A new book by Financial Times journalist Dan McCrum tells the story of Wirecard. The German company, which acted as a payment processor (an intermediary between shopper and merchant), appeared to be one of continental Europe’s relatively few successful technology start-ups. Except it wasn’t. In June 2020, Wirecard filed for insolvency. Many of its assets and reported revenues had never existed. Markus Braun, the former CEO, is in custody and Jan Marsalek, the former COO, is on Europol’s list of most wanted fugitives.
McCrum had reported sceptically on the company for several years. BaFin, Germany’s financial regulator, had launched a criminal investigation—but not into Wirecard. The action was against McCrum and other doubters, for alleged market manipulation: the negative stories were depressing the share price. BaFin plainly perceived its role as one of protecting German companies against Anglosphere critics.
The story has a parallel in the United States. In the early 1970s, Equity Funding claimed to be one of America’s top 10 life insurance companies. It too was fraudulent. After its collapse, the company’s president and chairman, Stanley Goldblum, was sentenced to eight years in jail. A whistleblower within the company had warned stock analyst Ray Dirks, who advised some of his clients to sell their Equity Funding stock. Dirks had also contacted the Wall Street Journal, which at the time did not believe the evidence was strong enough to warrant the legal risks of publishing the story. The paper’s reporters contacted the Securities and Exchange Commission (SEC), a federal government agency charged with preventing market manipulation and fraud, which then had a meeting with Dirks.
With rumours circulating and the company’s share price dropping, Equity Funding failed. Its downfall had taken less than a month. The SEC then took action against Dirks for insider trading, securing his conviction. The case went all the way to the Supreme Court before America’s most senior judges reached the obvious conclusion that the public interest in the exposure of fraud outweighs the public interest in maintaining an orderly market in a fraudulent company’s shares.
The public interest in preventing fraud is obvious. But so is the public interest in fair prices, product safety, competitive innovation and financial stability. That is why we have economic regulation. The Wirecard and Equity Funding cases illustrate the problem of regulatory capture: the process by which a regulatory agency comes to identify with the industry or firms that it oversees. This leads to regulators serving the interests of established companies, prioritising their concerns over the protection of consumers and the wider public, and favouring incumbents over actual or potential entrants.
In the UK, Brexit has had little immediate impact on regulation because most European Union provisions were initially treated as retained UK law. But, for many Brexiters, the principal rationale for leaving was the desire to be rid of oppressive Brussels diktats, so all areas of EU regulation are currently under review. A batch of bills concerning data, animal welfare, procurement and genetic modification is now before parliament. A new Financial Services and Markets Bill sets out the new duties of the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA), both supervisory bodies.
There are certainly many opportunities to improve regulation by rendering it more effective in protecting the public and less burdensome for business. Among the few upsides to Brexit we might include the prospect of scrapping Solvency II (a scheme implemented by EU member states in 2016 which discourages long-term investment by insurance companies) and Key Information Documents (an EU mechanism which has become a vehicle for providing misleading information to retail investors).
Most of the pressure for regulatory reform comes not from consumers, but from the affected industries. And that pressure is most predictably and powerfully seen in financial services. The removal of the cap on bankers’ bonuses, now almost the only measure from the Liz Truss/Kwasi Kwarteng era to survive, was certainly not the result of pressure from voters—or even the Conservative membership.
There are obvious dangers to politicians, the agencies they empower and the regulators they appoint becoming too close to industry. We have already tried—in the words of Gordon Brown in his Mansion House speech of 2006—to “advance with light-touch regulation, a competitive tax environment and flexibility”. As the current governor of the Bank of England Andrew Bailey laconically observed, that didn’t end well for anyone.
Modern economic regulation began in the Gilded Age, in the US. The objective was to rein in the trusts established by the “robber barons” who dominated American business at the end of the 19th century. The first of these regulators was the Interstate Commerce Commission (ICC), established in 1887 to oversee railroads. The measure was a response to populist agitation, particularly among farmers in the Midwest, against the power of railroad trusts. But regulatory capture was already on the next train.
When Grover Cleveland regained the presidency in 1892, he appointed Richard Olney as attorney general. In private practice, Olney had often represented railroad interests. Some of his former clients saw his promotion as an opportunity to emasculate the ICC. But in a letter to Charles E Perkins, president of the Chicago, Burlington and Quincy Railroad, Olney counselled caution. The ICC can be “of great use to the railroads”, he wrote. “It satisfies the popular clamour for a government supervision of the railroads, at the same time that the supervision is almost entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business and railroad view of things.” Olney was prescient. Within a few years, the ICC was effectively operating a cartel on behalf of rail interests. After all, if it was unfair to charge more than the fair freight rate the ICC had approved, then must it not also be unfair to charge less than the fair freight rate the ICC had approved? Or so the argument went, and the courts agreed.
