The Revolving Door
Notes from the Vault
Larry D. Wall
The financial regulatory agencies have a critical role in determining the direction of financial regulatory policy. The legislation on financial regulatory issues passed by Congress rarely contains detailed instructions to the regulatory agencies. Rather, most legislation establishes goals for the individual agencies and gives each one a toolbox of regulatory powers with which to attain the goals. Moreover, the various goals set by Congress for the individual agencies sometimes have very different implications for the appropriate use of the tools provided by Congress. The multiplicity of goals leaves it to the regulatory agencies to decide how best to balance the various objectives.
The discretion provided to the heads and boards leading the financial regulatory agencies (hereafter, the agency leaders) has the potential to create substantial conflicts of interest. One type of conflict arises from the so-called revolving door, in which some people appointed to regulatory positions had previously earned their livelihood from that industry.1,2 Conversely, other people who had served as regulators return to jobs dependent in some fashion on that industry. The revolving door between regulated and regulator has long been a fact of life, albeit one that is perhaps more noticeable with the increased turnover of agency leaders when a presidential administration changes.
This Notes from the Vault post provides a high-level discussion of the revolving door of agency leaders, including an analysis of the issue from the perspective of the regulated industry, some consideration of why agency leaders often have an industry connection, and what could be done to reduce the resulting conflicts of interest.
The revolving door from a regulated industry perspective
The simplistic view of the revolving door is that it allows industry to block effective supervision and regulation: the senior regulators are drawn from insiders; these regulators write largely ineffective rules and back them up with weak supervision and enforcement; and then the regulators get rewarded with high-paying jobs after finishing their stint with the government.
As with many things, the reality is more complicated. Of course, a regulated industry prefers a regulator who views the industry as making a valuable contribution to society and is generally sympathetic with allowing the industry to continue largely in its current form. However, there are several reasons why many professionals in an industry may also prefer effective regulation over at least some aspects of their business.
One reason would be to stop "bad" practices and/or eliminate the "bad apples" in organizations. This sort of regulation can be helpful, for example, by boosting demand for the industry's products by giving consumers confidence that the products they purchase meet some minimum standards. A related benefit is that effective regulation can provide a lower-cost way of stopping practices that might otherwise be restricted by more draconian regulation after some future blowup.
Another reason why an industry or parts of an industry may prefer regulation is to help enhance its competitive position. Even regulations seemingly unrelated to competition may nevertheless limit competition by raising the cost of entry (as I discussed here with regard to the fintech industry). Regulation can also affect the structure of an industry in ways that favor some participants and disadvantage others. For example, changes in regulation helped cause a dramatic impact on the structure of stock markets in the United States, according to Carnegie Mellon Professor Chester Spatt.
Along with these benefits conferred on the existing industry, individuals within an industry may benefit from effective regulation related to their area of specialization. For example, banks hire community affairs specialists to help them satisfy their responsibilities under the Community Reinvestment Act. Banks hire compliance staff to make sure they are following rules related to market conduct (including consumer protection). Even prudential regulation has served as a source of employment growth, as banks have hired many highly paid, quantitative finance types to work on risk-based capital and stress testing models. Additionally, consulting and legal firms employ additional large numbers of people to assist banks in complying with the many regulations. The various people involved in these activities have an incentive to back effective regulation that supports continued demand for their services.
Picking agency heads and boards
The selection of the agency leaders follows the article II, section 2, clause 2 of the U.S. Constitution, which states "The President...shall nominate, and by and with the advice and consent of the Senate, shall appoint ambassadors, other public ministers and consuls, judges of the Supreme Court, and all other officers of the United States, whose appointments are not herein otherwise provided for, and which shall be established by law...." The terms of these appointments vary across the agencies, but they are generally for four or more years.
In selecting agency leaders, the president and his advisers (hereafter, the administration) are going to choose individuals based on a variety of considerations, typically including the extent to which the nominee's views on the industry are aligned with those of the administration and also the ability of the nominee to make sound decisions in the agency's area of responsibility. People who have worked in an industry or related areas are more likely to have well-developed ideas of what policies they would pursue after appointment. Moreover, these people are likely to be better able to avoid inadvertent mistakes arising from a lack of in-depth understanding of the industry. Thus, the natural pool of nominees is likely to be heavily weighted toward those whose livelihood in one way or another has depended on public policies related to the industry they would regulate.
Reducing the impact of the revolving door
Some measures have been taken to reduce the problems associated with the revolving door at both the leadership and staff level. For example, each of the regulatory agencies has its own set of rules that apply to their leaders and staff. Additionally, each of the agencies has its own Office of Inspector General and each agency is subject to oversight hearings by Congress.
In terms of what more can be done to reduce the potential impact of the revolving door on regulatory policy, there are at least three possibilities: (a) reduce the discretionary power of the regulatory agencies, (b) change the appointment process, or (c) restrict employment opportunities after leaving the regulatory position.
