Good Luck with that: Getting Bank Examiners to Act

November 28th, 2008 by Andy Spero

This post greatly expands upon a comment we made about regulation in Even A Perfect Bailout Will Fail and possibly elsewhere.

Regulators as wise monkeys.

Today’s The Wall Street Journal has an article entitled, Bank Examiners Are Told to Step Up Sanctions on Lenders.

The first sentence of the article says it all: “The U.S. government’s armies of bank examiners have been ordered to be more aggressive in applying formal sanctions to financial institutions when problems are found.”

Unfortunately, ordering does not make it so, and we doubt that it will work. We’re not making a blanket condemnation here, but we’d be interested in knowing if and how the government deals with the incentive problems that we address below.

Unless the Fed, the OCC, and the OTS immediately transfer and reassign examiners, we doubt that many new issues will be found. Furthermore, if such issues are discovered, we doubt that those issues will be reported. (In this post, we’ll call such bank-related problems “issues,” and reserve the word “problem” for the dysfunctional incentives that may exist within the regulatory agencies.) Of course, there are many obvious issues that can be noticed without formal examinations and investigations.

Incentive Problems

There are, in fact, a couple of related incentive problems worth mentioning. (1) Many examiners spend many years examining only one firm. At large institutions, the examiner is usually located on the bank’s premises–possibly sharing office space, e-mail systems, and dining room privileges with bank employees and managers. (2) Many examiners seek (and gain) employment with the same financial institution that they previously examined.

We’ll briefly address the second issue first by asking: what incentive does an examiner have to take a “hard-line” by questioning the value of assets or capital reserved if it may infuriate or alienate a potential employer? (We’ll return to this issue at the end of the post, too.)

The elimination of the prospect of future employment, however, does not eliminate the incentive problem for long-time examiners. For reputational reasons, they may still lack the motivation to closely scrutinize and report issues.

Now, clearly some degree of familiarity is beneficial when examining or auditing institutions because that knowledge reduces the set-up and operating costs of performing the examination: portfolios, systems, and key personnel are all known by the repeat examiner. In addition, it becomes quite expensive for the government to move examiners and quite disruptive for examiners and their families to be periodically relocated to different institutions in possibly different regions of the country (or to travel extensively).

It is the case that certain higher-level managers are rotated, but that seems insufficient to ensure that lower-level workers will necessarily report issues of which they know. Moreover, who is more likely to discover (or be informally informed of) such issues?

Sunk Cost Fallacy

Our long-time examiner incentive problem is similar to the sunk cost fallacy that has been extensively studied by economists–including information economists–who address the question: why do managers keep investing in (seemingly obvious) losing projects?[1. There are other explanations, too. For example, we like this quote by Father Joseph Holzner, author of Paul of Tarsus,: “When a man feels the burden of guilt on his soul, he tries hard to justify himself before his own conscience and before others by increasing his false zeal, and thus he sinks yet deeper into evil.”]

There is an option-value explanation that if (exogenous) circumstances change, the poorly-performing project may become valuable; so, it is worth the cost to maintain that flexibility (and pay the equivalent of an option premium). That explanation makes the decision to invest to be very much like insurance.

The information story is different and involves adverse selection and reputation. A manager who made or who supported the initial investment may feel that his reputation is at stake and his judgment may be questioned by admitting that a project that they had picked as a winner was actually a loser (and so others may infer that the said manager is a loser, too.)