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Monday, February 4, 2013

Fixing the Foreclosing Banks: A Hidden Conflict of Interest in Regulatory Compliance

After the financial crisis of 2008, regulators in the U.S. ordered banks to hire consultants to implement more than 130 “enforcement actions,” which represent 15% of the cases. In 2011 alone, regulators mandated that eleven banks hire consultants to determine whether mortgage borrowers had been wrongfully evicted. The consultants collected about $2 billion in fees, which amount to more than half of what homeowners were to receive under the $8.5 billion settlement that ended the consultants’ work. According to regulators, the consultants’ work was plagued with inefficiencies. This is probably the least of it, for virtually any expectations for “an industry that is paid billions of dollars by the same banks it is expected to police” are bound to be chimerical in nature.
When the Office of the Comptroller of the Currency penalized JP Morgan Chase in early 2013 for flaws in the bank’s money-laundering controls, the regulator ordered the bank to hire a consultant with “specialized experience” in money laundering and without any conflict of interest. Yet with the bank hiring the consultant, a conflict of interest is thereby incurred.  “How can you be independent if you’re hired by the entity you’re reviewing?” Senator Jack Reed, Democrat of Rhode Island, asked. According to the New York Times, some “banks that work with consultants continue to run afoul of the law. At other times, consultants underestimate the extent of the misdeeds or facilitate them, preventing regulators from holding institutions accountable.” In other words, the bankers who hire the consultants must have the sense that their banks can continue to get away with the bad practices. Meanwhile, the consultants have a disincentive—from having been hired by the banks—in finding the hands that are feeding them at all culpable.
Besides the conflict of interest simply in being hired and paid by the banks, some of the consultants tolerated a conflict of interest in terms of connections. For example, in spite of the comptroller’s office insisting that its staff had vetted the consultants to spot conflicts of interest (an approach that implicitly ignores the conflict of interest in the banks hiring and paying the consultants!), Deloitte, which was allowed to be hired by JPMorgan, had previously audited Washington Mutual and Bear Stearns. JP Morgan had acquired those two firms during the financial crisis. When HSBC was sanctioned in 2003 regarding its money-laundering controls, the bank hired Deloitte to review compliance. Unfortunately, Deloitte had also worked for HSBC from 2006 to 2008 to build a system to monitor money flows more effectively. Deloitte could hardly be an objective critique of the system that it had instituted. That Deloitte has been suspected of helping institutions cloak illicit transfers of money to rogue nations suggests that the comptroller’s office did not exactly perform due diligence in obviating potential conflicts of interest.
Lest it be assumed that the operative conflict of interest is limited to previous roles or even a bad track record, Sen. Reed’s question bears particular emphasis: “How can you be independent if you’re hired by the entity you’re reviewing?” Astonishingly, this perceptive question effectively discredits the entire public accounting industry, for CPA firms are hired and paid by the companies that the CPAs independently audit.  Sen. Reed’s question says, in effect, that the audits cannot be independent under the system as it is designed. In other words, the system itself is problematic, so something stronger than reform is needed if the deep conflict of interest is to be eradicated from the roots up.
In pointing to the faulty job of the office of the comptroller in spotting conflicts of interest, my intent was to make the point that we are not very good at spotting institutional conflicts of interest. The “biggie” right in front of us goes virtually unnoticed and the CPA industry is presumed to have been fixed. Doubtless we will be surprised the next time a CPA firm’s audit is found to be too “friendly” or even enabling at the expense of the public’s interest. We tend to go from incident to incident, totally missing fundamental structural flaws in business and government. It is as though we were accustomed to looking only a little distance ahead while driving. No one is tasked specifically even with making systemic or structural conflicts of interest transparent, let alone with fixing them.


 Jessica Silver-Greenberg and Ben Protess, “Doubt Is Cast on Firms Hired to Help Banks,” The New York Times, January 31, 2013.