Influence as a Mechanism of Regulatory Capture in the Financial Industry

By Shahira Johan

The Basel Committee on Banking Supervision (BCBS) believes that the

implementation of Basel standards is “critical to improve the resilience of the global banking

system, promote confidence in prudential ratios and encourage a predictable and transparent

regulatory environment for internationally active banks”1. However, the efficacy of the Basel

capital rules has received much criticism particularly in view of its apparent failure to detect

and prevent the 2008 global financial crisis. As a result, the credibility of financial regulators

has come under severe scrutiny from public interest groups who have become increasingly

sceptical of the former’s ability to effectively regulate the industry. A survey conducted by

the Cato Institute cited that the 48% of Americans have “hardly any confidence” in either the

Wall Street or the financial regulators2.

The failure of regulation is believed to stem from the persistence of regulatory capture

particularly through the mechanism of influence of the private sector involved in the

consultative element of the regulatory policymaking process. This results in regulatory

policies that promote the interests of the banks at the expense of the public.

However, there is also a contrasting argument that supports the necessity for industry

engagement as part of a comprehensive approach to arrive at ‘good policy’. It is also

acknowledged that influence can be imposed in other forms outside of the consultative

approach such us bribery and lobbying3.

This paper will attempt to discuss the available literature regarding the role of

influence of two main agents in the financial industry namely the government and the banker

1
‘Implementation of the Basel standards’ https://www.bis.org/bcbs/implementation.htm?m=3%7C14%7C656
2
Results from the Cato Institute 2017 Financial Regulation Survey (Ekins 2017).
3
The Report by the Financial Crisis Inquiry Commission established by the US Congress to investigate the roots
of the crisis found that the financial sector spent $2.7 billion in federal lobbying expenses and $1 billion in
campaign contribution between 1999 and 2008 which FCIC believed to have played a central role in
“weakening regulatory constraints on institutions, markets, and products” (Eric Monnet 2014, p.4).

1
and its effect on regulatory capture. In particular, the paper will examine the evidence of

regulatory capture in the design of the Basel capital rules. The paper will also discuss

potential weaknesses in the policymaking process that makes it susceptible to regulatory

capture and the measures that can be implemented to mitigate such adverse outcome.

Basel capital rules

The BCBS or Basel Committee is one of the committees hosted by the Bank for

International Settlements (BIS) which is an international financial organisation that serves to

promote monetary and financial stability. Although the membership of the BCBS comprise of

45 members from 28 jurisdictions, the standards it develops are de facto benchmark

regulation for the majority of the national-level banking system4. The key piece of standards

produced by the BCBS is the Basel capital rules which have gone through significant

evolution since the beginning of the Basel Capital Accord in 1988 (Basel 1) which called for

a relatively simple target – the maintenance of a minimum ratio of capital to risk-weighted

assets of 8% by internationally active banks5. Through an extensive consultative process

over a 6-year period which included inputs from banking sector representatives, a revised

capital framework known as Basel II was introduced in 2004 designed to improve the

formulation of capital requirements that would better reflect the underlying risks of the rapid

financial innovations at the time. One of the critical outcomes of Basel II that has been cited

as the cause of the banking system weaknesses which precipitated the 2008 global financial

4
The BIS is the leading international financial organisation owned by 60-member central banks that make up
95% of the world GDP. The establishment of the BCBS in 1974 was a response to the serious disturbances in
international currency and banking markets. The pervasive interlinkages within the global financial system has
been the primary driving force for closer cooperation between the BCBS and other standard setters such as the
International Organisation of Securities Commission (IOSCO) and the International Financial Reporting
Standards Foundation (IFRS Foundation) and the world’s largest public lenders, the International Monetary
Fund (IMF) and the World Bank, to develop and supervise the implementation of global standards that will
ensure consistent and effective implementation in order to maintain financial stability and efficient markets.
5
Minimum capital ratio requirement is the key indicator of the bank’s financial soundness. It is the level of
capital that is necessary to be maintained in order to absorb any unexpected losses that may occur from the
nature of risk of the businesses/ transactions undertaken by the bank that could result in the bank becoming
insolvent.

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crisis is the recognition of private risk measurement and control methodologies6. By allowing

these private or internal risk frameworks, financial regulators have inadvertently exposed

themselves to a higher level of information asymmetry, thus impairing their ability to

discharge their primary duty of ensuring the adequacy of the capital measurement in the first

place.

Following the 2008 crisis, an enhanced version of Basel II referred to as Basel III was

introduced in 2010, requiring even higher levels of capital and additional requirements

relating to minimum liquidity ratios and the supervision of systemically important banks

(SIBs)7. However, the revised rules continued to receive wide criticism from some influential

financial policy-makers for succumbing to pressures from what can only be described as an

almost delusional nationalistic agenda that continues to want to protect the competitiveness of

national economies despite the significant changes in the risk environment in which banks

currently operate8. Critics argue that the capital requirements are not high enough and are

sceptical that home authorities can enforce objective judgment over the supervision of banks

where there are strong bank-industry ties (Howarth and Quaglia 2016).

