Spero Consulting

This post greatly expands upon a com­ment we made about reg­u­la­tion in Even A Per­fect Bailout Will Fail and pos­si­bly elsewhere.

Reg­u­la­tors as wise monkeys.

Today’s The Wall Street Jour­nal has an arti­cle enti­tled, Bank Exam­in­ers Are Told to Step Up Sanc­tions on Lenders.

The first sen­tence of the arti­cle says it all: “The U.S. government’s armies of bank exam­in­ers have been ordered to be more aggres­sive in apply­ing for­mal sanc­tions to finan­cial insti­tu­tions when prob­lems are found.”

Unfor­tu­nately, order­ing does not make it so, and we doubt that it will work. We’re not mak­ing a blan­ket con­dem­na­tion here, but we’d be inter­ested in know­ing if and how the gov­ern­ment deals with the incen­tive prob­lems that we address below.

Unless the Fed, the OCC, and the OTS imme­di­ately trans­fer and reas­sign exam­in­ers, we doubt that many new issues will be found. Fur­ther­more, if such issues are dis­cov­ered, we doubt that those issues will be reported. (In this post, we’ll call such bank-​related prob­lems “issues,” and reserve the word “prob­lem” for the dys­func­tional incen­tives that may exist within the reg­u­la­tory agen­cies.) Of course, there are many obvi­ous issues that can be noticed with­out for­mal exam­i­na­tions and investigations.

Incen­tive Problems

There are, in fact, a cou­ple of related incen­tive prob­lems worth men­tion­ing. (1) Many exam­in­ers spend many years exam­in­ing only one firm. At large insti­tu­tions, the exam­iner is usu­ally located on the bank’s premises – pos­si­bly shar­ing office space, e-​mail sys­tems, and din­ing room priv­i­leges with bank employ­ees and managers. (2) Many exam­in­ers seek (and gain) employ­ment with the same finan­cial insti­tu­tion that they pre­vi­ously examined.

We’ll briefly address the sec­ond issue first by ask­ing: what incen­tive does an exam­iner have to take a “hard-​line” by ques­tion­ing the value of assets or cap­i­tal reserved if it may infu­ri­ate or alien­ate a poten­tial employer? (We’ll return to this issue at the end of the post, too.)

The elim­i­na­tion of the prospect of future employ­ment, however, does not elim­i­nate the incen­tive prob­lem for long-​time exam­in­ers. For rep­u­ta­tional rea­sons, they may still lack the moti­va­tion to closely scru­ti­nize and report issues.

Now, clearly some degree of famil­iar­ity is ben­e­fi­cial when exam­in­ing or audit­ing insti­tu­tions because that knowl­edge reduces the set-​up and oper­at­ing costs of per­form­ing the exam­i­na­tion: port­fo­lios, sys­tems, and key per­son­nel are all known by the repeat exam­iner. In addi­tion, it becomes quite expen­sive for the gov­ern­ment to move exam­in­ers and quite dis­rup­tive for exam­in­ers and their fam­i­lies to be peri­od­i­cally relo­cated to dif­fer­ent insti­tu­tions in pos­si­bly dif­fer­ent regions of the coun­try (or to travel extensively).

It is the case that cer­tain higher-​level man­agers are rotated, but that seems insuf­fi­cient to ensure that lower-​level work­ers will nec­es­sar­ily report issues of which they know. More­over, who is more likely to dis­cover (or be infor­mally informed of) such issues?

Sunk Cost Fallacy

Our long-​time exam­iner incen­tive prob­lem is sim­i­lar to the sunk cost fal­lacy that has been exten­sively stud­ied by econ­o­mists – includ­ing infor­ma­tion econ­o­mists – who address the question: why do man­agers keep invest­ing in (seem­ingly obvi­ous) los­ing projects?[1. There are other expla­na­tions, too. For exam­ple, we like this quote by Father Joseph Holzner, author of Paul of Tar­sus,: “When a man feels the bur­den of guilt on his soul, he tries hard to jus­tify him­self before his own con­science and before oth­ers by increas­ing his false zeal, and thus he sinks yet deeper into evil.”] 

There is an option-​value expla­na­tion that if (exoge­nous) cir­cum­stances change, the poorly-​performing project may become valu­able; so, it is worth the cost to main­tain that flex­i­bil­ity (and pay the equiv­a­lent of an option pre­mium). That expla­na­tion makes the deci­sion to invest to be very much like insurance.

The infor­ma­tion story is dif­fer­ent and involves adverse selec­tion and reputation. A man­ager who made or who sup­ported the ini­tial invest­ment may feel that his rep­u­ta­tion is at stake and his judg­ment may be ques­tioned by admit­ting that a project that they had picked as a win­ner was actu­ally a loser (and so oth­ers may infer that the said man­ager is a loser, too.)

How It Relates to Regulation

Most bank activ­i­ties are long-​lived – because they are or because they are like invest­ments. Thus, for dubi­ous ongo­ing ven­tures, the exam­iner must decide whether or not to crit­i­cize or men­tion them.

Imag­ine a multi-​year ven­ture, activ­ity, or invest­ment that the exam­iner has not men­tioned or crit­i­cized in pre­vi­ous years. Gen­er­ally, it would be highly unlikely that there were no warn­ing signs in prior peri­ods, espe­cially if the examiner’s supe­rior were gifted with per­fect, ²⁰⁄₂₀ hind­sight, which is quite easy to pos­sess (and requires much dis­ci­pline to control).

In that case, we could imag­ine the undis­ci­plined supe­rior ques­tion­ing the examiner’s past per­for­mance: “did you miss it because you are incom­pe­tent or did you catch it and fail to men­tion it because you are duplic­i­tous?” (Here is an essay on Strate­gic Con­sis­tency and Man­age­r­ial Dis­ci­pline.) It seems that any exam­iner with any bit of fore­sight could also make this inference.

Thus, it may be in the ratio­nal – though not con­sci­en­tious – examiner’s best inter­ests to act as a trin­ity of wise mon­keys and sup­press his pri­vate infor­ma­tion and discoveries.

Empir­i­cally and as a tax payer, we do believe it is fair to ask: how many exam­in­ers or final­ized exam­i­na­tion reports warned about any of the prob­lems that we are now expe­ri­enc­ing? How many of those unre­ported mortgage-​related issues arose only in 2008 or the lat­ter half of 2008? In that respect, the reg­u­la­tory agen­cies seem much like the government-​regulated credit agen­cies with their over-​optimistic scenarios.

We can’t hypoth­e­size all of the blame lower-​level work­ers. There are cer­tainly con­sci­en­tious exam­in­ers who may or may have men­tioned issues. Given our quite skep­ti­cal view of the (fallen) nature of man, it is quite easy to believe that in some cases their warn­ings were sup­pressed by their supe­ri­ors, who despite rota­tion, may be have attempted to main­tain good feel­ings with their sub­ject banks in their desire for a well-​paying cor­po­rate job.

Reg­u­la­tion as a Crutch (Causes Atrophy)

We’ll have more to say about the dele­te­ri­ous effects of reg­u­la­tion. We’re for­mu­lat­ing a post about the false sense of secu­rity that risk man­agers may pos­sess after they sat­isfy the ques­tions of (seem­ingly simian, albeit intel­li­gent simian) reg­u­la­tors. In other words, there is no rea­son to believe that pass­ing reg­u­la­tory hur­dles alone is equiv­a­lent to effec­tive risk or uncer­tainty management.