The discretionary power of the agencies could be reduced if Congress were to write more detailed legislation spelling out what policies the agencies should follow.3 The problem is that Congress has always had the ability to write more detailed legislation but has instead chosen to yield power to the regulatory agencies, which suggests the legislature perceives good reasons for the current arrangement. In the area of financial regulation, part of the difficulty with writing more detailed legislation is that doing so would sometimes require members of Congress to spend considerable time working on very technical issues. A second reason for allowing supervisory discretion is that regulated firms are constantly engaged in regulatory avoidance—that is, looking for new ways of complying with the letter but avoiding the intent of binding regulations. Giving the agencies broad discretion is likely to result in a timelier response than waiting for changes to go through the legislative process.4
A second possibility would be to find a different way of selecting agency leaders that prioritize hiring ones with no industry related experience.5 The problem is that it takes away the previously discussed benefits of hiring someone with industry related experience without completely solving the problem. Those appointed as leaders can still make decisions during their term that boost their postemployment earnings.
Conversely, agency leaders could be banned from working in positions related to the industry they regulated. Any such plan would need to address what is meant by an industry related position, which may not be easy to define. Nevertheless, an effective ban would eliminate leaders' incentive to make regulatory decisions based on their implications for the leaders' postemployment income. However, such a ban would also greatly reduce the incentive for anyone associated with the industry to accept an appointment to a regulatory agency leadership position, as doing so would mean they could not use the human capital they had built up prior to taking the leadership position. Indeed, even those who had no prior industry experience would need to consider whether they would want to accept an appointment knowing they would be severely limited in their ability to use the expertise they gained at the regulatory agency in their postagency appointment. One likely consequence of such a ban would be that the pool of top-notch candidates willing to accept employment could be biased toward those close to retirement.
Of course, it would be possible to fashion policies that reduce the gains from subsequently accepting an industry related position without completely banning such a position. For example, University of Tennessee Professor Glenn Harlan Reynolds has sketched out a proposal to tax the revolving door (see here and here). His proposal would impose a surtax of 50 percent to 75 percent on the excess of the postgovernment earnings of political employees (such as agency heads) over what they had previously earned (such as the greater of their earnings before entering government and their government salary) for the first five years after they leave the government. In support of the proposal, he gives several examples of people involved in important regulatory decisions who shortly thereafter took high-paying positions from employers that benefited from their decisions.
Reynolds's proposal would reduce leaders' incentives to distort policy decisions but also tend to reduce their return on their human capital after they leave the regulatory agency. As such, the proposal would have an adverse impact on the willingness of individuals, especially individuals with strong earnings growth potential, to take a regulatory position. Whether the improvements in incumbent leaders' incentives would exceed the cost in terms of a smaller pool of candidates for these leadership positions is a difficult to answer empirical question.
The revolving door in financial regulation attracts continuing attention because of the power granted to the agencies by Congress. The measures that could mitigate the problem include Congress providing very detailed instructions to the agencies, a ban on nominations of industry related people, or a ban on taking an industry related position after leaving an agency. However, each of these measures creates other problems that thus far have been perceived as even worse than the current situation. Thus, the approach taken to date has been to seek to mitigate the problem via a set of ethics rules, backed up by outside monitoring. Given the stakes, ongoing efforts should and are being made to develop more effective ways of limiting conflicts of interest.
Larry D. Wall is executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Paula Tkac for helpful comments. The view expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please email email@example.com.
Wall, Larry D., and Robert A. Eisenbeis, 2000. "Financial Regulatory Structure and the Resolution of Conflicting Goals." Journal of Financial Services Research 17, no. 1: 223–245.
1 This discussion is intended to include anyone who takes a regulatory position after holding a private sector job for which their compensation was influenced by prior regulatory decisions and/or anyone whose future private sector earnings could be enhanced by decisions they made as a regulator. Examples of such positions would not only include people who work in the industry but also consultants and lawyers for the industry. It would also include those who work in opposition to the industry to the extent it influences their incomes, such as trial lawyers who seek damages from the industry in civil suits. It would not necessarily include university professors to the extent their primary involvement is through teaching and research, but would include them to the extent they provide relevant consulting services.
2 See Bloomberg View author William D. Cohan for a discussion of a firm that specializes in providing consulting services on financial regulation, which has hired several former members of financial regulatory agencies.
3 For example, Congress decided in 1987 that Federal Reserve measures to speed check clearing were inadequate and responded with the Expedited Funds Availability Act that included mandatory schedules, according to University of California Professor Edward L. Rubin. However, even this act provided substantial discretion in other areas to the Federal Reserve.
5 Another idea that would reduce the pool of people willing to take government positions is a Public Citizen proposal to ban payments paid by some financial services firms to individuals that take senior government positions, which it calls "golden parachutes." However, depending upon how some of these payments are structured, it might be more accurate to regard some of these contractual provisions as intended to mitigate the disincentive created by "golden handcuffs." That is, many financial and nonfinancial firms make grants of cash, stock, and options that vest over some period of time but which are subject to forfeiture if the employee leaves the firm prior to their vesting. These provisions are called "golden handcuffs" because they are intended to make it expensive for the employee to quit and then start working for a competitor—a concern that does not apply if the person is going to work for a public sector body.