Home > finance, modeling, musing > I think I understand the revolving door problem

I think I understand the revolving door problem

October 3, 2013

I was reading this Bloomberg article about the internal risk models at JP Morgan versus Goldman Sachs, and it hit me: I too had an urge for the SEC to hire the insiders at Goldman Sachs to help them “understand risk” at every level. Why not hire a small team of Goldman Sachs experts to help the SEC combat bullshit like what happened with the London Whale?

After all, Goldman people know risk. They probably knew risk even better before 1999, when they went IPO and the partners stopped being personally liable for losses. But even now, of all the big players on the street, Goldman is known for being a few steps ahead of everyone else when it comes to a losing trade.

So it’s natural to want someone from deeply within that culture to come spread their technical risk wisdom to the other side, the regulators.

Unfortunately that’s never what actually happens. Instead of getting the technical knowledge of how to think about risk, how to model a portfolio to squirrel out black holes of mystery, the revolving door instead keeps outputting crazy freaks like Jon Corzine, who blow up firms through, ironically, taking ridiculous risks at the first opportunity.

So, why does this happen? Some possibilities:

  1. Goldman Sachs promotes crazy freaks because they make great leaders while constrained inside a disciplined culture of calculated risks, but when they get outside they go nuts. This is kind of the model of Mormon children who are finally allowed out into the world and engage in tons of sex and drugs.
  2. On the flip side, perhaps Goldman Sachs keeps the people who actually understand the technical part of risk very deep in the machine and these guys never get leave the building at all.
  3. Or maybe, people who understand risk sometimes do go through the revolving door, but they don’t share their knowledge with the other side, because their incentives have changed once they’re outside.
  4. In other words, they don’t help the regulators understand how banks lie and cheat to regulators, because they’re too busy watering down regulation so their buddies can continuously lie and cheat to regulators.

Whatever the case, for whatever reason we keep using the revolving door in hopes that someone will eventually tell us the magic that Goldman Sachs knows, but we never quite get anyone like that, and that means the the SEC and other regulators are woefully unprepared for the kind of tricks that banks have up their sleeves.

Categories: finance, modeling, musing
  1. October 3, 2013 at 7:12 am

    The way to tap Goldman’s risk management is to require all the banks to provide transparency into their current exposure details. Then, sit back and watch how Goldman adjusts its position to each bank.


  2. Recovering Banker
    October 3, 2013 at 8:31 am

    For the JPM whale, I think the SEC would have benefited more from a no-nonsense auditor. JPM established material risk-taking outside of their standard risk management processes, so the material weaknesses in controls were not a surprise. And other banks have had similar issues (e.g. UBS).


  3. Higby
    October 3, 2013 at 8:46 am

    Here is a section of Ross Levine’s paper that tries to address this problem, but I am not sure if his “Sentinel” proposal gets at the fact that you emphasize, namely, that regulators need the very expertise (however slimy) of those they wish to regulate.

    This is an important side of ‘regulatory capture’ that I have never seen discussed anywhere before. Even those recruited to staff the Sentinel will, by their socialization as Wall Streeters, remain double-agents. This is what makes ethical oath taking at the Harvard Business School so idiotic. No ritual can reverse instilled loyalties, no empty ritual will alter social ties and networks that *literally* constitute those embedded in them.


    Click to access 2012_IRF_Governance_of_Financial_Regulation.pdf

    First, the Sentinel would have the power to demand information, the expertise to evaluate that information, and both the prominence and independence to make its judgments heard. It would be difficult for policy makers to ignore the Sentinel’s views. While regulators could refute the Sentinel’s analyses and persuade policy makers to reject its recommendations, the Sentinel would provoke an informed debate.

    By breaking the monopoly that regulatory authorities too frequently haveover information and expertise, the Sentinel would enhance the analysis – and hence the design – of financial policies. Just as monopoly breeds inefficiencies in production, a monopoly on financial market and regulatory information by regulatory agencies breeds inefficiencies in the governance of financial policies.

    If the public and its representatives do not have the information and expertise to assess and challenge the decisions of the regulatory agencies, then this will hinder the effective design, implementation, and modification of financial sector policies. For example, while the Fed was aware of the destabilizing effects of its capital policies many years before the onset of the crisis, the public, Congress, and the Treasury would have found it difficult to obtain this information and discuss alternative policies with the Fed. A Sentinel would have reduced the probability that US regulatory authorities would make the types of systematic mistakes over many years that helped trigger the 2008 global financial crisis.

    Critically, although the Sentinel would not limit the de jure power of these regulatory agencies, and it would not create another agency with regulatory power, the Sentinel would force the regulators to defend their analyses, decisions, and actions. The Sentinel would promote transparency and informed debate, but it would not diminish the role or responsibilities of existing regulatory agencies in promoting the safety and soundness of the financial system.

    Second, in creating an informed, expert institution that is both independent of short-run political forces and independent of the private profit motives of financial markets, the Sentinel would push the policy debate toward focusing on the general welfare of the public and away from the narrow interests of the powerful and wealthy.