This legal deference to regulatory judgement was the precursor to what became known as the Chevron doctrine, which held that the law will not quarrel with the good faith exercise of regulatory discretion. This doctrine has been overturned in the recent batch of decisions made by the new six-to-three conservative majority on the US Supreme Court. The Court ruled that the Environmental Protection Agency had exceeded its powers in issuing directives designed to combat climate change. The American right now believe that they will obtain more favourable outcomes from Congress than from executive agencies. On that issue, at this moment in US history, they may be correct. Experience shows however that matters are more complicated. Political judgements are more fickle than regulatory decision, and executive agencies are empowered so as to protect regulation from short-term political vagaries.
The paradigm case of regulatory capture was the Civil Aeronautics Board (CAB) in the US. Few would doubt that airline safety must be regulated. But, lobbyists explained, only soundly financed airlines can be relied on to maintain safety standards, so the regulator must ensure that fares are not too low and competition not too intense. After its formation in 1938, the agency licensed no new interstate carriers at all. Southwest Airlines, founded in Texas in 1966, could operate only because the state was large enough to allow the carrier to fly major routes without crossing state borders, which would have made it subject to federal jurisdiction. The airline pioneered low-cost air travel.
In the 1970s, a curious coalition came together in Congress to pass legislation to clip the CAB’s wings. The left correctly believed that the agency was under the control of business interests. The right correctly judged that free markets would serve airline customers better than the sclerotic status quo. In 1977, Alfred E Kahn, a Cornell professor who had literally written the book on regulatory capture in the airline industry, was appointed head of the CAB with the objective of winding it up. By 1985, the agency was finally abolished.
Competition flourished. Southwest Airlines became a major national carrier, while sluggish incumbents such as Trans World Airlines, Braniff and Eastern disappeared. European aviation had been similarly uncompetitive as governments protected their national carriers, but the US example and the EU’s emphasis on creating a single internal market undermined the cartels. The stage was set for low-cost carriers to offer flights that cost barely more than a Ryanair sandwich.
Today, the brief of aviation regulators in Europe and the US is largely limited to the oversight of safety. But capture is evident here also. The world’s fleet of Boeing 737 MAX planes was grounded after two disastrous crashes between 2018 and 2019. The findings of the Congressional enquiry that followed confirmed that Boeing had preferred to tweak the 50-year-old 737 than design a new aircraft. The American manufacturer, indulged by the Federal Aviation Administration (FAA), had attached more importance to winning its global market competition with Europe’s Airbus than to ensuring passenger safety. Most of the agency’s responsibilities had been delegated to employees of Boeing. Although many of these honest engineers expressed disquiet at the corners that were being cut, they found the regulatory apparatus largely indifferent to their concerns.
Along with aviation, financial services and pharmaceuticals are the most heavily regulated of industries, and are also the industries in which failures of regulation and cases of regulatory capture have been most evident. In Britain, the “raised eyebrows of the governor of the Bank of England” were once seen as—and to a degree were—a powerful regulatory tool. The City of London was a club of men of similar background and social class and a shared sense of how business should be conducted. This did not necessarily include serving customers well, but a certain integrity meant that if people stole they did so only in familiar and well-accepted ways. The internationalisation and professionalisation of finance meant the industry was increasingly populated by outsiders, while ever-growing rulebooks were required to take the place of tacit understandings of how things were done. The new formality rendered the mechanisms of capture more complex than they had been, though in some ways more transparent.
Sometimes regulatory capture is the product of simple corruption, but documented examples of this are rare in advanced economies. On the other hand, the “revolving door” is certainly a problem—able employees of regulatory agencies are likely to receive better-paying offers of jobs in the businesses they regulate and are well aware of this possibility, even when they are regulators. In 2014, attorney James Kidney retired from the SEC after more than 25 years, having unsuccessfully pushed for the prosecution of executives involved in events around the 2008 financial crisis. In an excoriating valedictory address in 2014, he observed: “We lose our best and brightest as they see no place to go in the agency and eventually decide they are just going to get their own ticket to a law firm or corporate job punched.”
Kidney continued: “They see an agency that polices the broken windows on the street level and rarely goes to the penthouse floors. On the rare occasions when enforcement does go to the penthouse, good manners are paramount.” Take the example of Carmen Segarra, employed by the Federal Reserve Bank of New York, who lacked the requisite “good manners”. Segarra was “embedded”—in some heavily regulated industries, such as banking, regulators may work in the offices of the businesses they supervise. She commuted every day to the headquarters of Goldman Sachs.
Segarra’s relationship with her co-workers and superiors deteriorated to the point at which she secretly began to record her experiences. The extent of capture she recounts is extreme. “We want them to feel pain, but not too much” was how her supervisors at the New York Fed had summed up their approach in her first days on the job. Instructed to review Goldman’s policy on conflicts of interest, she concluded that the bank didn’t have one. She became highly critical of Goldman’s role in the 2011 merger of El Paso and Kinder Morgan, but to little effect. Segarra lost her job with the Fed soon after. When a court in Delaware assessed the transaction, it lambasted the bank which—imagine the horror—agreed to waive its $20m fee for the deal.
