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Capture and the Financial Crisis: An Elephant forcing a rethink of Corruption?

By Kaufmann | November 3, 2008 3 Comments »

Mushrooming analysis of the determinants of the financial crisis are all over the web.  They range from simplistic and blanket accusations of the ‘greed’ of the market capitalism to the arcane technical explanation of a misguided regulatory covenant on the other.  And the spectrum in between is crowded, including the misstep by Treasury Secretary Paulson in letting Lehman fail that fateful weekend.

When all is said and done, some consensus may emerge about which particular combination of a few fundamental factors, coupled with recent policy and oversight failure, were the culprits.  I am not weighing in now on what the precise ingredients of such debacle were.  Instead, I want to focus on one factor that has often been kept under wraps:  the regulatory and policy capture by vested interests.  This has been years in the making.  And we have been researching and measuring the notion of capture for a decade, and providing some general warning.  A frank and open debate about this issue, grounded on sound analytics and data, is overdue…

Let us fast forward first, so to concretely illustrate.  We are told now by the Wall Street Journal and CBS that in recent years, Freddie Mac and Fannie Mae spent millions of dollars lobbying some influential members of congress, in exchange for, among others, lax capital reserve requirements for these mortgage dinosaurs.  More generally, thanks to their lobbying prowess, over the years these obsolete institutions had become virtually untouchable behemoths.  In some past administrations, a few high level Treasury officials had grasped how dangerous these anachronistic institutions were, but could do nothing about it.  A classic case of capture.

Consider next the ‘small’ derivatives unit of AIG, headed by Joe Cassano, conveniently located in London so to ensure particularly lax oversight over the dubious accounting and disclosure practices evidently abetted by its chief (and even possibly by AIG’s own CEO).  Upside benefit with no downside risk to the Wall St. executiveAway from oversight, and loath to disclose their actual financial situation, this unit of less than 400 staff spearheaded hyper-risky financial derivatives which practically brought down the AIG’s empire of over 100,000 employees in 130 countries, and possibly with it, the world’s financial system as we used to know it.

The confident arrogance of these AIG principals (who were taking immense systemic and social risks while maximizing their own benefits at little private risk to themselves), was the result of a de facto regulatory capture by the all-mighty firm.  They could engage in virtually any financial ‘engineering’ they wished, including insuring exotic and junk CDOs, without oversight, and with total disregard for basic standards of accurate financial disclosure to analysts, shareholders and prospective investors.  And the short term profit and bonuses for the principals were stratospheric.  As stratopheric is now the cost to the public, gone global.

seeing red: downside risk was passed on the public

Slight rewind to April 2004 for one more telling instance of capture.  A riveting account of what happened in basement meeting in Wall Street only appeared last month in the New York Times. That meeting took place four years earlier at the Securities and Exchange Commission (SEC), when the five largest investment banks had put their collective weight to persuade the SEC to allow them to relax regulatory restrictions they (and other such financial institutions) faced in taking on much larger amounts of debt.  The meeting before the five SEC commissioners (one of whom asked skeptical questions but was rebuffed) was sparsely attended, and went unreported in the media.  It lasted 55 minutes.

The SEC decision was to relax such debt constraints on this group of large investment banks, but to subject them to a modicum of oversight.  Yet subsequently, and up to the current crisis, there was no real oversight either.  The SEC did not even staff such oversight unit properly, and up to recent months the SEC leadership was on the record suggesting that the banks were adequately capitalized, and that they could essentially oversee themselves.

Enter now the problematic field of study of corruption, which has many challenges nowadays.  One of them is having underplayed for too long the study of misgovernance in the financial sector.  But briefly about the basics first: the way corruption is traditionally defined in this area of research is flawed, and its approach to measurement also requires further scrutiny.  The interpretation of the traditional definition of  “abuse of public office for private gain” is often ‘legally’ biased towards unearthing evidence that an egregious illegal act has been committed, and, further, it is biased towards pointing a finger at a public official as the main culprit.

I thought this definition was inadequate years ago, when we were quietly writing about it (e.g. research papers such as ‘Legal Corruption’).  The incipient evidence from the current mammoth financial provides more dramatic evidence than any paper anybody may have written.