Regulatory capture in the financial industry

The seminal economic theory of regulation claim that regulators could be influenced

by special interests and end up being ‘captured’ by the firms it is supposed to discipline

(Stigler 1971). The model for regulatory capture was subsequently formalised by Peltzman

6
Basel II allows banks to adopt Internal ratings-based (IRB) approaches for credit risk and Advance
measurement approaches (AMA) for operational risk computations which are important parameters in the
derivation of the minimum regulatory capital requirement. Under these approaches, banks develop their own
empirical models to quantify the required capital for each class of risk instead of using the crude measures
provided under the Basel II rules. The BCBS had intended for the allowance to reward and encourage banks to
develop and put in place highly effective risk management regimes. However, this intent may not necessarily be
shared by the banks who view capital holding as an expensive exercise because this limits their leveraging
ability to conduct profit generating activities such lending.
7
Systemically important banks (SIBs) are banks whose failure might trigger a financial crisis.
8
The Governor of the Bank of England, Mervyn King, argued that the new rules were insufficient to prevent
another financial crisis and demanded capital levels considerably higher than the level set out in Basel (King
2010).

3
(1976) who provided three distinct formal set-up to regulation in particular one which focuses

on price-entry regulation where the model comprised of three classes of players: a politician

who holds the coercive power of the state, an undefined quantity of producers, and an

undefined quantity of consumers. The main feature in Peltzman’s model is that the official

appears to be trading off the benefits from favouring two different masters: consumers and

producer (Dal Bó 2006). The ‘captured’ official causes the corruption in the regulatory

process such that the public good is sacrificed in favour of the commercial interests of the

regulated entity (CFA Institute 2016).

In the financial sector, regulators have two distinct roles of policy making and

industry supervision. In the first, policy making is driven by economic and financial theories

leading to the conceptualisation of policies such as the risk-based capital framework (Basel

capital rules). We have explained the extensive consultative process the BCBS undertakes in

its policy development by working closely with various stakeholders including banking

industry representatives to solicit feedback including the practical nature of proposed

regulations. However, financial innovation is often nurtured by the industry and when

academia and the authority trail behind the industry, regulators have to depend on the

expertise that resides with the industry which they are tasked to regulate.

Consequently, regulators also fall behind in the second task of effective supervision

which requires them to have superior information over the industry as a whole and its players

individually. The Warwick Commission on International Financial Reform noted that the

interaction between regulators and the financial industry reflects the asymmetric character of

the industry, in that industry participants have more information than either clients or

regulators (Persuad et al. 2009, p.1). Bagley (2010, p.5) also stated that even a diligent

agency might “participate in a capture dynamic” because “the agency might depend on

information from the affected entities and lack the means or ability to review that information

4
sceptically. Or the agency might come to see the world the way that its regulated entities do.”

In his statement at the U.S Congressional hearing, Beim stated that this was “the ‘‘weak

form’’ of regulatory capture, regulation is negative for the companies, but the regulator does

not strictly enforce the rules, and fails to control company behaviour in the way intended by

the law” (Warner et al. 2015, p.53).

Financial regulation is unique because unlike most other public utility regulation, the

definition and measurement of public benefit and harm is usually not a fixed optimal

solution9. All stakeholders agree that maintaining sufficient capital is paramount but capital is

expensive especially in an industry where margins have been on the decreasing trend10.

Hence, bankers are faced with the unsurmountable task of balancing the need to maximise

shareholders’ value with risk taking behaviour that may be good for profits but bad for the

bank’s overall financial soundness. Basel III’s detailed requirements also impose additional

compliance costs which puts additional pressure on banks hoping to curtail operating costs in

order to improve profitability. Cosimano and Hakura (2011) found that raising bank’s

marginal cost of funding lead to higher lending rates which have the potential effect of

harming business in particular small and medium enterprises which are often evaluated to be

riskier11. Thus, the conflict of capital holding also transcends to the public who wears two

opposing faces, one being the depositors’ who would like to be ensured of the safety of their

deposits and the borrowers’ who would prefer to borrow at a lower cost.

Furthermore, economic theories are dynamic and changes throughout time. The

revival of the efficient markets idea in the 1970s was accompanied by an intellectual

inclination to recognise the superiority of the free market thus reigning in the scope of

9
In most instances, limited supply and higher prices for public utilities such as electricity and water imposed by
the producers are clearly harmful to the consumers. Governing bodies would also likely regulate industry
practices which may maximise producer’s surplus but pose other harmful effects to the general standard of
living such as the case with environmental laws.
10
See (Covas, Rezende, and Vojtech 2015).
11
See (José Félix Izquierdo, Santiago Muñoz 2017).

