The Case of Carmen Segarra and “Regulatory Capture”

Washington DC“The economic role of the state has managed to hold the attention of scholars for over two centuries without arousing their curiosity.” ~George Stigler, “The Theory of Economic Regulation,” 1971.

Now that the unpleasantness of the financial crisis and Great Recession are being slowly relegated to the pages of economics textbooks, let’s ask: What’s changed after the 2007/8 near-death experience? Are the Big Banks smaller and more nimble? Are the regulators older and wiser? Sadly, the answer to both questions is a resounding “No!” 

The following quote from a Fortune article [By every measure, the big banks are bigger”] – should you choose to believe it[1] – speaks for itself:

The biggest bank in the nation, JPMorgan  JPM -1.80% , has $2.4 trillion in assets alone — the size of England’s economy. And JPMorgan is seven times larger than the nation’s No. 10 bank U.S. Bancorp  USB -1.81% , which itself has $350 billion in assets — along the lines of Austria — and at this point is probably part of the TBTF club as well. Also way up: Profits. The four biggest banks in the U.S. alone, which along with JPMorgan include Bank of America  BAC -1.95% , Citigroup  C -2.04% , and Wells Fargo  WFC -1.34% , made collectively nearly $45 billion in the first six months of the year, nine times what those same banks made five years ago.

Assets have grown more than many other size metrics. But across the board, nearly every measure of the big banks’ size is up. In terms of loans, according to FDIC data, 42% of all loans outstanding by U.S. banks come from the five largest. That’s up from 38% before the financial crisis. The four biggest banks in the nation employ just over 1 million people. That’s up from around 900,000 just before the financial crisis.

And those big banks have less competition. Just over 1,400 banks have disappeared in the past five years. About 485 failed. The rest were merged into other banks.

And what about the regulators? Are they now chastened, having missed [some, such as myself, would say “ignored”] the drumbeat of warning signs in the lead-up to the crisis? Nada! Nein! Nyet!

Take, for example, the recent expose’ by ProPublica and NPR, about secret recordings made by Carmen Segarra, an examiner at the New York Fed in 2011, who was fired in 2012.  The reason? Because she had the temerity to insist that Goldman Sachs adopt a conflict of interest policy with some teeth.

Under a Fed mandate, the investment banking behemoth was expected to have a company-wide policy to address conflicts of interest in how its phalanxes of dealmakers handled clients. Although Goldman had a patchwork of policies, the examiner concluded that they fell short of the Fed’s requirements.

That finding by the examiner, Carmen Segarra, potentially had serious implications for Goldman, which was already under fire for advising clients on both sides of several multibillion-dollar deals and allegedly putting the bank’s own interests above those of its customers. It could have led to closer scrutiny of Goldman by regulators or changes to its business practices.

Before she could formalize her findings, Segarra said, the senior New York Fed official who oversees Goldman pressured her to change them. When she refused, Segarra said she was called to a meeting where her bosses told her they no longer trusted her judgment. Her phone was confiscated, and security officers marched her out of the Fed’s fortress-like building in lower Manhattan, just 7 months after being hired.

“They wanted me to falsify my findings,” Segarra said in a recent interview, “and when I wouldn’t, they fired me.”

For an explanation as to just why the Fed might want to make sure Goldman had a conflict of interest policy, one need only look to the infamous Abacus transaction, in which Goldman created an aggregation of collateralized debt obligations (“CDOs”), which were sold to AIG as spun gold, but were, in actuality, mere straw. Knowing that Abacus was composed of highly risky junk [it had been handpicked by Bill Gross, then of PIMCO, who thereafter also bet against it] Goldman bought “credit default swaps,” a form of hedging insurance, which essentially bet that Abacus would fail.  It did, and Goldman made a paper profit of $2.9 billion. I say “paper profit,” since before Goldman could turn it into greenbacks, AIG, not surprisingly, failed. But never fear, with friends in high places, such as Sec. Treasury Tim Geither, a former President at the New York Fed, the government bailed out AIG with taxpayer money, thus insuring that Goldman would be repaid dollar-for-dollar on its slimy bet against its own highly-touted product that it had sold to investors. As for lesser companies, the financial crisis forced them into bankruptcy, where they recovered a mere percentage of their “paper profits”.

Regulatory Capture.  According to an October 6, 2014 article on the subject, the term comes from a concept first identified 43 years ago in a paper by George Stigler.  Until the Carmen Segarra case, this arcane term had been reserved for the halls of academia.

