Caroline Baum: Regulators suffer from Stockholm Syndrome

Everyone over the age of 45 remembers the photo of heiress Patty Hearst wielding an M1 Carbine when she and three comrades robbed the Hibernia Bank in San Francisco on April 15, 1974. Hearst had been kidnapped by the Symbionese Liberation Army, a left-wing guerilla group, two months earlier. By the time her photo was captured by Hibernia's internal security camera and beamed across the world, Hearst had adopted a new name (Tania) and a new mission (the SLA’s).

Diagnosis (and legal defense): Hearst was suffering from what psychologists call Stockholm Syndrome, a phenomenon where captives identify with their captors in order to survive.

Diplomats have been known to manifest the symptoms of Stockholm Syndrome: They ‘go native’ when they're posted to a foreign country for a long time.

Regulators don’t have diplomatic immunity either. “Regulatory agencies come to identify themselves with the industry they’re regulating,” says Neal Soss, chief economist at Credit Suisse in New York.

Promotion is one thing. Regulators understandably want their industry to be competitive. When Japan was home to the largest banks in the world in the 1980s, regulators in the US and Europe lowered capital standards so their banks could compete, says Robert Eisenbeis, chief monetary economist at Cumberland Advisors and former research director at the Federal Reserve Bank of Atlanta.

“Sometimes it looks a lot like regulatory capture when regulators are just looking out for the interests of their constituents,” he says.

Capture and Seize
Sometimes, not always. A clear case of a regulatory capture was the relationship between the now-defunct Federal Savings and Loan Insurance Co and the S&L industry, according to Eisenbeis. The FSLIC, which provided deposit insurance to thrifts, “was charged with promoting the S&L industry and homeownership,” Eisenbeis says. “It was guaranteed they’d be captured.”

Then there’s the case of Fannie Mae and Freddie Mac, the two housing finance agencies that were captured — even before they were seized by the federal government last September to avert collapse. Fannie and Freddie “used their clout to enforce capture, to escape regulation,” Eisenbeis says. They took advantage of a weak regulator and powerful allies on Capitol Hill to “raise regulatory capture to a new level,” he says.

D-Day for Banks
How did we get into a mess requiring massive government intervention and investment in the banking industry if regulators were doing their job? The government released the results of stress tests on the 19 biggest banks following several delays, a week of previews and repeated assurances from Treasury Secretary Tim Geithner that the outcome would be “reassuring.” The Obama Administration’s soft rollout of the test results defused the negative news, starting with Bank of America’s failing grade (pupil needs $34 billion of additional capital). Nine of the 19 banks have enough capital to withstand the most adverse scenario, according to the government’s report. Ten banks need to raise a combined $74.6 billion of capital.

Last week, there were concerns the tests might be compromised when it was learned regulators were briefing the banks on the results and giving the banks an opportunity to respond.

Only Incompetence
What kind of test is subject to the test-taker’s review? Did the banks succeed in “helping” regulators see the results in a more flattering light?

“I don’t think regulatory capture infected the stress tests,” says economist Bob Litan, vice president for research and policy at the Kauffman Foundation in Kansas City and a senior fellow at Washington’s Brookings Institution. “The Fed people are very professional, and the taxpayers are on the hook.”

Rather, the sorry state of the banking industry that prompted the government to run stress tests — something regulators do all the time — is the result of “a massive collective regulatory failure,” Litan says.

What a relief to know regulators weren’t shielding their charges from public scrutiny. They were just “negligent and incompetent,” says Bert Ely, chief executive of Ely & Co, a bank consulting firm in Alexandria, Virginia.

How did it happen that a handful of regulatory agencies and a gaggle of regulators on the premises of the big banks failed to identify the degree of risk?

Outsourcing Risk Judgment
Bank regulators aren’t bad people. They don’t decide to close their eyes and look the other way while their charges cook the books.

The regulatory capture may be entirely unconscious.Imagine a regulator from the Office of the Comptroller of the Currency posted to JPMorgan Chase & Co. He goes to work each day and observes bankers wearing expensive Italian suits and English shoes pulling down 30 times his salary. (OK, they used to.) Our regulator starts to think, gee, I can do his job. Maybe they’ll hire me.

There’s something besides “banker envy” that allowed losses to balloon, Litan says.

“Basel told regulators to outsource risk judgment to the rating agencies and to the bankers themselves,” he says, referring to the international capital adequacy requirements for industrialised nations developed at the Bank for International Settlements in Basel, Switzerland.

No Defense
Just think about the inherent conflicts.

Rating agencies were paid by the issuers of the securities, not they investors. That was the first line of defense against risk. Check.

Bankers that took the risk with other people’s money were charged with assessing that risk. That was the second line of defense. Check.

Bankers used intricate equations and models to come up with their risk assessment. The model is only as good as the assumptions that go into it.