On November 2014, the Banking Subcommittee on Financial Institutions and Consumer Protection of the Senate was asked to determine whether the US Federal Reserve was being “too cosy” with the industry it oversees. Suspicions were raised by one of its former examiners, Carmen Segarra. Indeed, a few weeks before Carmen Segarra had claimed she was “silenced” by her line managers during her supervision of Goldman Sachs.Footnote 1 She discovered in 2011 an important failure in Goldman Sachs conflict of interests policy and wanted to report her statement, but her Fed superiors pressured her to alter her report and her refusal cost her career.Footnote 2 The President of the Federal Reserve Bank of New York, William C. Dudley, who before taking office in the central bank was a Goldman Sachs economist, has been called to testify before the American Senate.

Three years before, the report of the Financial Crisis Inquiry Commission concluded that capture was one of the reasons leading to the financial crisis.Footnote 3 It created a favourable environment for the relaxation of the regulatory burden (Pagliari 2012) and hence allowed for excessive risk-taking by private institutions. Associated with lax supervision, all the necessary conditions were met to trigger a financial crisis. Hence, this hearing constitutes a beginning of awareness of the importance of capture in financial supervision.

Capture can touch on all the levels of public decision-making and action: government, parliament and even sometimes the scientific expertise that advises them. Hence, public decisions that “entails benefits or costs to groups that are likely to be involved in political lobbying” (Bénassy-Quéré et al. 2010) have been delegated to independent regulatory agencies (IRAs).Footnote 4 However, recent events tend to indicate that these independent agencies are not any less susceptible than the legislator to being influenced by special interests. Therefore, are financial supervisors protected from regulatory capture?

To answer this question, in Sect. 6.1 I first define the concept of capture as a departure of regulation and supervision from the general interest with respect to two subgroups: materialist and non-materialist capture. In Sect. 6.2 I then explain its normalization among supervisors with three processes derived from the literature on organizational behaviours: institutionalization, rationalization and socialization. In Sect. 6.3, I assess whether financial supervisors are from now on insulated from the influence of the financial industry. Finally, I attempt to explain the reason for financial supervisors’ failure to prevent capture.

1 The Concept of Capture

At all times, industries have tried to protect and promote special interests. Their behaviour is completely rational: they apply pressures on the regulatory bodies in order to influence the decision-making process. Nevertheless, the industry should not have a disproportionate impact on this process.

Stigler (1971) observes that regulation is mostly designed for the benefit of the supervised sector. Hence, the industry has acquired a persistent and immoderate influence that disturbs the original balance of interests (Baxter 2011). Sometimes, the supervisor follows the prescription of the regulated industry and loses sight of the general interests. In this case, he is captured by the industry he regulates.

Since Stigler’s definition, other types of capture have been highlighted by the literature. They can be gathered into two main groups: materialist capture and non materialist capture (Freeman Engstrom 2012). In both forms of capture, the industry succeeds in influencing the regulatory and supervisory process at the expense of the general public.

The two concepts are based on polar assumptions regarding the supervisor’s rationality. In materialist capture, the supervisor purposely favours the industry’s interest over the general public’s, while in non-materialist capture he ends up confusing or assimilating the industry’s interest with the public’s interest.

1.1 Materialist Capture

Materialist capture refers to the traditional form of capture that mostly figures in the seminal works. Stigler (1971) analyses the regulation of trucks in the USA, where in order to obtain lenient legislation the industry pays for the votes and resources a political party needs. Tirole (1986) and Laffont and Tirole (1991) introduce a model where the asymmetry of information creates an incentive to the industry in bribing the regulator to convince him not to tell the government the real situation regarding its costs (Dal Bó 2006). Martimort (1999) adds to the previous model Congress’ response to the threat of capture. Less and less discretionary power is left at the agency but increased bureaucratization tends to decrease the agency’s efficiency. Finally, Albino et al. (2013) formalize the interaction between firms and regulators and explicitly account for their mutual influence, thereby proving the incentive for collusion.

