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.