Herewith is a summary of the concept.  [In reading the summary below, one has to ask whether this is exactly what we have seen over the past five years with the piling on of laws, rules and regulations, that, while ostensibly opposed by the Big Banks, gives them a distinct advantage over their smaller competitors, since the former are far better able to afford the cost of compliance. See my prescient post on the topic here.]

1. Government regulation can protect incumbent firms from rivalrous price wars and prevent entry into lucrative markets.

 2. Since the regulated firm oftentimes has a more comfortable and profitable existence than the non-regulated firm, private companies “compete” for a scarce supply of regulation.

3. Though a regulatory agency such as the ICC or the FCC may have been created with the (vague) intention of correcting market failures, as time goes by the agency is subject to “capture” by the firms they regulate. That is, the regulatory agency invariably tends to issue regulations that work to the advantage of regulated firms.

4. Regulated firms expend considerable resources to lobby the regulators. It is not uncommon for an official of a regulatory agency to wind up in a high-paying job with a firm that previously fell under their regulatory purview.[2]

5. The regulators may not want to antagonize the firms they regulate because they want to “keep their options open.”

6. Capture theory predicts that regulated firms will earn higher rates on return (on average) than non-regulated firms.  [Source:][3] 

Captive Theory, Then and Now. After a little research, it is clear to me that “captive theory” as originally conceived by Mr. Stigler, was based upon economic theory, not political theory.[4] And while the seeds of “captive theory” go back as far as Plato’s Republic, it is not exactly the same principle we see at work today.

Today’s version of captive theory which we are witnessing post-recession, is the result of a confluence of (a) liberal political thought that human society needs to be regulated for its own good, and (a) political self-survival, which requires unlimited lawmaking to guaranty cradle-to-grave employment.

A more concise definition of Regulatory Capture today appears in Preventing Regulatory Capture –Special Interest Influence and How to Limit it”:

…a process by which regulation . . . is consistently or repeatedly directed away from the public interest and toward the interests of the regulated industry by the intent and action of the industry itself.

The story of Carmen Segarra above is a classic case of the all-too-cozy relationship between regulators and the regulated that results in tepid oversight.  After all, who knows when one may be needing a job in the private sector?  So what is the blowback from the Segarra case?

Here is what Michael Lewis[5] told, in its article, Maybe This Is Why Segarra Drove The Fed Nuts”:

The simple answer is that it’s become standard practice for Fed employees to go to work for Wall Street firms, so the last thing they want to do is to alienate those firms and come across as people who don’t ‘get it,’” Lewis wrote to us in an e-mail.

That’s “regulatory capture” for you. (By the way, the idea of “capture” isn’t limited to regulatory bodies. Newsrooms suffer the same thing.)

When you ask a person making $150,000 a year to control a person making $1.5 million a year, you are asking for trouble,” he wrote. “To that, add the problem that the typical Fed regulator is in the awkward position of having to be educated about whatever the Wall Street firm has dreamed up.”

The Bloomberg article goes on:

In the anecdotes at the heart of her saga, notably the dispute over whether Goldman had a companywide conflict-of-interest policy that met the New York Fed’s (supposed) standards, she knew her job. She was a trained expert in compliance, and she said Goldman’s didn’t cut it.

But her bosses didn’t like the discomfort her results produced. Her findings weren’t, well, nice.

“It’s not like Goldman doesn’t know what an adequate policy contains, she says,” Jake Bernstein writes for ProPublica, recounting Segarra’s confrontation with her boss. “They have proper policies in other areas.”

“But can’t we say they have a policy?” her boss asks her in one recording. You can hear a little whine that says, “Can’t you be nice?”

Funny, then, that the day this all broke, last Friday, Goldman issued a new conflict-of-interest policy that prohibits investment bankers from trading individual stocks and bonds.

Conclusion. There is no question that the financial crisis caught almost every regulator, all the way up to Fed Chair Alan Greenspan, flatfooted. But they never missed a beat. After a few obligatory mea culpas, the political reaction, aided and abetted by Sen. Chris Dodd, and Rep. Barney Frank, was to institute even more laws and rules, as if the ones already in place were either wrong or insufficient.