In materialist capture, the regulator is perfectly aware of the fact that he is harming general interests. He is confronted by a tradeoff between his own private interest or his regulator’s duties. Thus, he takes into account selfish objectives such as personal enrichment (corruption and bribery), carrier concern (recruitment in higher paying jobs in the regulated industry, campaign contributions) or whether the IRA’s funds depend on the supervised industry. Hence, materialist captures is also related to the literature on corruption and on revolving doors.

A structural problem, the asymmetric stakes among interest groups, allows “some interests to systematically win out over others” (Freeman Engstrom 2012). The financial industry has a stake in influencing regulation and supervision because it directly affects its profits. The industry is concentrated and well organized. Thus, it is tempted to influence its supervisors. The consumer group faces the well-known collective action problem (Olson 1965). Its diffuse nature and the resulting organizational problems prevent consumers from trying to influence regulation. In the light of the cost–benefit arbitrage, the profit from influencing the supervisor is not worth the costs incurred. There is an “asymmetry of stakes among interest groups” (Freeman Engstrom 2012).

To influence decisions, the financial industry offers personal benefits to the self-interested supervisor against a favourable regulation (Tai 2015). Such exchange of favours is only made possible because both sides are perfectly rational and have a positive incentive in shaping regulation toward special interests. As a result, the regulator favours industry interests over the general interest. Such a theory is therefore related to the rent-seeking and the government failure theories developed by public choice.

  • Rent-seeking theory is defined as a situation where an individual, a company or an organization attempts to obtain economic gain from others without reciprocally creating wealth for society.

  • Government failure theory analyses “the behaviour of governments under the assumption that all relevant agents pursue their self-interest” (Le Grand 1991). The main outcome is that government decision-making creates inefficiency and inequity.

1.2 Non-Materialist Capture

Non-materialist capture appeared more recently in the literature. It is a process of “colonization of ideas” (Freeman Engstrom 2012) that leads a supervisor to share the views of the regulated industry (Veltrop and de Haan 2014; Tai 2015). Unlike materialist capture, the regulator acts with the general interest in mind, and even the most well-intentioned supervisor would be captured. Non-materialist capture convinces him that making a pro-industry decision will be beneficial for everyone. It acts as a veil clouding the regulator’s vision until he loses sight of the ultimate goal of the regulation (Benink and Schmidt 2004). Non-materialist capture does not derive from the government failure theory. On industry’s part, the wish to influence a regulation stays unchanged.

  • Information capture

    Any regulatory agency depends on the information provided by the regulated industry (Bagley 2010). This structural dependence creates de facto an asymmetry of information, where the regulated industry has an informational monopoly.

    This asymmetry of information is not particular to the regulation of finance. Any regulatory agency in charge of overseeing an industry is subjected to this gap in information. According to Pagliari (2012), “‘capture’ is more likely when regulation is highly complex, and when information asymmetries between the regulated industry and the regulators are greater.” Both are characteristics of financial regulation and supervision.

    • Quantity of information

      Wagner (2010) explains how the industry captures the American Congress with an excessive use of information. As part of the rule-making process, legislators must proceed to public hearings and are “required by law to consider all the input received.”Footnote 5 The regulated industry submerges the Congress with an extraordinary amount of information in order to overwhelm the legislators and attempt to brainwash the legislator as regards the industry’s motives and intentions. Furthermore, “as the issues grow more numerous and technical, less well-financed interest groups find it hard to continue participating in the process” (Wagner 2010). Such a “machine-gun effect” associated with an asymmetrical participation between stakeholders leads to less pluralism and hence pro industry regulations.

      Such information capture, happening at legislator level, is likely to occur at the supervisory level of independent agencies. For matters such as enforcement and interpretation of the legislation, financial supervisors often proceed to hearings and other stakeholder consultations. As part of the supervisors’ duty, these prescriptions ensure the agency is held accountable for its actions.

