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«Regulatory Capture by Sophistication∗ Hendrik Hakenes† University of Bonn, MPI Bonn, and CEPR Isabel Schnabel‡ Johannes Gutenberg University ...»

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Regulatory Capture by Sophistication∗

Hendrik Hakenes†

University of Bonn, MPI Bonn, and CEPR

Isabel Schnabel‡

Johannes Gutenberg University Mainz, MPI Bonn, and CEPR

January 11, 2015

Abstract: One explanation for the poor performance of regulation in the recent fi-

nancial crisis is that regulators had been captured by the financial sector. We present

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

their sophistication. Banks can search for arguments of differing complexity against tighter regulation. Finding such arguments is more difficult for weaker banks, which the regulator wants to regulate more strictly. However, the more sophisticated a bank is, the more easily it can produce arguments that a regulator does not under- stand. Reputational concerns prevent regulators from admitting this, hence they rubber-stamp weak banks, which leads to inefficiently low levels of regulation. Bank sophistication and reputational concerns of regulators lead to capture, and thus to worse regulatory decisions.

Keywords: Regulatory capture, special interests, banking regulation, sophistica- tion, reputation, career concerns, financial stability, complexity.

JEL-Classification: G21, G28, L51, P16.

∗ The term “regulatory capture by sophistication” was coined by Martin Hellwig who inspired us to work on this topic. We are grateful for his encouragement and advice. We also thank Philippe Aghion, John Boyd, Charles Goodhart, Rainer Haselmann, Thomas Hartmann-Wendels, Matthias Kr¨kel, Kathryn E. Spier, Roland Strausz, Hal Varian, Nicolas Vieille, seminar participants in a Tilburg, Bonn, Munich, Aachen, Mainz, Heidelberg, Madrid, Berlin (TU), Vallendar, M¨ nster, the u Norwegian Central Bank, and the Max Planck Institute for Research on Collective Goods in Bonn, as well as conference participants at the Campus for Finance in Vallendar, the VfS (D¨ sseldorf), the u DGF (Wuppertal), the workshop on “Banks and Government in Globalized Markets” in Vienna, and the GEABA in Graz for useful comments and suggestions.

† Institute for Financial Economics and Statistics, University of Bonn, Adenauerallee 24-42, 53113 Bonn, Germany, hakenes@uni-bonn.de.

‡ Gutenberg School of Management and Economics, Johannes Gutenberg University Mainz, 55099 Mainz, Germany, isabel.schnabel@uni-mainz.de.

1 Introduction When the model-based approach to capital regulation was introduced [...] 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 thatthe sophistication of risk modeling 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.

–  –  –

One of the most disturbing features of the recent financial crisis is the inability of regulation, especially capital regulation, to prevent the crisis or at least mitigate its consequences. This is all the more surprising as, in recent decades, we have seen an increasing sophistication of regulatory approaches, moving from rigid capital ratios under Basel I to highly sophisticated methods based on banks’ internal models, first with regard to market risk under the 1996 Amendment of the Basel Accord, and then with regard to credit risk under Basel II. But rather than making the system more resilient, these approaches allowed banks to reduce their unweighted capital ratios to levels as low as 2 percent (Basel Committee on Banking Supervision, 2009). So why did banking regulation not prevent this development? Why did bank regulators and supervisors approve an approach that made the system less rather than more stable?

Hellwig (2010) argues that regulators had been captured by the sophistication of bankers and their models. In his view, regulators did not sufficiently appreciate that there was a conflict of interest between banks and the public. In particular, regulators may not have realized that banks do not internalize the effects of their failure on the remaining financial system and the real economy. While there probably is some truth to this argument, it is based on limited rationality and only vaguely related to the issue of sophistication. In this paper, we propose an alternative explanation of regulatory capture by sophistication that derives from a sophistication gap between bankers and regulators.

In our model setup, banks try to persuade the regulator to abstain from (tighter) regulation. We show that unsophisticated regulators may “rubber-stamp” banks even though regulation would be desirable from a social perspective. The reason 1 is that regulators are not willing to admit that they do not understand the bank’s arguments because they are afraid of harming their own reputation, and thus, for example, their future careers. This may leave weak banks under-regulated, endangering the stability of the financial system. While regulatory capture may occur at the level of the entire banking sector, capture may be even more likely at the bank-individual level when banks and supervisors enter into a dialogue about appropriate regulation, as intended in Pillar 2 of the Basel Accord (“Supervisory Review Process”). In such interactions between supervisors and banks, supervisors are especially susceptible to persuasion, and reputational concerns are most pressing.

Our model has three important ingredients. First, we need a persuasion technology.

Second, we allow for differing complexities of arguments and for varying degrees of sophistication of agents. Third, we propose reputational concerns (microfounded as career concerns in our model) as a reason for why a regulator may not admit that an argument is too complex for him. We model the interaction between a regulator and a bank. The probability of default (PD) differs across banks, but this cannot be observed by the regulator. From a social perspective, a bank with a high PD should be regulated, one with a low PD bank should not. Regulation comes at a cost for the bank, so the bank wants to persuade the regulator to abstain from regulation.

It can do so by presenting an argument. One can think of arguments as balls from an urn. A bank is represented by an urn filled with red and green balls, the fraction of red balls being equal to the probability of financial distress. At a cost, the bank can draw a ball at random, look at it and decide whether to show it to the regulator.

The bank can repeat this process as often as it likes, until it has found a ball that it wants to show to the regulator. The regulator will then update his beliefs about the bank’s type, and possibly refrain from regulation.

