CEOs need to Improve Relations with Their Regulators Too

Leaders of major companies – not just financial firms – increasingly recognize that, especially in today’s increasingly complicated environment and complex business organizations, it can pay to develop a more positive relationship with regulators, but for this to work regulators need to be flexible too.

August 23 2012 by Thomas H. Stanton

Every week brings another report about heavy losses or possible violations of law at a major company. Regulators impose fines, sometimes pursue criminal sanctions, and pledge to take “a much more aggressive posture” against wrongdoing. Stung by reports of weakness, they bring high-profile prosecutions to prove they are doing their jobs. Many firms and their regulators seem caught in a dysfunctional relationship in which companies are strong enough to manage their regulators, but not the risks that can cost companies and their shareholders so much.

Costs are intolerably high from events such as the BP Gulf oil spill, the PG&E San Bruno gas pipeline explosion, or major fatalities at the Massey Mining Company. In each of these cases, companies marginalized regulators who might have provided feedback to help protect the companies from costly mistakes. The Deepwater Horizon Commission investigated the catastrophic BP Gulf oil spill and found that BP’s nominal drilling regulator was weak because industry wanted it that way. Post mortems on other debacles reveal similar weakness, especially, but not only, at regulators such as the SEC and CFTC that are vulnerable to politically motivated cuts in their appropriations.

The financial crisis was the most expensive example of the dynamic. Trade associations and companies such as Fannie Mae and Freddie Mac enlisted Congress to thwart their regulators. Regulators in turn fielded examiners who missed major risks and too often failed to raise the penetrating questions that might have prompted CEOs, or at least board members, to seek answers before their firms failed.

The Financial Crisis Inquiry Commission interviewed CEOs, risk officers, traders, bankers, regulators, and policymakers, among others. As a lead researcher on governance and risk management, I studied a dozen firms, four that successfully navigated the crisis and eight that went out of business or required substantial government support to stay afloat. We found that housing and other asset bubbles encouraged a race to the bottom in credit standards. Only CEOs with judgment and discipline could resist the lure of profits that so many competitors reaped from subprime mortgages, “AAA”-rated mortgage securities, and other assets whose value collapsed in the crisis. Those CEOs kept their companies alive during the crisis.

Some CEOs saw the debacle coming and belatedly turned to regulators for help. Citigroup CEO Charles Prince asked then-Treasury Secretary Henry Paulson in 2007 with respect to leveraged loans, “whether given the competitive pressures there wasn’t a role for regulators to tamp down some of the riskier practices,” and “Isn’t there something you can do to order us not to take all these risks?” But by then it was too late.

Leaders of successful firms solicited feedback continuously. While they didn’t act on all, or perhaps most, such feedback, they developed a robust understanding of their firm and its environment that otherwise might not have been possible. An official of a successful major Wall Street firm proudly told an interviewer that, “The CEO often asks my opinion on major issues,” adding, “but he asks 200 other people their opinions too.”

Even CEOs who took feedback from people inside the firm had difficulty accepting input from regulators. JPMorgan Chase navigated the crisis exceptionally well. Yet, news reports suggest that, before multibillion dollar losses recently emerged in the JPM London office, JPM may have stonewalled supervisors who were trying to get information about risks that office was taking. Lloyd Blankfein, CEO of Goldman Sachs, another firm that survived the crisis, is quoted as deriding federal examiners as people who “get their coffee, sit in their offices, and…don’t work for us.”

There is a better way. Leaders of major companies – not just financial firms – increasingly recognize that, especially in today’s increasingly complicated environment and complex business organizations, it can pay to develop a more positive relationship with regulators. CEO Edmund Clark, who successfully led TD Bank through the crisis, argues that there must be “productive working partnerships between the industry and its regulators, enabling both parties to agree in principle on what needs to be done, and on the least intrusive way in making it happen.”

For this to work, regulators must improve their game too. Supervisors need to address criticism such as that examiners engage in “checking the boxes” compliance drills without understanding real risks of the company’s business, or that there are too many examiners from multiple regulators on site without focus on the most important issues.

Improved relations with regulators are important for nonfinancial firms as well. The Deepwater Horizon Commission took testimony from CEOs of two oil companies that it considered to have superior safety records, Exxon Mobil and Shell, who called for strong capable government supervision. Exxon Mobil Chairman and CEO Rex Tillerson stated that the petroleum industry should educate supervisors on technological developments so that they can ask the right questions. Shell CEO Marvin Odum told the commission that, “The industry needs a robust, expertly staffed, and well-funded regulator that can keep pace with and augment industry’s technical expertise. A competent and nimble regulator will be able to establish and enforce the rules of the road to assure safety without stifling innovation and commercial success.”

This then is a major lesson of the financial crisis and other expensive mistakes: CEOs need to include regulators among those from whom they accept feedback. Instead of marginalizing regulators, they should call for improved quality of supervision so that, while examiners may not always have access to answers, they can at least ask important questions and contribute to the quality of the company’s decisions about risk/reward tradeoffs.

CEOs also need to conduct due diligence into the actions of their trade associations. Is the association promoting a win-win relationship with regulators or is it simply protecting its weakest members by encouraging policies that lead to lax supervision? Major firms in all sectors have become larger and more concentrated and complex and prone to unanticipated risks. Feedback from a proficient supervisor is yet another source of valuable feedback that a capable CEO cannot afford to ignore.

Thomas H. Stanton teaches at Johns Hopkins University. He served as a lead researcher on governance and risk management at the Financial Crisis Inquiry Commission and wrote Why Some Firms Thrive While Others Fail: Governance and Management Lessons from the Crisis (Oxford University Press, 2012). He holds degrees from the University of California at Davis, Yale University, and the Harvard Law School.