5
regulation12. The involvement of the government who makes policy choices on behalf of its

constituents also adds another layer of opaqueness to the determination of public interest.

Regulators are also subject to the political climate over the business cycle, in which tougher

regulations (for example stricter credit) is more difficult to justify during boom periods

(ICFR 2012, p.136) yet controlling excesses becomes more popular during bust periods. “The

failure in many countries to introduce pre-emptive policies that would have moderated their

financial booms provides a striking example of a political economy hazard that is featured in

the regulatory literature” (Watson et al. 2013, p.7).

The experiential analysis of financial crises suggests that the two-tier set-up of

regulatory capture between the regulator and the beneficiaries (banks versus the public)

overlooks another important agent that is the government. Tirole (1986) analysed regulatory

capture in a three-tier hierarchy comprising a political principal (the government), a regulator,

and an agent (the firm). “While many US-centric have focused on the influence of financial

actors and other interest groups over the state, channels of pressure and influence between

European governments and their banking system within distinct European financial

ecosystems have frequently been presented as running both ways and feeding from each

other” (Eric Monnet 2014, p.7). Sir Howard Davies, the first Chair of the UK Financial

Services Authority explained how during the pre-crisis period “on the whole, banks [in the

UK] did not have to lobby politicians, largely because politicians argued the case for them

without obvious inducement” (ibid, p.6). Therefore, the traditional notion of regulatory

capture being the effect of industry influence does not adequately reflect the role of

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“Capture was helped by the emergent view that public agencies ought to be independent of politics. As part of
this process, a policy role for the private sector was legitimised. Intellectual capture, in turn, also relates to the
‘group-think’ that has taken hold in the making of financial policy. Regulatory and supervisory arrangements
are discussed and agreed in expert and apolitical terms, bringing like-minded individuals who, whether in the
official, private or academic sphere, can reach common understandings based on shared training, practice and
access to economic ideas.” (Persuad et al. 2009, p.28). Also Watson et al. (2013) noted that the run-up to the
financial crisis saw greater dependence on market risk assessments and, frequently, less intrusive supervision.

6
government pressure who may also side with the industry for its own funding needs and

support to drive growth in the real sector.

Influence and bargaining powers

(i) Consultative approach to policy design and supervision

Proponents of regulatory capture argue that banks with vital interests in the

formulation and implementation of regulations are able to organise themselves “into powerful

banking associations, which can afford lobbying efforts and well-prepared participation in

public debate on regulatory measures. In contrast, other concerned interest groups, such as

deposit holders, typically have more diffuse membership. Financial institutions tend also to

be well connected to the political establishment and thus to have access to channels of

influence” (Hardy 2006, p.4)13. Furthermore, bankers and supervisors are necessarily in close

contact and because supervisors need the cooperation of banks to perform their job, and/or

because the banks can become prospective employers, they tend to maintain a cordial

working relationship and may be reluctant to antagonise bank management (ibid). Griffith-

Jones and Persaud (2008, p.266) stated that “private bankers possess better technical expertise

than regulators, as well as superior resources to pay for studies that better inform their

positions”. In addition, the increased complexity in financial innovation has also heightened

the reliance on the banks by the supervisors in order to stay abreast with the rapid changes in

the industry.

However, Young (2012) studied the empirical evidence of the regulatory capture

hypothesis by private sector lobbying on the BCBS’s Basel II development, using extensive

archival material and interviews, and concluded that access to policymaking process did not

always translate into influence and in some instances had the effect of increasing the

13
Hardy cites various examples such as how the U.S savings and loan institutions were able to successfully
influence the regulations applied to them and the resolution of the subsequent crisis and how deregulation of
inter-regional branching and on deposit insurance in the U.S were largely concerned with the interests of banks
with relatively little regard for the interest of others.

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stringency of regulation. Similarly, the study14 by the CFA Institute in 2016 found that the

majority did not believe that regulatory capture exists as a persistent or harmful feature of the

regulatory landscape and that there was more agreement about the appearance of corruption.

The study also stated that “Especially in the United States, participants expressed a

significant sense that political influence from the legislative branch of the government, rather

than direct industry influence on regulators, exerts increasingly outsized pressure on financial

services regulation” (ibid. p.2)

The interaction of the various agents in the industry and the dynamism of economic

theories makes assignment of fault challenging. Indeed there is often ambiguity in the

potential outcome of financial policies. Kwak (2014) commenting on the deregulation

policies adopted by the regulators prior to the financial crisis, stated that “it is difficult to

prove that the deregulatory policies pursued by these agencies were clearly not in the public

interest as knowable at the time. In retrospect, given the economic and fiscal consequences of

the financial crisis, it seems obvious that policies that increased the likelihood or severity of

the crisis were not in the public interest” (p.73). Similarly, Baxter (2011) states “a legislature

may have adopted a particular policy because it is the right one and not because certain

groups might have bought or paid for the policy (even though this might perhaps also have

happened)” (p.177).

