How “Revolving Doors” between Banks and Regulators Could Improve Oversight

When people talk about the causes of the 2007–10 global financial crisis, weak regulatory oversight is usually near the top of the list. Some argue that a key source of this weakness is regulatory capture: the allure of lucrative job opportunities at banks discourages regulators from implementing tough policies.

But a competing school of thought says that regulators in fact have an incentive to implement sophisticated regulations, in the hopes of buffing their resumes to move through the revolving door between regulatory agencies and Wall Street. Insider knowledge of complex rules could make an experienced regulator a more appealing candidate to a bank.

Research by Chicago Booth's Amit Seru, with David Lucca of the Federal Reserve Bank of New York and Francesco Trebbi of the University of British Columbia, lends credence to this “regulatory schooling” version of the revolving-door theory by analyzing migration patterns from Wall Street to regulatory agencies during economic downturns.

In order for the quid pro quo of regulatory capture to be valid, the authors reason that employment data should show less movement from regulation to private banking during downturns. That would imply that workers are staying in regulation because of a lack of opportunities in banking rather than actively seeking regulatory jobs.

Instead, the researchers find that more people are choosing to move into regulation during downturns. They construct a dataset, spanning 25 years, of 35,000 workers who have posted their resumes on a professional networking site and who currently work or previously worked at regulators of banks and thrifts: the Federal Reserve Banks, the FDIC, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, or state bank regulators.

After confirming that the net flow of workers unsurprisingly favors regulation during bad times and private-sector banking during boom times, the authors parse the push and pull factors behind the flows. They analyze the relationship between individuals’ career paths and the regulatory intensity of the agencies that employed them, determined by measuring strictness in enforcing the most severe supervisory actions, defined as terminations or suspensions of deposit insurance, cease-and-desist orders, and prompt corrective action directives.

In support of the regulatory-schooling theory, the researchers find that more workers went from banking to regulatory jobs during periods of intense regulation, perhaps seeking expertise in complex rules to improve future job prospects. The researchers also find more outflows from regulation into the private sector during these periods, implying that workers seek to cash in on their valuable knowledge of sophisticated regulations. Across states and over time, the researchers find a consistent relationship between the strictness of enforcement and the flow of workers from the banking industry to regulatory agencies and back.

Though the researchers acknowledge that enforcement activity is not a proxy for regulatory complexity, they point out that enforcement largely determines the impact of the rules, along with the nature of the rules themselves.

“This evidence is admittedly naïve to some extent,” the researchers write. Determining whether the revolving door “distorts regulatory effectiveness at a micro level or leads to regulators favoring excessive regulatory complexity remain open questions requiring more research.” But the researchers’ findings inform this debate, as well as the discussion of whether agencies should move to block or slow this revolving door between regulatory bodies and the institutions they supervise.

The researchers note that regulators face a challenge in attracting and retaining talent, which has become harder over the past 25 years. While 88% of those who started working in regulation in 1988 were still in the industry three years later, that was the case with only 64% of those who started in 2008. Using information from workers’ resumes, the authors find that those with the highest human capital, measured by education level, tend to have shorter stints in regulation because they migrate to the private sector. They caution that limiting mobility between the regulators and the regulated may exacerbate the former’s challenges in attracting and keeping the brightest minds.