Leadership failure in U.S. financial regulatory agencies during the 2008 crisis

Banking Regulation

Captain -- You Do See That Blinking Light, Don't You?

An apocryphal story about an unnamed navy captain goes like this. The ship in question is sailing at a not insignificant clip on a very overcast night close to shore in preparation for docking. A number of sailors who are above deck see a blinking light in the distance that clearly -- to them -- appears to be a lighthouse. The captain, however, gives no orders either to slow or turn the boat. Each of the sailors thinks that perhaps he should ask the captain if he does indeed see what is becoming with each passing minute ever more clearly the lighthouse. But each in turn says to himself: "He's the captain. He must see the light. He'll make sure that we don't run aground." And then there is the terrible sound of the bow of the ship being shredded on the reef below the lighthouse.

Something rather like this happened during the American financial crisis of 2008, the consequences of which are still very much with us in the ongoing recession, which at this moment may well be transforming itself into a double-dip recession. While there were certainly signs that to those who are educated about the financial markets were as clear as a lighthouse beacon that there was something fundamentally rotten and systemically so about the American financial system, those who were tasked with turning the financial ship aside in time were derelict.

This paper examines how the leadership of U.S. regulatory agencies failed their constituents during the run-up to the horribly spectacular conflagration that overtook the U.S. financial sector, and especially the U.S. housing market. Those constituents included essentially the entire American population, but they also included everyone in other countries whose life and livelihood is affected by the state of the American economy, which is effectively a very large portion of the earth's population. The failure was in no way a simple misunderstanding of the rules of economics or a misapplication of them: It was a failure of human leadership and human intelligence, and its cost must be counted in human terms.

A number of forces came together to produce what is usually referred to as the financial meltdown of 2008 -- a meltdown that is often compared to various natural disasters, perhaps most commonly a tsunami. The invocation of natural disasters to explain (or excuse) the financial devastation of that year is significant, because it suggests that what happened was not something that could have been prevented by any human intervention. Like a volcano rising from the sea to spew forth lava, the financial institutions (primarily banks, but others as well) that support the nation's economic health were overtaken by unexpected and uncontrollable forces.

The limits of such analogies should be obvious, of course, for financial institutions, unlike volcanoes, can in fact be controlled by human intervention. And even in the case of actual natural disasters, there are things that humans can do, such as not building near fault lines or in flood zones. As the American financial system unraveled throughout 2008 and into 2009 (and arguably continues to do so), it was clear that the regulatory agencies that should have stepped in and warned about those economic seismic zones and been paying attention to the seismographs on their desks had been astonishingly inattentive.

A Little Regulation is a Dangerous Thing

During the Congressional hearings on the issue, Senator Coburn made the trenchant point that having a poorly run regulatory agency could do more harm than not having a regulatory agency at all. If there had been (for example) no Office of Thrifty Supervision (which was responsible for allowing WaMu to make home loans with a giddy disregard for economic realities), at least many individuals would have taken it upon themselves to pursue some investigation on their own. However, with the knowledge that there were government agencies that were supposed to be overseeing the banking industry and other financial institutions, individuals were left to assume that these institutions were economically healthy. Senator Coburn made the following statement to officers of the Office of Thrift Supervision:

As I sat here and listened to both the opening statement of the Chairman and to your statements, I come to the conclusion that actually investors would have been better off had there been no OTS because, in essence, the investors could not get behind the scene to see what was essentially misled by OTS because they had faith the regulators were not finding any problems, when, in fact, the record shows there are tons of problems, just there was no action taken on it. ... I mean, we had people continually investing in this business on the basis & #8230; that OTS said everything was fine, when, in fact, OTS knew everything was not fine and was not getting it changed. (Levin, 2011, p. 208)

The Congressional subcommittee, after both hearing testimony and conducting a wide-ranging investigation into the paper trail detritus of the economic disaster.

The subcommittee members came to a number of conclusions about why the regulatory agencies had failed to do their job and so failed to protect Americans from financial chicanery by the nation's banks, thrifts, etc. They summarized the key failings on the part of the agency leadership. Key among their findings was the fact that regulators, and especially those at the Office of Thrift Supervision, showed far too much deference to the corporate officers of the institutions that they were supposed to be supervising. (This phenomenon is known as "regulatory capture." )

Even one of those corporate officers who was supposed to be under regulatory supervision described the situation as one in which the Office of Thrift Supervision believed strongly that thrifts should practice 'self-supervision'. That regulators were so inclined came about from a variety of factors, Congress found, including the fact that on-the-ground investigators received little support from their supervisors and the additional fact (which was a direct result of the political direction of the Bush Administration) that their regulatory brief was so narrowly focused. The investigators had been rendered effectively toothless (Levin, 2011, p. 211).

OTS' deference to WaMu management appeared to be the result of a deliberate posture of reliance on the bank to take the steps needed to ensure that its personnel were engaged in safe and sound practices. The reasoning appeared to be that if OTS examiners simply identified the problems at the bank, OTS could then rely on WaMu's own self-interest, competence, and discipline to ensure the problems were corrected, with no need for tough enforcement action. It was a regulatory approach with disastrous results. (Levin, 2011, p. 215)

The above description is certainly not that of a rigorously regulatory attitude between WaMu and the Office of Thrift Supervision. This lack of any serious attempt to curtail activities of WaMu and other financial institutions reflected a Republican take on regulation.

This version of regulatory capture, as Davidoff (2010) writes, is a twist on what has been meant by this term because it is primarily a failure of regulatory leadership. Davidoff refers to this newer version of regulatory capture as ideological capture because it arises not so much from a too-intimate relationship between an industry an its regulators (although this still occurs too), but rather it features regulatory agencies that are headed by individuals who are not dedicated to the importance of regulation.

The reason is that the problem is not the old-style vision of regulatory capture in which the airline industry openly dictates to its regulators its governing rules, arranging for not only beneficial regulation but placing key people to head these regulators. This model no longer exists in financial sphere, if it ever did.

Instead, we have ideological and social capture of the top regulators. This is an issue that trumps what can be a model regulator at the bottom where the line people are quite competent, able and uncaptured, but the message from the top skews their effectiveness. (Davidoff, 2010).

The leadership of the regulatory agencies such as the Office of Thrift Supervision failed dramatically and repeatedly to rein in the companies that they were supposed to control so that they could not do the kind of serious and lasting harm that they did in fact do to the American financial system. But while they must take a good percentage of the blame, the leadership above them -- specifically the top-tier Bush Administration officials -- must also shoulder their portion.