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Why Government Regulators Need Corporate 'Boot Camp'

This is the first blog post in a new series on The Hearing called "Making Financial Regulation Work." This guest post was written by Lawrence Baxter and Joel E. McPhee.

Some of our banker friends say that government should stay out of the industry. This seems brazen when taxpayers are putting up billions of dollars to keep it afloat. Intensified regulatory oversight of retail, securities, and investment banking has been promised by governments all over the world, including the United States, and is surely inevitable. But our friends have a point: Our regulatory physicians have much healing to do themselves. Government regulators often appear bureaucratic, late to the issues, and out of touch with the nuances of business strategy and risk taking, particularly in the fast-paced world of securities and investment banking.

Regulatory modernization has to address the divide between thoughtful bankers who believe in market discipline and politicians calling for greater oversight. That's why we think that in order to acquire certain core skills new regulators should be sent through “boot camp” inside the very businesses they will eventually supervise.

Many good regulators were recruited from the echelons of banks back when taking deposits and lending money was the essence of banking. This was a stable business, the science of which was learned under the tutorship of the seasoned officers of the loan administration and treasury departments of banks. Those who worked in loan administration and treasury were the core elite of the company; they frequently rose to the top because they came from the inner sanctum and they knew the business of banking better than anyone else. Regulators coming through that system were effective when it came to evaluating the quality of a bank’s loan portfolio, loan loss reserves and capital adequacy. Their skills and experience endured long after their departure from these training grounds.

But the business of banking has changed dramatically over the past two decades.

Banks have diversified into securities, investing, insurance and more. The business has become much more complex, more profitable, and faster paced than anything the priests of the temple grew up in. As a result, the top management of banks has changed. Loan administration has merged with the broader risk management units within banks and few loan administrators become CEOs.

In the field of action, where dealmakers and traders can earn compensation that loan administration officers could only dream of, the business is dizzying. Derivatives, for example, have a half-life of weeks, not years. In this environment, the risk management function, let alone regulation, is prceived to be a nuisance, not a safeguard.

How, then, can regulators possibly engage with credibility? Why would a banker, earning millions a year in an exciting world consider regulation as part of his or her career path? How can regulatory agencies possibly offer the status, let alone the compensation and expertise, that the private market offers?

We believe there is a way around this dilemma. The military offers a helpful model. For the airline industry, the Navy and Air Force provide an elite training ground for pilots. The JAG Corps is one of the most elite legal departments any aspiring law partner could hope to enter. Graduates of elite units from the military dominate the security industry. Yet none of the members of these academies are paid anything like what they would earn, even as rookies, on Wall Street. They do it for love of country, superior training, and prestige. When they complete their service, they are sought after by private enterprise because they are the cream of the crop.

What these cadres of elites have in common is that they actually perform, not merely monitor, the activities of their future recruiters. One might imagine analogous training grounds for financial regulators. For example, large trading floors and new derivatives exchanges might be required to reserve space for a team of regulators in training. Candidate regulators — new graduates in law, business, or some other discipline — might spend a few years working on the trading floor alongside experienced traders, learning and practicing their art with trading accounts set up to model those of their experienced counterparts. Financial incentive to enter this field of endeavor may, in fact, come in the form of something akin to ROTC scholarships or, alternatively, by way of student loan forgiveness with a minimum period of commitment to the sponsoring regulator. Their hosts, too, might receive tax credits or other incentives for sharing facilities and expertise.

The result would be regulators-in-training who understand the modern banking business as well as their private counterparts. They would provide a conduit for the most up to date expertise to flow back to regulatory centers. Knowing the modern banking business inside and out would allow such regulators to be better equipped for spotting exotic scams and overly risky products.

These new kinds of regulators might not earn private banking salaries, but they would “compete” and ultimately “graduate” with the credibility of being able to do anything their civilian counterparts can do, as well if not better. Their long-term reward, perhaps after a specific contractual term, would be the ability to choose a career path in government or a likely number of private opportunities that would come their way by virtue of their status as elite financial managers — a form of pantouflage quintessentially American in its willingness to reward initial sacrifice in the public interest by our best and brightest.

Our model surely needs much tweaking and it addresses no more than one facet of modernizing regulation. Yet it is the kind of idea we should explore if we are going to take regulation to a level of positive consensus. The American taxpayer has paid dearly for repeated financial failures and we might do better if regulatory reform were to focus on a more imaginative development of troops than more weaponry.

--Lawrence G. Baxter is a law professor at Duke Law School. Joel E. McPhee is a consultant based in Charlotte, N.C. Both are former executives at Wachovia. The opinions expressed by the authors are entirely their own.

By Sara Goo  |  May 28, 2009; 6:01 AM ET
Categories:  Banking , Regulation  
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Next: The Showdown Over Chrysler and GM

Comments

Have you even considered the likelihood of regulatory capture with this proposal?!?!
It seems to me that there are plenty of former bankers (especially from GS) that are active in our regulatory regime. Just look at the Federal Reserve Bank of New York. It's filled with I Bankers, who will probably go back to working at the banks after overlooking their criminal activities. What problem are you solving here? It looks to me like you are merely institutionalizing the regulatory capture that already is occurring.

Posted by: pimpinbenzo73 | May 28, 2009 8:48 AM | Report abuse

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