      It is particularly the case when the discussed matter highly technical or when it takes place within a period of legislative inflation. The financial industry has expertise and knowledge of the issues and thus benefits from the “effectiveness of comment” in the decision-making process (Baxter 2011). Pagliari (2012) argues that investors, deposit holders and other consumers of financial services “face greater challenges in coordinating and in mobilizing the organizational and informational resources required to compete with the financial industry groups in the marketplace for influencing regulation.” As a result, the agency does not perceive the alternative views owing to the lack of representativeness and fundings of the stakeholders holding them. The interpretation of the “empowering legislation” is distorted (Baxter 2011).

    • Quality of information

      Information capture may also occur through the use of highly sophisticated information. Hakenes and Schnabel (2015) argue that the financial industry captures the regulator through the use of highly complex information. The regulator is therefore unable to understand the argument of the industry owing to his lack of expertise. He does not have “the means or ability to review that information skeptically” (Bagley 2010). Instead of admitting his weakness, the regulator acts as if he understands the argument of the financial industry. He rubber-stamps banks even though regulation would be desirable from a social perspective.

      Two reasons prevent the unsophisticated regulator from admitting his shortcomings. First, he is concerned about his reputation and does not want to signal his lack of expertise. Second, he may be more easily convinced and shortchanged by the financial industry’s scientific argument. Regarding the issue of capital requirements, Hellwig (2010) argues that “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 that the 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.” Thus, by increasing the sophistication of the information, the industry raises the information gap and is more likely to convince a proud regulator.

  • Intellectual capture

    Intellectual capture gathers several subdefinitions of non-materialist captures: cultural capture (Kwak 2013), social capture (Davidoff 2010), cognitive capture (Buiter 2008) and deep capture (Baxter 2011). Although named differently, their definitions are quite similar. They mostly refer to the regulator’s education, background, experience, networks and other social interactions that tend to create an overall proindustry paradigm.

    Three mechanisms help to explain how intellectual capture occurs: identity, status and relationships (Kwak 2013).

    • Identity: “Regulators are more likely to adopt positions advanced by people whom they perceive as being in their in-group.” This perception may be because the regulator used to work for the financial industry or because he works a lot with bankers and socially interacts with them.

    • Status: “Regulators are more likely to adopt positions advanced by people whom they perceive to be of higher status in social, economic, intellectual, or other terms.” The financial industry’s representation in media and art may be at the root of this explanation. Although discredited after the last financial crisis, the financial industry used to be associated with success and popularity.

    • Relationships: “Regulators are more likely to adopt positions advanced by people who are in their social networks.” A regulators might know a lot of financial workers because of his education, past experience and so on.

The result of these three mechanisms is that the supervisor identifies with the industry. It is a process through which the arguments of the financial industry appear to the supervisor more legitimate and trustworthy. However, it is not because he does not understand the arguments. The supervisor is more familiar with the financial industry’s concerns. He has internalized the objectives and interests of the financial industry. He understands the norms and values of the sector. He values the financial industry’s work. Hence, the supervisor is more receptive when the argument comes from the financial industry.

In addition, identification also has an impact on the supervisors’ perception of consumer advocates and other NGOs. They belong to a rival group that is not trusted. Their arguments appear less credible or even fallacious.

Despite this identification with the financial industry, working as a supervisor should also create another social identification. Identifying with the regulatory framework should contradict the identification with the financial industry and reduce its negative impacts on regulation and supervision (Dal Bó 2006). Nevertheless, regulatory agencies lack a strong institutional identity and a professional credibility. This prevents supervisors from developing a sense of belonging among the supervisors (Veltrop and de Haan 2014).

2 The Normalization of Capture

In the previous section, I define capture with a microlevel perspective. But capture is considered as one of the causes leading to the financial crisis. A microfounded phenomenon would not lead to such macrolevel consequences. Thus, capture spread like wildfire into the regulatory framework and created a totally uncontrollable chain reaction. How do we move from a captured regulator to generalized capture?

