the smartest guys in the room (”smarter than everone else?…REALLY!) THESE ARE ALL PART AND PARCEL TO THE BRAINWASHED PROBLEM OF ARROGANT SUPREMACY IN THE FINANCIAL SECTOR THAT ALLOWS THESE SAME PEOPLE THINK THEY ARE JUSTIFIED IN FACILITATING THE WEALTH INDUSTRY BY EVERY MEANS POSSIBLE…BECAUSE THE ENDS DO JUSTIFY THE MEANS IN THEIR THINKING. It amounts to nothing more than a climate of ridicule and intimidation to suppress counterbalances that were meant to scrutinize unscrupulous "engineering" practices. It reminsd one of the mafia ranking on the petit intelligence of law enforcement they see as inept and impotent to stop them. The final verdict is that we need not throw out the baby with the bathwater. The idea of institutional regulation is solid and proven. Take it decade by decade in evaluations. You will have to pay special attention from the time of the late 70s when corrupting the system became part of big money strategy. The truth is that we have an ancient system created at the beginnings of the 2oth century which was pounded for more than three decades to turn finance into a wild west show. You can’t blame the old system when it was never upgraded to handle 21st century crooks, con artists, and backed by a mesmerizing intelligencia which even today get branded as smarter than eveyone else. I for one would like to hear from more of the old school regulators like Mr. Coffey than these newly appointed Financial wizzards. Regulators may well redeem the system with more honesty and intelligence than we have encouraged them to share. Its all a matter of judging who ws bought already and who is being honest. And in our culture…THAT’S THE PROBLEM!
THERE IS A VERY INTELLIGENT DIALOGUE that follows in the refered commentaries between Bond Girl and Mr. Coffman. It would be worth your time to go and check that very informative exchange of ideas from both ends of the playing field.
baselinescenario.com/2...

Aug 18 08:39 AM

[Sud:]

To begin with, we should have a law that limits the number of political appointments; perhaps it should be limited to only the top regulator. Secondly, that regulator should not have the power to fire top level carrier personnel without cause and replace them with their own appointees. Furthermore, there should be limit to how many of their appointees can be brought in, and they should not be at the top most levels! This is the sort of thing that happened at the Justice Dept. under the previous admin.

Aug 18 05:11 PM