    This cannot be stressed enough. As emphasized by a vast literature, financial institutions pay virtually unlimited sums to shape financial policies, regulations, and supervisory practices to serve their private interests. As emphasized by an equally vast literature, narrow political constituencies work tirelessly on tilting the financial rules of the game so as to collect a greater share of the economy’s resources. And, as emphasized by a much smaller literature, a community influences the behavior of individuals and since regulators work closely with those in the financial services industry – and indeed sometimes come from the private sector and return to the private sector – the financial services industry exerts a subtle influence over regulators. This ‘communal’ influence on regulation is not necessarily corruption. It simply reflects the fact that humans
    are social animals that respond to their social groups.

    Thus, it is vitally important to have an independent, expert, capable, and informed group to provide an objective assessment of financial policies. Such an institution does not exist in most countries, certainly not in the USA. While the Sentinel itself is imperfect, it is an improvement; it would help induce authorities to focus more on the public interest in selecting, implementing, and reforming financial policies.

    The Governance of Financial Regulation
    © 2011 The Author International Review of Finance © International Review of Finance Ltd. 2011 page 53


  4. Abe Kohen
    October 3, 2013 at 9:29 am

    Cathy, I am not aware of the SEC hiring too many traders, quants or risk managers. Friends have told me that to get a job at the SEC one applies online, waits 6-8 months to hear back from them – if at all – and perhaps gets an interview. The SEC has too many lawyers and too few domain experts. It’s not risk people not wanting to share. It’s lawyers protecting their turf. As for “auditors,” they are a joke. Straight out of school with no real finance background, or even older auditors nodding their heads. No chance of catching a Madoff or even noticing a Texas hedge (or even knowing what a Texas hedge is – two trades in the SAME direction – doubling up – not hedging). Is there a solution? Have a regulatory agency run by domain experts, not by lawyers looking to make 7 figures when they join a Wall Street firm in trouble as Chief Compliance Officer. Chances of that happening? Close to zero.


    • Tim
      October 3, 2013 at 5:29 pm

      I have to agree. I’m a US military veteran who went to Wall Street and moved to official Washington post-crisis to try and help. Logically, I figured people would be beating down my office door looking to exploit my skill set. But the opposite happened — cold shoulder. There are way too many bureaucrats here hell-bent on protecting their rice bowl even if the country suffers for it. They were civilians who cared more about a steady paycheck than service and glory. And if you’re in the government working first and foremost for the steady paycheck, it need hardly be said what a loser you are.


  5. Gordon Henderson
    October 3, 2013 at 9:50 am

    Why is this an issue for regulators at all? JPM put on a series of trades that lost money. Their internal reporting protocols were flawed, and as a result, senior management might have misled investors through their public statements, but beyond that? The loss was absorbed by shareholders, which is what’s supposed to happen, no? So what’s the regulatory issue?


  6. tdhawkes
    October 3, 2013 at 10:20 am

    It sounds like you are describing a casino, which is what our economy has become.


  7. October 3, 2013 at 10:26 am

    As you’ve noted in other contexts, the problem is the system and is not going to be fixed by a few people.

    There are some people who have left Wall Street who do “get it”. Gary Gensler seems to be one. Rick Bookstaber another (I highly recommend his book “Demon of our Own Design”)

    Even at Gensler’s level, a few such people are clearly not enough to change the system. He did some useful things but ultimately got marginalized and stymied.

    Robert Rubin is another GS alum. I don’t think his problem was (or is) a lack of technical understanding of the way markets work or risk. But he is intellectually captured by the idea that markets work and is blind to the scuzziness. His self-image / self-interest won’t let him accept the possibility that his actions or those of people like him can have such awful consequences.

    Obviously, it would be good to have people with a deep understanding of the markets. But mostly the regulators need to be designing systems that are robust enough that the whole house of cards won’t collapse even when the inevitable gaming and screw-ups occur. They need to understand the meta-problems, not the details.

    Of course, that’s not likely to happen until the political system is overhauled.


    • Higby
      October 3, 2013 at 1:01 pm

      This illustrates the problem — homogeneity of personnel flows: same social-class, same schools, same culture. Moving from one-side of the revolving door to the other changes nothing; professionalization/socialization predominates.

      This opens up a wider discussion of the role of the professionalizing project in organizational isomorphism, and why ethics has become such a problem in the face of isomorphic pressures (DiMaggio and Powell, 1983). Remember the Dilbert cartoon, where Alice hit a Harvard MBA so hard in retribution for the financial collapse, that all the MBAs would feel it? Good example.


    • Abe Kohen
      October 3, 2013 at 2:03 pm

      Actually, the devil’s in the details. Most regulators understand neither the “meta-problems,” nor the details. And regulators don’t design systems. They propose rules meant to reign in the system. You regulate too much in one direction and it’s unfair to customers. You regulate too much in the other direction and it’s unfair to the sell-side. It’s a balancing act, and without the domain knowledge the errors are bound to abound.


