Finance Cops or Lapdogs?

March 01, 2012  

A new book says toothless regulators helped cause the 2008 crisis.

Guardians of Finance: Making Regulators Work for Us 
By James R. Barth, Gerard Caprio Jr. and Ross Levine  
MIT Press

By Leah Spiro

It was the perfect storm, a huge accident, a 100-year flood. That’s how Alan Greenspan, Henry Paulson, Ben Bernanke and Timothy Geithner explain the crash of 2008–2009: as an impossible-to-forecast act of God.

The authors of Guardians of Finance: Making Regulators Work for Us beg to differ. To them, the crash was the result of lapdog regulators starstruck by the very industry they were supposed to be policing. Regulators failed to sound the alarm on the financial industry due to basic human nature: Why would they damage their own chances of smoothly segueing into a high-paying job in the industry?

The problem is that financial regulators are a part of the financial services industry "community," the authors say. They interact with the industry on a daily basis and adopt its views. "The public is sitting in the upper bleachers and the regulatory officials can scarcely, if at all, hear their cry," they write. "We urgently need some way to hold regulators accountable for their behavior." The authors know of what they write. James Barth was chief economist of the Office of Thrift Supervision and the Federal Home Loan Bank Board. Gerard Caprio Jr. was an economist at J.P. Morgan and the World Bank. Ross Levine is a professor of economics at Brown University.

Who are the "Guardians of Finance"? They are unelected officials who are not directly accountable to the public. The book takes a close look at the Federal Reserve System, the Securities and Exchange Commission, the Treasury Department, the FDIC and others, and analyzes each agency’s dysfunctionality. The Fed, with its system of regional banks, is too intertwined with the banking industry; the SEC was ineptly led by Christopher Cox, who is portrayed as a bumbler; and FDIC examiners are too easily intimidated by Goliath banks.

The authors harshly criticize the Dodd-Frank Act of 2010, which they argue is doomed to fail. The new entities created by Dodd-Frank, such as the Consumer Financial Protection Bureau and the Office of Financial Research, are tucked into the Fed and the Treasury, and thus are not shielded from the pernicious revolving door. The CFPB and the OFR are not incentivized to alert the public to oncoming financial train wrecks.

Barth, Caprio and Levine propose the creation of yet another agency. They call it the Sentinel, with a capital S. This agency will be an intellectual, investigative watchdog that is truly independent. It will be staffed by forensic accountants, financial economists and other technicians who are prohibited from signing up for jobs in the financial services industry for many years. It will have only one task: to write reports on how well regulators are doing their jobs. It will have no power, except the power to obtain any information it wants. The goal is to shine light on regulatory problems, start an informed debate and improve the operation of the financial system. For example, "What if a Sentinel had highlighted the FBI’s 2004 fraud report in mortgage finance and the fact that the Fed was not responding to it?"

Guardians of Finance is a surprisingly lively and provocative book about a hellishly complex and staggeringly boring subject. True, a cynic would say the authors’ motive is full employment for economists. The Fourth Estate has a far better track record as watchdogs. Yet the idea of a public early-warning system is appealing. If nontaxpayer funding is used, if the Sentinel is not located in Washington or New York, and if Paul Volcker will head it, it is worthy of serious consideration.

Leah Spiro is president of Riverside Creative Management, a literary agency.

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