Quis custodiet ipsos custodes (after they retire)?

Nassim Taleb has a thought provoking blog on the subject of gamekeepers turned poachers at the Huffington Post. Specifically he deals with regulators who use their in-depth knowledge of government regulations to secure extremely well paid employment, helping firms sail as close to the regulatory wind as possible, upon leaving public service. At Davos last year, Taleb was approached by Alan Blinder, a former Vice Chairman of the Federal Reserve Bank, who attempted to sell him a financial product that in effect leveraged regulatory arbitrage.

Tell me if you understand the problem in its full simplicity: former regulators and public officials who were employed by the citizens to represent their best interests can use the expertise and contacts acquired on the job to benefit from glitches in the system upon joining private employment — law firms, etc.

Think about it a bit further: the more complex the regulation, the more bureaucratic the network, the more a regulator who knows the loops and glitches would benefit from it later, as his regulator edge would be a convex function of his differential knowledge. This is a franchise. (Note that this franchise is not limited to finance; the car company Toyota hired former U.S. regulators and used their “expertise” to handle investigations of its car defects).

Taleb gives some insight into why this is a serious issue. It not only allows private companies to subvert the spirit of regulations, but also skews incentives for regulators while they are still working for the state.

First, the more complicated the regulation, the more prone to arbitrages by insiders. So 2,300 pages of regulation will be a gold mine for former regulators. The incentive of a regulator is to have complex regulation.

Second, the difference between letter and spirit of regulation is harder to detect in a complex system. The point is technical, but complex environments with nonlinearities are easier to game than linear ones with a small number of variables. The same applies to the gap between legal and ethical.

Third, regulation, like drugs, has side effects, and like drugs, it can harm the patient — something in my work I call the iatrogenics (harm done by the healer). People do not mention that regulation helped promote the Value-at-Risk method of risk measurement in replacement to age-tested heuristics — these methods blew up banks.

Fourth, we need a more severe monitoring of the activities of public officials and a solution to the following conflict. In African countries, government officials get explicit bribes. In the United States they have the implicit, never mentioned, promise to go work for a bank at a later date with a sinecure offering, say $5 million a year, if they are seen favorably by the industry. And the “regulations” of such activities are easily skirted.

The financial crisis we have just lived through, and are struggling to recover from, was caused in large part by regulatory failure. These issues matter. Given that, what should we do about them?

Should regulators and other government officials be prohibited from taking up private sector employment on retirement? If not, should an internal team monitor the activities of former government employees for ethics breaches? And, if so, who will guard the guards?

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