  8. mathematrucker
    October 3, 2013 at 12:35 pm

    Playing LDS community’s advocate for a second, you did at least cover yourself a bit by saying “the model of” Mormon children. However, the hypothesis that Mormon childhoods are in general so straitjacketed that, at a significantly greater rate than non-LDS children, Mormons become obsessed with sex and drugs the moment they leave the nest, just doesn’t pass my smell test. Admittedly I haven’t looked at any numbers, but to me the assertion sounds likely to be as mythical as Mormonism itself.


  9. October 3, 2013 at 2:29 pm

    Yes, the devils in the details but we could make big strides forward in simple ways:

    1) Merge SEC and CFTC (I know, everyone will say it’ll never get through Congress, but if we restrict ourselves to measures likely to get through Congress, …

    2) Limit leverage, Increase capital requirements about 5X.
    (This doesn’t need to get through Congress, I think the Fed could do it themselves). BUT, it should apply to all systemic institutions, not just banks.

    Mathbabe will note that they will use derivatives to undermine item 2.

    So, regulators do need some domain knowledge to work to prevent that. But, you do not need to have worked on Wall Street to be able to understand it.


    • Abe Kohen
      October 3, 2013 at 3:22 pm

      Josh, bureaucracies never shrink. They just grow. Neither the SEC, nor the CFTC will give up what they consider theirs. Does anyone think that S&P500 Index futures should be regulated by the same people who regulate cotton and hog futures? No, but that’s the way it is. Wish it would change, but I think hell will freeze over before that happens.

      As for leverage, I suggest you check out Tom Brown’s bankstocks.com. He says that increased capital requirements have no impact when the shit hits the fan and there is a run on a stock, such as with Bear F’n Stearns or Lehman Brothers. You may not agree with a lot of what Tom writes, but he makes a convincing argument about how increased leverage would not have helped.

      You don’t need to be a math PhD to know about polynomials, but you certainly would have little understanding of some of the things Cathy knows. Same with regulators with no Wall Street experience. You can read Graham & Dodd or Grinold & Kahn or Bodie, Kane & Marcus or Hull and still have no clue about how a trading desk operates.


  10. Josh
    October 3, 2013 at 3:26 pm

    Cool, another Josh.

    So many things to write about this one, but I’ll content myself with some short comments around the magic that is Goldman.
    (1) the performance of their alumni is generally not spectacular outside Goldman. While they remain just as smart and ambitious as inside, it seems they miss the organizational set-up that apparently causes (the right) information to flow (in the right ways). Also, they lose the network effect of working intensely with a collection of similar people doing, you know, God’s work.

    (2) Maybe they have been lucky. There have been a couple of times that the firm has just barely dodged an existential threat. To take a recent example, GS (and MS) were probably 2 days (plus or minus) away from following Lehman down the tubes. Did it help that an alum was US Treasury secretary at the time? Maybe you make your own luck . . . but, of course, they don’t always have a lock on the top policy jobs, so if the financial crisis had hit earlier or later, they probably wouldn’t have had that advantage.

    (3) Why do they still have clients who follow their advice? This is the one that I just can’t get. Sure, I’m happy to listen to what they have to say, but it is always front-and-center that they are an adversary with their own interests at heart.

    As an aside, will the “God’s work” quip ever get old? I don’t think so, and I intend to teach it to my children once they’ve started to appreciate sarcasm and irony. Wouldn’t want them to start using it earnestly.


    • October 3, 2013 at 3:28 pm

      Holy shit you’re right. I can’t believe I don’t use that phrase every time I steal my kids’ french fries off their plates.


  11. FogOfWar
    October 3, 2013 at 3:28 pm

    Think you’re being much too cynical here. Work in gov’t for a significant portion of time and you’ll run across “revolving door” people who in fact take their jobs at the government every bit as seriously as they took their jobs when they work at the private sector, and apply their skills to help the government craft and implement fair and effective rules.

    The trick is how to get those people to do the good work they do without those who go to government service for cronyistic reasons.



  12. October 3, 2013 at 10:38 pm

    I agree with one of the comments above the SEC is bass ackwards with having a lawyer at the the helm, as things will never improve as they need a sharp shooter at the top and it shows. If you ever saw the PBS documentary called “The Untouchables” DOJ Lanny just wreaked of insecurity as he didn’t know what to do, where to look and how to use any forms of technology with investigating the banks and just kind of sat there and whined. Just my opinion but his voice and body language said it all so a bunch more like this is not doing much at all. He just whined….nobody likes that.


  13. Mark
    October 7, 2013 at 12:22 am

    It will always be true that industry people will have some of the most useful knowledge for the government trying to serve the common good. Whether they are really incentivized to share that knowledge such that common good is truly served is another question, although there are good people in every industry who might step up. The problem is the fact that the campaign financing for polticians is aggregated and then routed through the hands of lobbyists, so that they are not just delivering ideas and analysis, but they are also making the politicians very existance possible. This ensures that the incentives are wrong. Get money out of politics.


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