Question

Do you see any issue with the close relationship between the government and the financial industry? Why or why not? Please give an example of this close relationship between government officials and the financial industry. (from movie: inside job)

Answer 1

Government regulation affects the financial services industry in many ways, but the specific impact depends on the nature of the regulation. Increased regulation typically means a higher workload for people in financial services, because it takes time and effort to adapt business practices that follow the new regulations correctly.

While the increased time and workload resulting from government regulation can be detrimental to individual financial or credit services companies in the short term, government regulations can also benefit the financial services industry as a whole in the long term. The Sarbanes-Oxley Act was passed by Congress in 2002 in response to multiple financial scandals involving large conglomerates such as Enron and WorldCom. The act held senior management of companies accountable for the accuracy of their financial statements, while also requiring that internal controls be established at these companies to prevent future fraud and abuse. Implementing these regulations was expensive, but the act gave more protection to people investing in financial services, which can increase investor confidence and improve overall corporate investment.

The government plays the role of moderator between brokerage firms and consumers. Too much regulation can stifle innovation and drive up costs, while too little can lead to mismanagement, corruption and collapse. This makes it difficult to determine the exact impact government regulation will have in the financial services sector, but that impact is typically far-reaching and long-lasting.

An important factor underlying the financial crisis of 2007–2009 has been the failure of regulators and supervisors in the United States and in Europe to set and enforce proper rules to prevent the reckless behavior of bankers. Supervisors in the United States and Europe allowed banks to circumvent capital requirements by creating various entities that did not appear on the banks’ balance sheets. Investors were willing to lend to these entities because the sponsoring banks were providing guarantees. The supervisors did not object to banks’ keeping these exposures off their balance sheets, nor did they try to limit the banks’ obligations from the guarantees. The obligations ended up greatly weakening the sponsoring banks and bankrupting some of them when the crisis broke in the summer of 2007.

In the United States, bankers serve on the boards of the regional Federal Reserve banks, which are in charge of supervising banks and even in setting the regulations. For example, Jamie Dimon, CEO of JPMorgan Chase, has been on the board of the Federal Reserve Bank of New York since 2007 and will serve through 2012, even as the New York Fed is directly involved in formulating and enforcing capital regulations and other policies impacting JPMorgan Chase and other banks. This situation can create significant conflicts of interest.

Second, regulators exhibit what is known in sports as the home-team bias of referees, the subconscious sympathy of referees for the team that is cheered by the home crowd. If the crowd of onlookers, such as segments of the press, politicians and industry specialists, favor certain people and institutions, supervisors may become biased and favor them as well. The home-team bias is particularly strong if the affected firms claim that a regulation unfairly
damages their ability to compete with away teams, firms in other countries.

Firms in the industry influence politicians and administrators by lobbying and by providing money, particularly for election campaigns. Firms in regulated industries want to make sure that appointees to regulatory positions will not be too challenging.

In this context, it is important to realize that special interests tend to be much more vocal than the general public. As regulation matters greatly to them, so they invest heavily in lobbying. To any individual without a special interest, the regulation may seem too unimportant to warrant much of an investment of attention or energy. Even if, in the aggregate proper enforcement of the regulation would be called for, because so many people are affected, special interests that fight the regulation may have much more influence.

In banking, however, the damage from ineffective regulation and supervision is harder to detect. Moreover, for the reasons we discussed earlier, politicians may find it quite appropriate or convenient for regulators and supervisors to be lax toward banks. The public is dispersed and disorganized, and other individuals and firms have little to gain individually from pushing banking reform. Everyone has dealings with banks, and many find it beneficial or necessary to maintain their good relationships with the banks. In this environment, confusing and flawed arguments — the bankers’ new clothes — are more likely to affect policy. This situation can change only with significant pressure from the public. Nonprofit citizens’ and public-interest groups try to provide a counterweight to lobbying by industry groups, but their resources can hardly compete with those of the financial industry, and they often find it difficult to gain access to politicians and regulators.

Much is wrong with banking, and much can be done about it. If politicians and regulators fail to protect the public, they must face pressure to change course