This briar patch of new regulations benefits only the Big Banks; their comparative cost of compliance is far less than their smaller brethren. This means they have a competitive advantage.  And what about the regulators paid to regulate? Well, they continue to play nice – as evidenced by Ms. Segarra’s recordings, ever mindful that not only do they understand the morass of laws they wade into every day, but the private sector, with its big bucks, awaits…

So today, “Too Big To Fail” is alive and well; the Big Banks are indeed bigger, as are the regulatory agencies overseeing them. In fact, the Consumer Finance Protection Bureau, the devil’s spawn of Dodd-Frank, is a regulatory leviathan, answerable to few and independent of Congressional funding.[6]

However, as recently as December 10, there are signs that some of the Dodd-Frank rules are already beginning to be eased. Over the next two years, we are likely to see further retrenchment of that law.

It is this very phenomenon of reinventing the regulatory wheel by blue state pols following every crisis that the American people soundly rejected in the 2014 mid-term elections.[7]  They want less government intrusion, not more. 

The following words were true in 1989, and they are true today:

Government is not a solution to our problem, government is the problem.” ~January 20, 2981 President Reagan’s First Inaugural Address



[1] Lest you doubt the article, go to the following other links, here, here and here, for corroboration.

[2] According to a June 2012 ProPublica article here, JPMorgan Chase is populated with former regulatory alums: One current staffer on the Senate banking committee, Dwight Fettigis a former lobbyist for JP Morgan. In 2009, the bank hired him to work on “financial services regulatory reform.” Meanwhile, JP Morgan is stacked thick with former committee staff. Naomi Camper – Currently a lobbyist for JP Morgan. Prior to that, from 2001-2004,she was an aide to Senator Johnson. Kate Childress –A JP Morgan lobbyist since 2008, she is also a former aide to Chuck Schumer, D-N.Y., who sits on both the Senate Banking and Finance committees. Steven Patterson –A JP Morgan lobbyist and formerly a staff director for economic policy for the Banking committee. Nate Gatten— A JP Morgan lobbyist based in London who was reportedly called back to Washington recently to help with the company’s damage control. He is a former lobbyist for Fannie Mae, and, in the 1990s, was a banking aide to former Senator Robert Bennett, R-Utah, who also sat on the committee. P. Michael Nielsen – A lobbyist with a firm run by former Senator Bennett, he has been retained by JP Morgan for help with federal probes, according to Bloomberg. He was also a senior policy adviser to the committee from 2007 to 2010. American Banker also reported that three other outside lobbyists currently working for JP Morgan were once affiliated with the committee: Jason Rosenberg – A lobbyist at The Glover Park Group and formerly an aide to Jon Tester, D-Mont., who sits on the committee. Jenn Fogel-Bublick – A lobbyist at McBee Strategic Consulting and formerly a Democratic counsel on the committee.  Mike Chappell – A lobbyist for Fierce, Isakowitz & Blalock and a former press assistant to Senator Roger Wicker, R-Miss., another committee member. A former senator on the committee, Mel Martinez, R-Fl., is also now the JP Morgan exec in charge of Florida, Central America, and the Caribbean. Martinez was elected to the Senate in 2004 and went to the bank in 2010. Bloomberg reported that he was called to Washington after the losses were reported. Lobbyists for JP Morgan appear to be keeping busy. The bank spent $7.6 million on lobbying last year, according to the Center for Responsive Politics.

[3] For a good discussion of captive theory over the centuries, see the following 2012 article here.

[5] Michael Lewis is a Bloomberg View columnist. He is the author of the best-sellers “Flash Boys: A Wall Street Revolt,” “The Blind Side: Evolution of a Game,” “Moneyball: The Art of Winning an Unfair Game” and “Liar’s Poker,” among other books. Read more.

[6] With the mid-term tsunami, I suspect more than a few of these bureaucrats will be polishing up their resume’s and C.V.s just in case they get a pink slip from the Personnel Department.

[7] Cracks in Democratic solidarity began to develop shortly after the election.  One of the most reported was the statement on November 25, 2014 by 3rd ranking Senate Democratic, Sen. Charles Schumer, who complained that during the depths of the Great Recession, Mr. Obama should have focused less time touting health care reform, and giving more attention to jobs and the economy.  Interestingly, in a post on November 16, nine days earlier, I mentioned the same thing.  [“As we spiraled into the Great Recession in 2009-2010, President Obama ignored the economy, and instead barnstormed the country touting his signature health care law, which was passed without nary a single Republican vote.”]  You don’t suppose Chuck reads my blogs, do you?