We assume that the complexity of arguments differs. More precisely, each ball has a “complexity” represented by a number between 0 and 1. Moreover, the bank and the regulator each have a certain degree of sophistication, again lying between 0 and 1. If the bank’s (or the regulator’s) sophistication exceeds the ball’s complexity,

it can observe the color; otherwise it cannot. The regulator comes in two types:

type H understands all arguments, whereas type L is less sophisticated than the bank. The regulator’s future salary is assumed to depend on his perceived type. He thus wants to keep his reputation as high as possible. In some equilibria, the bank is always (or never) regulated, hence argumentation is unnecessary and does not occur in equilibrium. In the interesting parameter range, however, the equilibrium induces 2 regulatory capture by sophistication. The type H regulator sets the standard for arguments so high that he is just convinced. If the bank is more sophisticated, it is easier for the bank to make arguments, and the standard for arguments is set higher in order to keep the argument informative. This entails negative consequences for a type L regulator. He does not understand a larger portion of arguments. Yet if he admitted that he did not understand, his reputation would be lost; he thus nods the argument through. The more sophisticated the bank, the easier it becomes to fool the regulator (if he is of type L) and the worse the regulatory decision becomes.

The unsophisticated regulator is captured by the bank’s sophistication.

Our model is applicable to different areas of financial regulation. The first is financial supervision when the supervisor has discretionary power, as is the case under Pillar 2 of the Basel Accord. In fact, the discretion of supervisors under current regulation is substantial. For example, supervisors check the appropriateness of internal models in the IRB approach. The bankers can try to convince the supervisors of the high quality of their risk management tools in order to avoid regulatory intervention. Another example is the application of Volcker Rule type regulations where supervisors have to distinguish between transactions carried out for speculation, hedging, or market making purposes. Discretion will also be important in the specification of countercyclical capital buffers and in other areas of macroprudential regulation. Finally, the same issues arise in resolution planning, for example in the preparation of living wills. The problem is most severe when the sophistication gap between bankers and supervisors is substantial, as is typically the case in modern banking. Hence, according to our model, the observed shift towards more discretionary powers of regulators involves the risk of exacerbating regulatory capture, especially in combination with an increasing discrepancy between regulators’ and bankers’ sophistication.

A second application is optimal bank closure. When a bank is in distress, the supervisor has to decide whether the bank should be resolved or bailed out. The bank has a strict preference for being bailed out. The bail-out decision of the regulator will depend, for example, on the chances of bank recovery and on the degree of systemic risk from bank failure. The bank will try to persuade the regulator that it deserves to be bailed out. One way to do so is to present favorable future scenarios to give proof of the bank’s strength or picture the disastrous consequences of bank failure.

3 Finally, the model may also be applied to the regulatory process. Consider, for example, the discussions surrounding the introduction of risk-based models, as described by Hellwig (2010). The banking lobby argued in the 1990s that capital regulation at the time fell well behind the current standard of banks’ risk management. While there was some truth to this, rigid capital ratios were much easier to understand and hence to be controlled by regulators than banks’ internal models.

Given the discrepancy in salaries and hence presumably also expertise in risk management between the financial sector and regulatory bodies, regulators could not easily be on par with the banks to be regulated. It is well possible that regulators were not willing to admit this discrepancy due to reputational concerns.

While there exists a broad literature on the governance of financial institutions, the governance of regulatory bodies and the incentive structures of regulators are still poorly understood and the literature is scarce. Some recent empirical papers suggest, however, that regulatory capture may be an important feature of the finance industry. Becker and Opp (2014) present evidence from the insurance industry that regulatory changes may have been driven by regulatory capture. Behn, Haselmann, and Vig (2014) show empirically that the use of internal models in bank capital regulation benefited large banks but adversely affected financial stability, which they interpret as evidence of regulatory capture in banking.

Our paper is also closely related to several strands of literature that are not directly concerned with banking but with lobbying in general. The literature on regulatory capture dates back to Laffont and Tirole (1991, 1993) and Giammarino, Lewis, and Sappington (1993).1 An excellent survey and introduction to the theory of lobbying is given by Grossman and Helpman (2001, chapter 4).2 Moreover, our paper is related to the theoretical literature on games of persuasion (see Milgrom and Roberts, 1986; Shin, 1994; Glazer and Rubinstein, 2001, 2004, 2006; Sher, 2010).

In our model, the bank presents verifiable information to the regulator, the decision maker. It thus influences the regulator’s beliefs, but the regulator anticipates the bank’s objectives. Our paper introduces the sophistication of players and the complexity of arguments into games of persuasion.

1 The theory of regulation is much older, including Huntington (1952); Bernstein (1955); Stigler (1971); Levine and Forrence (1990), to name a few prominent articles.

2 The literature on lobbying has also been very active in recent years (see, e. g., Armstrong and Sappington, 2004, 2007; Feldmann and Bennedsen, 2006).

4 There are different kinds of regulatory capture that we do not address in the model.

The first is social capture, which occurs when former bank managers start to work for the regulator, or when bankers and regulators are just too tight.3 Another kind of capture we do not model is a judicial arms’ race, where the regulator has problems to regulate a bank because the bank’s lawyers can kill any attempt.4 Monetary capture, involving side payments and bribes, or the outlook of regulators to get well-paid jobs at banks, is also left aside.

Our paper has important policy implications. The welfare analysis shows that the whole process of argumentation does not improve overall welfare in our model. In fact, the outcome is always worse than if the regulator always regulated the bank.

Hence, our model suggests that a rule-based regulatory process may be preferable to discretion, which casts some doubt on the observed tendency towards more discretion in banking supervision. The outcome is worst when the sophistication gap between regulators and bankers is large. Therefore, capture could be reduced by offering competitive salaries in supervisory agencies in order to allow supervisors to be at eye level with the banks to be supervised. Professional training of supervisors is also important to reduce the sophistication gap. Moreover, regulators should be immunized against pressure from career concerns, for example by offering tenure.

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