Many poor lost out, worldwide

As we wrote some time ago, the focus on corruption needs to move away from exclusive focus on the ‘abuse of public office’ and squarely acknowledge that corruption often involves collusion between the public and private (and at times outright capture by the private potentates).  Further, corruption ought to also encompass some acts that may be legal in a strict narrow sense, but where the rules of the game and the state laws, policies, regulations and institutions may have been shaped in part by undue influence of certain vested interests for their own private benefit (and not for the benefit of the public at large).  It may not be strictly illegal, but unethical and extra-legal.  This undue influence by private vested interests on the state sector may, or may not, involve the exchange of a bribe or, depending on the country’s laws, another illegal act.

Therefore, it makes sense to have a neutral and broader definition of corruption, akin to: “the privatization of public policy”.  In addition of being a legally neutral definition, it moves beyond coarse manifestations of bureaucratic bribery, and it would encompass undue influence or capture of regulations and policies by narrow interests.

Would this view of corruption change the measurement of how countries rate on corruption?:

Absolutely.

Let us take the case of the United States.  Over the past few years, traditional measures of corruption, such as Transparency International CPI, have placed the US at about the 10th percentile, currently in fact ranking as the 18th among the 180 rated countries.  By stark contrast, when we calculated an index that only focused on ‘legally corrupt’ manifestations (undue influence through political finance, powerful firms influencing politicians and policy-making), the US rated in the bottom half among over 100 countries where businesses were surveyed!

Capture as Corruption

In our estimates, countries like the Netherlands, Norway, Denmark and Finland scored highly on the extent of corporate legal corruption and undue influence (1st to 4th, respectively, among the 104 countries rated).  By contrast, the US rated in 53rd place, Russia was 74th, and Italy 47th.  Chile was rated 18th, well above the US on this particular legal corruption dimension, and so were countries like Botswana, Colombia and South Africa, which also rated well above the US.  Conversely, Argentina and Venezuela rated much worse than the US.  This data is from four years ago (the same variables are not available more recently), but typically such ratings do not improve dramatically unless there is a major political change and decisive reforms. The data is here (go to 2nd tab ordering by Corporate Legal corruption).

[Postcript: :  this here an article on this issue that was written for Forbes shortly thereafter, and the theme of legal corruption and capture also featured in my farewell presentation (here) at the World Bank in early December 2008].

Topics: capture, Corruption, financial crisis, G-20, Measurement Frontiers, Public Financial Management, Public-Private Linkages, Regulation & Security, Rule of Law, Transparency | | 3 Comments

3 Responses to “Capture and the Financial Crisis: An Elephant forcing a rethink of Corruption?”

  1. Boyd Reid Says:
    December 5th, 2008 at 3:54 am

    You have made a very strong case for the widening of the definition of corruption beyond “abuse of public office for private gain”.

    Transparency International (TI) did this some time ago with “the misuse of entrusted power for private gain” (http://www.transparency.org/news_room/faq/corruption_faq).

    This, I think, covers the governance capture that you describe so well as well as all instances, in both the public and private sectors, where a person abuses his or her position for private gain. So it would cover the case of Enron, for example.

    TI’s CPI, because is solely concerned with the perception of corruption on the part of public officials, is inadequate and at times misleading.

    TI’s corruption measuring needs to catch up with its broader definition.

  2. Hari Mulukutla Says:
    December 10th, 2009 at 5:29 am

    Great Article and points, Mr. Kaufmann. Its about time the definitions are broadened and large institutions stopped behaving like ostriches. I bet your measurement of corruption and perception of it in countries will change even more dramatically if you include geo-political and socio-economic corruption such as invading countries for oil under the pretext of WMDs ! Where will the US and other allies rate then? Luckily for us we have regime change here in the US. We need fundamental, substantive and unbiased work to define corruption across various sectors globally and clearly communicate its tragic effects and include this in the measurements. TI has showed how it can be done. Now it needs to be broadened as you say.

  3. On Corruption, Agency Capture and Forest Service Experience « A New Century of Forest Planning Says:
    April 26th, 2011 at 3:36 pm

    [...] more traditionally narrow framing as bribes, kickbacks, direct money payoffs, etc. In a post titled Capture and the Financial Crisis: An Elephant forcing a rethink of Corruption, Kaufmann says, it makes sense to have a neutral and broader definition of corruption, akin to: [...]

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