Sen. Elizabeth Warren recently told New York Federal Reserve President William Dudley to man up on bank enforcement, warning him that if he won't, "we need to get someone who will."
This phrasing makes it sound as if the problem with Fed oversight lies in the regulator's testosterone levels. It doesn't. The root of the problem is conflict of interest not between Mr. Dudley and his former employer, Goldman Sachs, but between the Fed's dual role as regulator and enforcer.
The Fed's responsibilities have greatly expanded since the financial crisis. Whereas the Fed used to be comfortable as a behind-the-scenes regulator, we now expect it to be a public enforcer as well. As smart and accomplished as Mr. Dudley and his minions at the New York Fed might be, the strain of grappling with the near-impossibility of doing both jobs well within the same organization is showing. Not only are regulating and enforcing two different roles, doing both together means that the Fed is inevitably required to critique its own cooking. That's a conflict that often doesn't end well.
Bank regulation requires spotting and fixing problems before bad stuff happens. It's the "fire warden" role Mr. Dudley mentioned during his Senate testimony, and it's more about the very hard work of prevention than cleaning up after the fact. The difficult and somewhat thankless nature of this role is why our heroes tend to be prosecutors and detectives who break the case and put away the bad guy, not the intelligence operatives who work the shadows to prevent catastrophe and whose victories lie in headlines that never get written.
Bank regulation is intelligence work. It requires developing an understanding of the complexities of someone else's business. In order to achieve this understanding, regulators must create relationships within organizations and build trust to get the information they need. The people best suited to spotting and controlling emerging risks faced by regulated banks often have backgrounds similar to those of the bank staffers they are charged with overseeing. That means the "revolving door" Sen. Warren derides is probably a necessary feature of sound regulation. Stopping people from going back and forth between government and industry can assure purity of purpose, but at the cost of ignorance. Regulators will be pristine, untainted, and much less effective.
Regulatory enforcement, on the other hand, is about picking up the pieces after the bank has failed or the big loss has been sustained. Enforcers figure out what went wrong, assign blame and exact punishment to shape future behavior. This requires prosecutorial skills, but much less in the way of relationships with regulated parties or real-time knowledge of what banks are doing. Enforcers typically have some time after the fact to investigate bank practices. We expect strength, integrity and punishment from our enforcers, but not necessarily intimate familiarity with banking operations.
When we house regulators and enforcers under the same roof, conflicts are bound to occur. The enforcer comes in to clean up a mess, and the purported wrongdoers protest that the agency's examiners said they were fine after reviewing their books just six months before. Then the enforcer is left to deal with questions about the regulator's performance.
Other tensions abound. Examiners tell banks, "Be candid with us, we're here to help you avoid risks." But the bank fears that any information it provides will be used against it by the enforcers. Therefore regulators and enforcers compete to set the tone of the relationship. To a post-financial-crisis Congress looking for stronger enforcement, the regulatory side looks weak.
Similar conflicts occur in other oversight settings. For example, larger banks and businesses often have both internal and external auditors. The internal auditor keeps tabs on business operations on a continuing basis, probing for and correcting accounting and control weaknesses. The outside auditor comes in less frequently to reviewing periodic financial statements and corporate records, including internal audit documentation. What happens if a company tries to outsource its internal audit function to its external auditor? The Securities and Exchange Commission regulations say this violates audit independence requirements, which are designed to avoid the conflict of interest inherent in having an external auditor audit its own internal workpapers.
Yet we allow a similar conflict to persist where banking regulation is concerned. The Fed as regulator burrows into complex bank operations to ensure that banks are identifying and controlling their risks. Then after a bad event occurs, the Fed as enforcer is supposed to swoop in and judge the aftermath, which might well include a failure of regulation.
The government treats these as competing roles to be managed, not a conflict of interest. No wonder Mr. Dudley seems confused about how to describe his role to Congress.
Mitchell Berns is a financial services litigator with Fox Rothschild LLP in New York. He is a former regulator of the Federal Home Loan Banks.