2.1 Institutionalization

Institutionalization is a process through which an isolated practice is banalized and becomes common practice in an agency (Ashforth and Anand 2003). Standardizing conduct leads to two outcomes. A normalization process rises a doubtful practice to the rank of a norm and an adaptation process impairs the regulator’s awareness of the inappropriateness of his behaviour. Either way, bad practice becomes part of the day-to-day work.

The institutionalization process is reinforced by two factors. A “permissive ethical climate” leads to a laissez-faire approach where no one in the institution really cares about ethics and integrity. A weak leadership, which has internalized these poor practices, sends a negative signal to the institution as a whole. For instance in financial supervision, revolving doors have been totally institutionalized. The practice of hiring a banker for a regulatory position is nowadays as widespread in Europe as it is in Northern America. It may be both because of a weak ethical environment and because this is common practice among senior supervisors.

2.1.1 Rationalization

Rationalization is a process through which captured supervisors tend to legitimate their act. As corrupt persons do not view themselves as corrupt (Ashforth and Anand 2003), captured supervisors may not see themselves as captured. By rationalizing, supervisors deny the impact of capture on their decisions.

Ashforth and Anand (2003) highlight eight arguments used by decision-makers to rationalize corruption. Some of these arguments can be transposed to intellectual capture (Poulain 2016):

  • the legality argument, “if it is not forbidden, it is not an issue,” concerns all practices that are not yet legislated, such as the prior tenure of supervisor in the financial industry. The absence of legislation acts as a proof of the harmless nature of their behaviour. To justify their action, they can argue that one cannot criticize supervisors for the absence of a rule.

  • the rationalization of ideologies tends to reconcile the general interest with the financial industry’s interest by negating all the negative interpretation of a regulator’s act. For instance, the argument of force used to justify revolving doors is often the need for expertise within the regulatory agencies. Another example is how a softer regulation is explained by the fact that tough supervision may hinder economic growth by weakening banks’ profitability.

  • The denial of injury consists, for the regulator, in denying that his act may have decreased the well-being or the utility of the general public. In the case of financial regulation, this argument appears quite useful as the impact of intellectual capture is pretty hard to assess (Kwak 2013).

  • The denial of responsibility occurs when a supervisor argues that he had no other choice because of “circumstances beyond [his] control such as management orders, peer pressure, dire financial straits, being deceived, existing precedent, that everyone else does it” (Ashforth and Anand 2003).

  • Refocusing attention is defined for intellectual capture quite differently from in the case of corruption. This argument consists in moving the object of discord to another issue. For instance, Villeroy de Galhau, the former banker recently named as the head of the Banque de France, attempted to prove his integrity and independence to the general public by getting rid of all his financial interests. Hence, by focusing the attention to financial interests, the original debate has shifted and intellectual capture has been totally forgotten.

2.2 Socialization

Socialization is the process that ends the cycle of normalization. It refers to the transmission of practices to newcomers. Hence, as institutionalization occurs at the macrolevel, socialization means internalizing practices at microlevel. In other words, it makes you learn how not to think outside the box.

The socialization process is effective when it combines two facts:

  • The new recruit shall be sensitive to the practices. The institution (here the agency) chooses individuals that are familiar with these practices (through previous experience, organizations, networks). Hence, these new recruits are already pre-socialized.

  • The newcomers shall be conventional rather than rebellious. Cressey (1986) argues that “White-collar criminals … should be viewed as conformists rather than as deviants.”Footnote 6 Although used to explain the spread of corruption, conformism constitutes a good explanation for the normalization of the practices inducing non-materialist capture.

This socialization is even stronger and faster if top-level management teaches newcomers these new “rules.” In addition to bond and affiliate with the senior members, they are also likely to identify with them, as they represent the hierarchy and with it success. Indeed, Zey-Ferrell et al. (1979) conclude that “perceptions of peers’ behavior had a greater impact than the respondents’ own beliefs about what constituted ethical behavior” (Ashforth and Anand 2003). This is also the conclusion of Kwak (2013):Footnote 7 “When senior New York Fed officials want their staff to go easy on Goldman Sachs they don’t even need to lift a finger. The institutional culture takes care of it for them.”

