Embedded Regulators: Superhero Robots Fighting 'Too Big to Fail'?

Supervisors monitoring firms form within can provide some big advantages, but this arrangement also presents some potential problems

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If you work at a large financial institution, Big Brother is watching a little more closely. That's the message from a Wall Street Journal article, explaining the projected growth of so-called embedded regulators. They might look like co-workers in the cafeteria, but they're really part of some government agency trying to more closely watch what you're doing. The article portrays these regulators as trying to identify unforeseen risks and shady behavior, but the potential advantage of having regulators' on the inside goes even deeper.

The Value of Having Regulators On-Site

The stated purpose is straightforward enough. Aaron Luccetti reports:

Regulators have inspected their companies for safety and soundness, financial performance and the quality of management and directors for decades. The on-site reviews are thorough and can produce friction between the bank examiners and their subjects, according to bankers and regulators. The Fed's latest how-to "Commercial Bank Examination Manual" is 1,808 pages long, and examiners have the power to "review all books and records maintained by a financial institution."

In addition to policing the rules, Fed examiners should "identify vulnerabilities in a firm early enough to head off major problems," says Daniel Tarullo, a Federal Reserve governor.

Obviously, it's easier to monitor a Wall Street firm from inside its downtown Manhattan headquarters than from a cubicle in Washington. So there's a practical reason why these "embeds" are on-site instead of regulating remotely. And while it's possible that they could overhear an interesting conversation from time-to-time in an elevator or hallway, the next financial crisis isn't likely to be averted because a trader was bragging about some dangerous new financial product he just sold to a clueless investor.

The presence of these embeds inside the firms they regulate provides a potentially much more important purpose. If a gigantic firm begins to collapse, then embeds can begin working on its resolution without the market catching on as quickly. The Federal Deposit Insurance Corporation has already mentioned embeds' presence as an important component of its effort to combat the too big to fail problem. By having regulators on-site already, panic may be avoided and a firm wound down quickly and effectively without causing a broader financial crisis.

The Danger of Having Regulators On-Site

Of course, regulators face some challenges when it comes to their embeds. Being on-site makes the revolving door just that much easier to walk through. Regulators joining the firms that they once regulated is not a new concept. Indeed, it's become common. Imagine how much easier it is for embedded regulators to take a job at the firm they regulate. After all, they see their future co-workers every day and have already developed relationships. They know the office -- their commute wouldn't even change. And the firm's management will quickly spot and try to recruit smart, talented embedded regulators who they work with frequently.

Embeds could feel even more pressure to go easy on a firm than outside regulators. If embeds aggressively pursue close adherence to the rules and become seen as the bad guy, then everyone around them every day will detest their presence. That's not a fun position to be in. But they'll also get to know the employees of these firms more closely than other regulators, and possibly develop a more sympathetic view than a true outsider would. Such relationships could also lead to lax supervision. Finally, as mentioned, if they have some aspirations to up their salaries and work for a bank, then their leniency could pay off one day.

As a result, it will be pretty tough for regulators to find the right sort of people who can thrive as embeds. They'll need extremely thick skin, almost no ability to empathize, and no interest in money. If only our robot technology was a little more advanced.

Image Credit: Lunchbox Photography/flickr