A revolving door at the Bear Stearns headquarters in New York outside the offices of global investment bank, securities trading and brokerage firm Bear, Stearns & Co. on Madison Ave on March 17, 2008 in New York. JP Morgan Chase bought Bear, Stearns & Co, for 2 USD a share, with help of 30,000 billion USD in financing of Bear, Stearns assets from the US Federal Reserve.AFP PHOTO/DON EMMERT (Photo credit should read DON EMMERT/AFP/Getty Images)

Strict Regulation Makes the Revolving Door Spin Faster

Matt Levine is a Bloomberg View columnist writing about Wall Street and the financial world.
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Here are some possible theories of the financial-regulatory revolving door:

  1. Regulators want to get higher-paying jobs at banks, so they go easy on banks to make the banks like them and hire them.
  2. Regulators want to get higher-paying jobs at banks, so they try to be diligent, fair, competent and zealous, so that the banks are impressed by them and hire them.
  3. Regulators want to get higher-paying jobs at banks, so they are hard on banks in ways that force the banks to hire lots of ex-regulators -- to understand complicated rules, say, or to work as monitors for regulatory settlements.
  4. Regulators want to get higher-paying jobs at banks, so they are hard on banks in general, hoping that the banks will hire them to just shut them up.
  5. Regulators want to get higher-paying jobs outside of banks, so they ban banks from engaging in certain activities and then quit to do those activities themselves.
  6. Regulators actually get paid more than bankers, so they have no desire to leave and all of this is irrelevant.

Theory 1 is a popular favorite, but it seems so dull and unimaginative. Like: If you have a lazy friendly regulator who doesn't make you do too much, doesn't enforce the rules too strictly, doesn't look too hard at your activities, doesn't get angry when you break the law, bakes you cookies whenever you meet ... why would you hire him? What would he do for you? The theory is, what, you'll create a good long-term incentive for his replacement? I don't know. If you have an easy regulator, you already have what you want. Why hire him away from the regulator and run the risk that his replacement will be a terror?

Theories 2 through 4 -- in whatever combination -- have always struck me as far more compelling. If you're a diligent regulator, you're at least advertising that you'd be a diligent employee too. If you write a simple rule, no one will need your expertise to interpret it. If you write a viciously complicated rule, you can bill $1,000 an hour forever to tell clients what it means. And if you're a terror, then someone somewhere will give you a million bucks a year to stop doing that and hope that your replacement is nicer.

Theories 5 and 6 strike me as unusual and/or dumb but I put them on the list for completeness. Are there others?

These are fun things to think about on first principles, but here is a absolutely delightful New York Fed staff report called "The Revolving Door and Worker Flows in Banking Regulation" that just tries to find out the actual answer. They construct a database of 35,000 current and former federal and state banking regulators, see when those people moved from the private sector to regulatory agencies and from regulators to the private sector over the last 25 years, and then compare those movements to measures of strict enforcement actions. None of this is perfect -- you can quibble with their measures of strict enforcement, and the sample of people is sort of anecdotal and very Fed-heavy -- but it's pretty interesting.

Here's the revolving-door result:

Empirically, we find a positive association between the intensity of strict actions over time and across states and the net inflows into the regulatory sector. Looking more closely at gross flows, we find that this relationship is driven by more inflows into regulatory jobs in periods of high enforcement/more intense regulatory activity. Gross outflows from the regulatory sector are, in fact, higher around periods of higher enforcement activity. We find similar patterns when we focus on cross-state variation only by including time fixed effects. This implies that the association between regulator activity and worker flows is identified even when we use variation across states and regulators and is not just capturing aggregate economic conditions. Based on the discussion above, the patterns we uncover are opposite of what would be implied by a quid pro quo story but are instead consistent with the regulatory schooling story.

That is: If regulators were going easy on banks to try to get the banks to like them and hire them ("a quid pro quo story"), then more regulators would leave for banks in times and places where they went easier on banks. But in fact more regulators leave for banks in times and places with stricter enforcement. Nonetheless, stricter enforcement is correlated with net flows from banks to regulators, which the authors take as evidence of a "regulatory schooling story": That is, high-enforcement regulation is complex, so banks want to hire former regulators and bankers want to go work for regulators to figure out the regulation.

That's basically Theory 3, that regulators make life difficult for banks so that banks have no choice but to hire former regulators. One question you might ask is, which other theories is this compatible with? Theories 2 and 4 remain totally plausible, I think; from this data you can't tell if the strict enforcement signals mostly diligence, or mostly complexity, or mostly just being annoying.

But there are other compatible theories too. In particular, the fact that during periods of strict enforcement, movement from banks to regulators picks up, much more strongly than movement from regulators to banks. This could be "regulatory schooling," where bankers go to learn the new rules. Or it could be a Trojan horse; banks infiltrating harsh regulators with their own people to try to soften the enforcement.

Or it could be just that people want to be on the winning team. When enforcement is harsh and banks are being shut down by regulators, it's no fun to be at a bank. That's when the regulators are having all the fun.

  1. I'm mostly thinking about the beautiful story of Raj Date, who left Deutsche Bank to be a consumer financial regulator, barred banks from making certain mortgages, and then left to make those mortgages himself. But arguably anyone who worked on rules restricting bank trading, and then left for a non-bank trading firm, is in a similar situation.

  2. You laugh, but someone actually said that.

  3. All of those theories, by the way, address only the door from regulator to bank. It runs the other way too -- bankers become regulators -- and that's even more complicated. As a bank, you certainly want your nicest and most pushover employees to become regulators. But what do the employees want? The regulators?

  4. John Cochrane has also written about it here.

  5. I think it's from LinkedIn: "The empirical analysis in the paper relies on a sample that is constructed using career transitions from CVs in the database of a leading social networking website for professionals."

  6. Here's the relevant table:

    [imgviz image_id:i3fEN.QL3UPo type:image]

    Higher enforcement activity leads to higher net flows from banks to regulators (columns (1) and (2)), made up of significantly higher gross flows from banks to regulators (columns (3) and (4)) but also higher gross flows from regulators to banks (columns (5) and (6)).

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matthew S Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Toby Harshaw at tharshaw@bloomberg.net