3 Are Financial Supervisors Insulated from Capture?

It is not possible to work on the psychological or sociological aspect of capture. Nor it is possible to expect the financial industry to “give up the fight.” It is part of the supervisory game. Setting proper governance practices that ensure the institution’s soundness and the supervisor’s ethical behaviour is the remaining possibility. But how far are we from this goal?

3.1 Materialist Capture

Materialist captures occur when the industry offers personal benefits to acquire the supervisor’s leniency. Such positive incentives are typically of two types: personal enrichment or carrier concerns.

  • Personal enrichment

  • Exchanging monetary favours for political support is illegal in most countries. Corruption and bribery are not allowed and are punished with all severity. In Europe, the anti-corruption package aims at implementing “a stronger monitoring and a proper implementation of existing legal instruments.” In addition, the Commission “foresees a wide range of EU-level actions to adequately tackle corruption.”Footnote 8 At international level, some policies such as the OECD Anti-Bribery Convention or the United Nations Convention against Corruption have been set up and are ratified by countries on a voluntary basis.

  • Regarding gifts and hospitality from interest groups, some restrictions (and even prohibition) are applied in most IRAs. For instance, the European Central Bank Guidelines lay down some ethical principles concerning this area. Notably, members of the Eurosystem central banks and their staff members are forbidden from “soliciting, receiving or accepting a promise related to receiving for themselves or any other person any advantage connected in any way with the performance of their official duties.”Footnote 9

  • Campaign contributions or donations from industry to political campaigns are either forbidden or highly restricted. This is for instance the case in the USA with the Political Action Committee (PAC) system. When an interest group wants to get involved in the political process, it creates a PAC. This organization collects and receives money from the members of the interest groups and provides financial support to political campaigns. These PACs are submitted to several restrictions on the level of donation per candidate, political party and even election. Private firms and trustees cannot donate to PACs.

  • Carrier concerns

  • The prospect of higher paid employment may be considered as a supervisor’s carrier concern. According to Pagliari (2012), “regulatory authorities often find in the firms they regulate and supervise the most common source of future employment.” Worker flows from the public sector to the private sector constitute part of the revolving door issue. They may be governed either by a cooling-off period that forbids the former regulator to directly seek employment in the financial industry after termination of duties or a permanent ban. The severity of the rule depends on the seniority of the supervisor. These prescriptions are, for instance, set up at the US Security and Exchange Commission. However, these policies are still not sufficient. Between 2001 and 2013, the practice among financial institutions of hiring former employees of one of six US regulatory agencies increased by 18–55 % (Shive and Forster 2016).

  • Although worthy of criticism, policies governing materialist capture are partially set-up. The existence of these prescriptions testifies that there is some beginning of recognition of the issue. However, there is still space for the improvement of regulation of regulators’ post-employment.

3.2 Non-Materialist Capture

The current legislation hardly controls the risk of non-materialist capture. Excessive social interactions may be conducted through three channels. First, the supervisory agency may want to hire a former banker. Second, the supervisory agency may organize hearings and a consultation process to benefit from financial institutions’ expertise and information. Finally, the agency may be granted with advisory commissions that are composed of representatives of the financial sector.

Again, the worker flow from the private to the public sector remains unregulated (Poulain 2016). The only prescriptions set the basic requirements regarding the regulator’s needed qualification. For instance in the USA, the Revolving Door Ban states that the regulator’s recruitment shall be based on the “qualification, competence, and experience” of individuals.Footnote 10 Consequently, a growing number of supervisors come from the financial industry. In 2009, the OECD examined the revolving doors for a set of IRAs across eight countries. Apart from one supervisor (i.e. Iceland), all IRAs have recruited their senior employees from the financial industry.