(ii) Degree of sophistication

The Basel capital standard is a daunting piece of regulation comprising of several

pieces of document totalling 516 pages. The rules themselves are highly technical and

allowance for internal modelling techniques under the IRB and AMA approaches increases

the level of sophistication to a select expertise. Hakenes and Schnabel (2014) presents in their

14
The study comprised a series of structured conversations with leading global regulators, CEOs, chief
compliance officers, general counsels, and chief risk officers in the U.S, Canada, the U.K, and Asia regarding
regulatory capture and regulatory conflicts of interest in the financial industry. (CFA Institute 2016)

8
paper a micro-founded model with rational agents in which banks capture regulators by their

sophistication. The idea of regulatory capture by sophistication was originally purported by

Hellwig (2010, p.6), “When the model-based approach to capital regulation was introduced,

however, the regulatory community was so impressed with the sophistication of recently

developed techniques of risk assessment and risk management of banks that they lost sight of

the fact that the sophistication of risk modelling does not eliminate the governance problem

which results from the discrepancy between the private interests of the bank’s managers and

the public interest in financial stability”.

Hakenes and Schnabel concluded that “reputational concerns of regulators may lead

to inefficiently low levels of regulation because regulators may be captured by the financial

industry due to a discrepancy in the degree of sophistication between the banks to be

regulated and the regulatory bodies”(p.24). In the aggregate listening to the banker

deteriorates the regulatory outcome and therefore they advocate for a rule-based regulation

(such as the Standard approach under Basel rules) over discretionary one (such as the IRB

and AMA approaches). Dialogues between regulators and bank at the individual level as

required under the Pillar 2 of the Basel II (“Supervisory Review Process”) causes regulators

to become vulnerable to the confounding explanation of the bankers. This vulnerability

caused by information asymmetry and gap in expertise is likely to persist into the

implementation of resolution regimes such as livings wills under Basel III. As with capital

regulation, banks are much better able to understand the details of the living wills’

construction than regulators.

Mitigating measures

One of the measures to mitigate the effect of regulatory capture by the mechanism of

influence is through disclosure and transparency. The CFA Institute study recommends that

more transparency in the interactions between the government, regulators and banks be made

9
for public consumption by maintaining audio or video recordings available for public record.

In order to address the issue of expertise, appropriate compensation that reflects the

complexity of their task and the opportunity costs of a career in public service is required to

attract and retain qualified experts. Alternatively, policy design should have less discretion in

order to reduce the natural disadvantage that the regulator faces with asymmetry of

information. Aside from proper monetary incentives, sufficient controls over the revolving-

door phenomenon that is pervasive in the finance industry must be instituted to lessen the

impact of camaraderie that could be seen as a cause for supervisory leniency.

Another aspect of the regulatory capture equation that has not received much traction

is increasing competition in the industry by reviewing the market efficiency. According to

Schliephake (2012), opponents of competition argue that more competition erodes stability

because it reduces the charter value of the bank and therefore increases the incentives to take

more risk whilst proponents of competition argue that more competition improves stability

because banks who take more risks maintain higher capital and thus less susceptible to

systemic risk. The Warwick Commission promoted the idea of “right-sizing finance” to

challenge the dominance of “too big to fail” institutions which have increased in number in

view of consolidation within the financial industry. The notion of right-sizing finance

challenges the regulators and government alike to revisit the implicit tolerance to large

conglomeration in the financial sector which is seldom tolerated in the long run in other

industries.

Conclusion

Regulatory failure within the financial industry is not merely the result of regulatory

capture. Furthermore, the mechanism of regulatory capture as traditionally understood does

not take into account the interaction of government which historically has shown that it is

more than able to impose pressure on purportedly independent agencies. When the motives of

10
the banks and governments are aligned, the dynamics of regulatory capture cannot be solely

attributed to the industry. Whilst the consultative approach is common place in the

policymaking process, more mitigating controls need to be put in place to minimise the

effects of influence and bargaining powers which will promote the interest of the industry at

the expense of the public particularly when potential outcomes are not immediately apparent.

Increasing transparency and reducing the use of discretion in both the policymaking and

supervisory process will facilitate accountability of the regulators to the public. Corollary,

regulators (and governments) should be taken to task to re-examine the optimality of the

market players in the industry and be willing to make bold decisions if necessary.

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