The 2008 housing crisis led to a record number of home foreclosures. In response, millions of Americans demanded accountability from financial markets. To some, the crisis served as proof of the dangers of unfettered capitalism and the need for more government regulation.

The post-crisis era gave rise to the popular sentiment that government needed to reduce the influence of “too big to fail” banks. (This moniker was based on the belief that some banks are so large that their collapse would jeopardize the entire economy, necessitating government intervention.) However, the relationship between government regulation and “too big to fail” presents an excellent case study on the dangers of regulatory capture.

The U.S. banking sector demonstrates how the regulatory process can produce unfavorable outcomes. After the 2008 financial crisis led to a massive government bailout of U.S. banks, lawmakers expanded their regulatory oversight. Dodd-Frank was instituted in 2009 to address the systemic risk of large banks. Since then, this 22,000-page regulation has crushed small banks in compliance costs, incentivizing merges and exacerbating “too big to fail”. Ironically, the laws and regulations aimed at reducing the influence of big banks made them more powerful. Big banks are bigger than ever, and community banks are quickly disappearing.

Ideally, government regulation should encourage desirable industry behaviors while protecting the public interest. In reality, government regulators are limited by information. The knowledge required to regulate all industries is impossible to gather due to the transaction costs associated with obtaining and disseminating information. Understandably, the federal government does not know the ends and outs of every industry.

In banking, the people with the specialized knowledge required to navigate and regulate financial markets are often bank compliance officers and current regulators. This means the people most qualified to regulate banks for the government are often former or current bank employees. Similarly, former government regulators are ideal candidates to become regulatory compliance officers in the private sector. This manifests in a revolving door of experts moving between the public and private sectors, which creates the perception – if not the evidence – of corruption.

To be clear, this regulatory process is not unique to the finance sector, but it does illustrate a core limitation of the government’s rules-making process. To avoid implementing harmful regulations that could worsen the problem being addressed, the government relies on private sector expertise. This information is dispersed and constantly changing, leaving the government with little choice but to engage industry leaders. However, these agenda-driven stakeholders usually have little to no obligation to protect the public interest.

This phenomenon creates a regulatory catch-22. In order to effectively govern, stakeholders need a seat at the table. However, individual stakeholders have agendas that may not align with the interest of the general public. Furthermore, individual stakeholders such as corporations and lobbyists may have more incentive to participate in the process than the general public.

In addition to this conflict of interest, the current regulatory process encourages rent seeking – corporations lobbying government for special benefits and protections. This usually benefits big corporations that are able to dedicate resources (e.g., hire lobbyists) to influence the rules-making process. Predictably, government regulation tends to tilt the competitive playing field in favor of big business.

Public choice theory recognizes that the process of government regulation often presents stakeholders with an array of incentives, disincentives and perverse incentives that can exacerbate the problem being addressed. These problems can often lead to what is known as regulatory capture. Regulatory capture occurs when special interests gain significant influence over public regulatory agencies and their implementation of policy.

The total effect of regulation on the economy varies across industries, regulatory scope and the level of enforcement. However, the effects on the U.S. banking system have become clear. As community banks suffer, big banks are defending the regulations that helped kill off their competition; likewise, the politicians they captured are doing the same.  Recognizing the limitations of government regulation isn’t reason enough to abolish the state’s regulatory authority. However, it is reason to be skeptical of policymakers and proposals that claim to protect citizens from the harmful influence of big business.

Dodd Frank exacerbated “too big to fail” and made thousands of community banks “too small to survive”. A bipartisan group of lawmakers in the House and Senate have introduced legislation to reign in these overreaching regulations. If successful, reforms could slow the trend of consolidation and allow for a more competitive banking sector.