Regarding public hearings and the consultation process, a control of the symmetrical participation of the stakeholders is never provided (Poulain 2016). The survey conducted by Pagliari and Young shows that “less than 10% of the stakeholders who respond to financial regulatory consultations belong to trade unions, consumer protection groups, non-governmental organizations, or research institutions.” The financial industry lobby is well endowed. To lobby in the European Union, the financial sector employs around 1,700 lobbyists gathered into 700 organizations (Corporate Europe Observatory 2014). It is five times more than the NGOs, trade unions and consumer organizations.

Almost all the financial supervisors are granted advisory commissions and a scientific committee (Poulain 2016). However, their composition is never regulated. A recent report from Corporate Europe Observatory (2014) indicates similar results for the European Commission, where “70% of all advisors in […] expert groups had direct ties with financial industry.” Furthermore, the OECD (2015) concludes that “undue influence on the policy-making processes by vested interests is a persistent risk due to loopholes such as unbalanced representation of interests in government advisory groups.”

Denial of this issue still exists, so it is not yet part of the public debate. In the absence of “the mere recognition of the possibility of self-interest on the part of regulators” (Boot and Thakor 1993), the likelihood of any change occurring is low. This capture is highly profitable for the industry: “No one has to be paid off, no one has to break the law, and no one asks too many questions” (Kwak 2013).Footnote 11

4 The Limits of the Concept of Capture

Financial supervisors benefit from policies that insulate them from materialist capture. But the absence of prescriptions regarding non-materialist capture questions both the independence and the technocratic nature of supervisory agencies. Both constitute the pillars that supposedly motivated the creation of these institutions. Why did we let non-materialist capture reach the regulatory agencies?

While efforts have been made to prevent materialist capture in financial supervision, policies for insulating supervisors from non-materialist capture are struggling to emerge. Part of the issue lays in the difficulty in defining non-materialist capture.

When dealing with materialist capture, identifying the wrong practices and proving their existence is quite easy. It may be an exchange of favours, a monetary transfer, a recruitment. It is a tangible reality that no one can deny. Regarding the non-materialist version, either you prove the existence of an information/expertise gap between the supervisor and the industry or you demonstrate that a supervisor has identified with the industry. In both cases, the demonstration is obviously highly complex, time-consuming and even costly.

Measuring supervisory outcomes is extremely difficult. To assess the effectiveness of a regulation, one must know what the general interest is. Hence, if the regulation improves the general interest, then it is efficient and beneficial. And there is the rub. No one is actually able to define the notion of general interest. In addition, Freeman Engstrom (2012) argues that “virtually any policy position can be framed as furthering the public interest.”

Finally, there exists no tangible proof of the link between poor regulatory outcomes and the presence of capture. The demonstration of this consists of enumerating a list of scandals and other regulatory failures that occur at individual level (such as the last Fed scandal with Carmen Segarra). Besides, a lot of external factors such as adverse economic conditions may be the source of regulatory or supervisory failures. Freeman Engstrom (2012) states that “arguments about capture necessarily turn on a difficult counterfactual inquiry about what public-interested regulation would look like in capture’s absence.”

5 Concluding Remarks

Financial regulators are still struggling with regulatory capture. Although materialist capture is starting to be overseen, non-materialist capture remains ungoverned. The regulatory dilemma and the difficulty in defining non-materialist capture may be part of the explanation for the poor arrangements that have been made to control this form of capture.

These past decades, we have surreptitiously given rise to the idea that the supervisor and the financial industry belong to the same side. An individual’s belief in the institution can be much more powerful than written laws that reduce the risk of intellectual capture. If everyone has the conviction that the supervisor cannot be captured, then undue influence is less likely to occur. As stated by Freeman Engstrom (2012), “ideas can become self-fulfilling prophecies […], it is common to hear that the administrative state is bad or that too much policy gets made by a runaway or captured bureaucracy. This rhetoric has a big effect. It degrades our faith in government. It undermines civic trust.”

Hence, beyond the improvement of financial regulators’ governance practices, there is a need for the creation of a strong institution that is never challenged by the general public or by the financial industry. It is about bringing about a culture of regulation.