Tuesday, September 30, 2014

The New York Fed: A Case of Regulatory Capture

According to The Wall Street Journal, a study sponsored by the Federal Reserve Bank of New York in 2009 uncovered “a culture of suppression that discouraged regulatory staffers from voicing worries about the banks they supervised.”[1] Whereas the report points to excessive risk aversion and group-think as the underlying problems, a fuller explanation is possible—one with clear implications for public policy.

The New York Fed is the primary regulator of many large financial institutions; this regulatory power is increased under the Dodd-Frank financial reform law of 2010. Put another way, the American public relies heavily on that Fed in keeping the sort of massive credit-freeze that happened in September of 2008 from happening again. Therefore, something like regulatory capture, wherein regulators of an agency have been “captured” by the regulated institutions, would heap mounds of systemic risk on a given financial system.

Unfortunately, Carmen Segarra, a former examiner at the New York Fed, released tapes in 2014 catching regulators going soft on the banks presumably being regulated. In fact, she claims she was fired in 2012 for “refusing to overlook Goldman’s lack of a conflict of interest policy and other questionable practices that should have brought tougher regulatory scrutiny.”[2] Generally speaking, her tapes make the central bank look “deferential and ineffectual, and apparently concerned above all with accommodating the banks it [is] supposed to regulate.”[3] This has regulatory capture written all over it.

As easy as it is to point to Fed staffers seeking to cash in by being soft on a regulated bank now in order to get a high-paying job at it later, that Segarra’s superiors had her change meeting minutes she had taken to eliminate a Goldman Sachs executive’s statement that “once clients become wealthy enough, certain consumer laws [don’t] apply to them.[4] To be sure, the executive was correct; wealthy individuals can qualify with the S.E.C. as accredited investors. Even so, that the New York Fed went to the trouble of eliminating the executive’s comment from the record—as well as dissuading Segarra from pressing the banker on his statement—may suggest that the light treatment comes from the top.

New York Fed President Stephen Friedman sat on Goldman’s board and had a large holding in the bank’s stock even though such a financial relationship violates Federal Reserve policy. William Dudley, the next president, had been a partner at Goldman Sachs. Moreover, the bank had given the Obama ’08 campaign $1 million—the largest single donation received. All of this points to why institutional (or structural) conflicts of interest are inherently unethical, as well as dangerous to a republic.

During a press conference in 2014, President Obama notably included himself in saying that no one in Washington is clean; the amounts needed to mount a successful electoral campaign mean that every elected officeholder is beholden to powerful interests that are regulated. This may explain why the president caved on a public option in his health-insurance reform that would be known as the Affordable Care Act. Similarly, he acted contrary to former Fed chair Paul Volker's recommendation that the Dodd-Frank legislation include a provision that would break up the largest banks on account of their systemic risk to the entire financial system and economy. Being beholden to wealthy interests in the status quo makes a mockery of anything resembling "real change."

So the White House may have been putting pressure on the New York Fed presidents who would have been inclined anyway to go easy on the banks as regulators. If Barak Obama is correct, then at least part of a solution is either mandatory public funding of campaigns or mandating that use of the public air-waves obliges television and radio companies to have plenty of free ad time for candidates before an election. The problem of the revolving door would still need to be dealt with, but at least the officials with tremendous regulatory discretion would not feel obliged to pay back the regulated instead of demanding more vigorous scrutiny.

[1] Pedro N. Da Costa, “N.Y. Fed Staff Afraid to Speak Up, Secret Review Found,” The Wall Street Journal, September 28, 2014.
[2] Sam Levine, “Elizabeth Warren Calls for Investigation of NY Fed Over Secret Tapes,” The Huffington Post, September 28, 2014.
[3] Ben Walsh, “The Fed Is Even Afraid to Ask Goldman Sachs the Easy Questions,” The Huffington Post, September 30, 2014.
[4] Levine, “Elizabeth Warren.”