Regulation requires industry specific expertise. Thus it is inevitable that regulatory officials will have similar backgrounds, training and skills to their counterparts in the businesses they oversee. It is stressful to be hostile to the people you deal with every day—few have the personal qualities required of a prison guard. Segarra’s position of an “embedded” regulator is no more enviable: it would have been much easier to be on good terms with the inmates.
The demands on regulators are multiple and strong. When public opinion is aroused—as it was by the 2008 banking crisis—its anger can be a powerful force. But most people have other things to think about. Industry lobbyists have only one thing to think about, and do so every working day. And so, with time, industry pressures steadily eroded measures like the ringfencing of retail banking from other financial activities in Britain, or the related “Volcker rule” in the US, named after the late central bank governor.
The raised eyebrows of the governor of the Bank of England were once a powerful regulatory tool
If regulatory capture were easy to control, it would not have been so prevalent or persistent. But first of all you have to want to control it. The plans to give the Treasury power to overrule City regulators and to require the FCA to promote the competitiveness of the British financial services sector have, at least at the time of writing, been somewhat weakened in response to criticism. But the intended direction of travel remains clear, as the finance industry continues to try to claw back the ground it lost after the global financial crisis. (Note: competitiveness should be carefully distinguished from competition: competition to offer British consumers and businesses better value for money is something we should all want; pursuing “competitiveness” as a regulatory objective means using regulation to attract activity to London from other financial service centres, something of benefit only to those who work in the industry, as we have learned to our cost already.)
There is a need for greater humility about what regulation can achieve. To respond to every regulatory failure by introducing more and more complex rules is a process doomed to fail, and it has failed. The result is a regulation industry in which regulators and compliance staff engage in ever-more abstruse dialogue with each other and have a shared interest in increasing the scope of their jurisdiction. Within such a structure, capture is inevitable. And executives outside the charmed, but junior, circle of professional regulators regard regulation only as something to be got around. As Winston Churchill observed: “If you make 10,000 regulations you destroy all respect for the law.”
If further evidence of this were needed, look to the US website Violation Tracker, which records an almost unbelievable $800bn of penalties paid by US corporations since 2000. Nearly half comes from the financial services sector, with pharmaceuticals accounting for almost another $100bn. The site identifies 268 different penalties levied on Bank of America, a banking conglomerate, and 91 imposed on Pfizer over a 22-year period. The frequency of these offences demonstrates that these companies regard regulatory violations as a cost of doing business rather than a matter for shame or cause of reputational damage.
Britain and the EU have much lower fines and less propensity to litigate against large companies. Still, the newly established Violation Tracker site for the UK records that Barclays has incurred 23 penalties since 2010 and was fined more than £10m by the FCA (or its predecessor, the Financial Services Authority) in 2012 and again in 2014, 2015, 2020 and 2022. The observation that the very largest fines imposed by the European Commission have been levied on American companies may reflect lower standards of behaviour by US businesses. Or, in a mirror image of the FAA’s anxiety to support Boeing, European regulators may be less vigilant in casting the beams from their own eyes than in detecting the mote in the eye of their neighbour. BaFin’s approach to Wirecard may be only an extreme case of the misuse of regulation to promote the competitiveness of local industry.
Jed Rakoff, attorney and then judge in the Southern District of New York, the world’s principal forum for both the commission and prosecution of financial crime, has described the process of perfunctory regulatory compliance which leads to the outcomes registered by Violation Tracker. He identifies the shift that has occurred from the charging of individuals to the—generally deferred—prosecution of corporations. The general counsel of the business acknowledges the concern of the regulator or prosecutor. A bargain is made in which the company agrees, usually without admitting fault or liability, to implement a compliance programme and to disgorge a financial penalty. The deferred prosecution deal puts any further action on hold, and no further action occurs. Until the next time.
As Rakoff argues, what is needed is a different strategy, one that holds individuals rather than corporations to account and emphasises organisational culture rather than an adherence to rules. Corporations cannot go to jail and executives may not care if the business that employs them has to write large cheques. But people can go to jail and, especially the kind of people likely to be working in these heavily regulated industries, are very concerned about the state of their personal bank accounts.
Hillary Clinton told Goldman Sachs (which reportedly paid her $225,000 for the speech; the revolving door accommodates politicians as well as technicians) that “the people that know the industry better than anybody are the people who work in the industry.” Whatever we think about the circumstances in which that observation was made, its truth is undeniable. And that is why “the people who work in the industry” should be accountable for the industry’s conduct. But “the people who work in the industry” should not be scoping its regulation.