'Regulatory Capture' Rears its Head in Recent Scandals

By FOXBusiness

Within the securities industry they call it “regulatory capture.”

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It’s what happens when governmental watchdog agencies charged with overseeing a given industry get too cozy with the folks they’re supposed to be watching and wind up acting on their behalf rather than those of the general public.

The scandals at brokerage firms MF Global and now Peregrine Financial Group (PFGBest) that have rocked the futures industry, as well as recent allegations that giant British investment bank Barclays (NYSE: BCS) manipulated key interest rates at the height of the financial crisis, have strengthened long-held fears that securities industry regulators are either asleep at the wheel or, worse, serving the wrong master.

After all, the memories of massive taxpayer funded bank bailouts, a deeply flawed ratings system rife with conflicts of interest and Bernard Madoff’s epic Ponzi scheme are still fresh in the minds of most retail investors.

Each of those scandals involved allegations that regulators could have and should have known that malfeasance was taking place but that they failed to step in in part because the line had somehow blurred between the regulator and the regulated.

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Among the agencies that have come under fire are the Securities and Exchange Commission, the Commodities Futures Trading Commission and more recently the National Futures Association. All three regulatory bodies have denied that regulatory capture played any role in the various scandals that have plagued the securities industry in recent years.

While the two most recent scandals involving the futures industry and global interest rate manipulation are in no way connected, the term regulatory capture has cropped up in relation to both.  And the larger message -- that the little guy doesn’t stand a chance in what is essentially a rigged game -- hasn’t been lost on investors and market analysts.

Bill O’Grady, chief market strategist at Confluence Investment Management in St. Louis, said both scandals carry the hallmarks of regulatory capture and the impact, especially on futures markets, could be devastating.

“Light Regulation is Not Necessarily Bad”

Historically the futures industry has been lightly regulated in part because the regulations are fairly clear cut. None more so than the regulation that requires futures brokerage firms to segregate their clients’ funds from any money used by the firm for it own purposes.

“Light regulation is not necessarily bad if all the lines are clear and bright,” said O’Grady. “In other words, if you do 'x' you’ll wind up in jail.”

That has always been the case with the regulation related to segregated client accounts.

“That money is sacrosanct. It doesn’t matter if the firm goes broke your money can’t be touched. That’s very simple and you don’t need a ton of regulators to maintain that promise. The whole system fails if that promise is not kept,” he said.

In the case of MF Global, which collapsed in October causing $1.6 billion in customer accounts to disappear, allegations arose that MF Global’s chief executive, Jon Corzine, a former New Jersey governor and co-head of Goldman Sachs (NYSE:GS) may have gotten preferential treatment from regulators because of his powerful background and wide political contacts.

Regulators have denied that Corzine received preferential treatment.

On Tuesday, the CFTC filed suit against PFGBest accusing it and its chief executive Russell Wasendorf of numerous charges including violation of customer fund segregation.

The allegations come at a time when American’s confidence in the banking system is already at a record-low 21%, according to a recent Gallup poll.

“The percentage of Americans saying they have a great deal or quite a lot of confidence in U.S. banks is now about half the pre-recession level of 41% recorded in June 2007,” said Dennis Jacobe, an economist who helped conduct the poll for Gallup.

In terms of investor trust, the futures industry stands to lose the most from the recent scandals. Two breaches of the segregated funds regulation in nine months is unprecedented.

Andrew Stoltmann, a Chicago attorney who specializes in securities fraud, noted that PFGBest had at least four enforcement actions filed against it prior to the current charges, including an earlier allegation of failing to segregate client funds.

“The fact that regulators, including the CFTC and the NFA, did not catch this fraud earlier despite the checked past of (PFGBest) is inexcusable, and likely the final nail in the coffin in eviscerating public trust in the commodities market” said Stoltmann.

How to Restore Trust?

Experts say that trust can only be restored if harsh punishment is meted out to violators.

“Trust of the whole industry is based on the sanctity of that segregated account. The only way for trust to be restored in individual speculators is if they see the guys who did this go to jail,” said O’Grady.

“If the exchanges don’t get on top of this real fast they are going to wind up losing their entire client base. The average retail futures broker is absolutely terrified of what happened at MFGlobal. And the fact that it happened again within the year is just deadly,” O’Grady added.

Speculation concerning regulatory capture related to interest rate manipulation is less nefarious perhaps but no less problematic.

The theory is that regulators contributed to the interest rate manipulation during the darkest days of the financial crisis by tacitly encouraging banks not to report their actual LIBOR rates. By withholding that information banks weren’t forced to reveal to the market which of them were in trouble and which weren’t.

Regulators may have felt they were helping the financial system by not revealing which banks were in trouble, which could have led to more Bear Stearns-like runs.

Nevertheless, it’s “more regulatory capture,” said O’Grady.

O’Grady, citing the lengthy Dodd-Frank financial reform bill passed last year, said additional complex regulation piled on top of old regulation will only contribute to regulatory capture.

“Good regulation is short, clear, clean and bright. You don’t need millions of pages,” he said.

The very heft of the Dodd-Frank legislation (over 2,300 pages) is proof to O’Grady that both sides – the politicians and Wall Street -- are trying to bend the rules in their favor.

“And when the rules are bent in favor of these guys it never benefits the little guy,” he said.