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What is Regulatory Capture?

In its simplest form, in the animal kingdom, it is called letting the fox guard the henhouse. That is to say, it consists of allowing regulation to be to designed by the very people that are supposed to be regulated.

One example of that was the repeal of the Glass Steagall Act in the late 1990s. This 1930s legislation was designed to separate investment banking from commercial banking, for good reasons, as we would soon find out. Who wanted it repealed? The investment bankers and and commercial bankers, who wanted to invade each others' turf. And specifically one commercial bank and one investment bank that wanted to merge?

And how did they get the regulatory approval? By offering the Secretary of the Treasury the third top job at the merged institution. This reflects the fact that apart from the two chairman, the Treasury Secretary was the third party, the midwife of the deal so to speak.

More recently, energy companies persuaded the SEC to change the process of evaluating reserves. It is an exact science that used to be performed by the engineers, to engineering standards. But now, the SEC has allowed the companies to estimate reserves using statistical, rather than engineering models. In essence, the statisticians, not the engineers now determined how oil companies will estimate reserves. And these are "stat arb" people like the ones who run hedge funds.

Meaning that the hedgies have captured the oil rating process, in much the same way that they (and the banks) captured the rating process, especially for exotic new instruments like CDOs and SIVs.