This American Life’s broadcast of recordings made by a former New York Fed employee has generated a wave of interest in the issue of regulatory capture of the Fed, a sort of “Stockholm Syndrome” that affects regulators who identify with the businesses that they regulate, in this case the big banks. Regulatory capture affects many agencies and is particularly concerning in light of the power of big banks, the potential for harm if oversight fails and the physical location of supervisors in the offices of the banks.
Beyond the issues raised in the broadcast, there are other, far more important structural issues of independence that we have written about several times before. One is tempted to say that the financial sector does not need to capture the New York Fed. It already “owns” it.
It is important to distinguish the Fed Board of Governors and the Washington staff from the New York Fed. The twelve regional Feds are separate entities, and the most important is the one in New York because it is at the epicenter of the industry. The regional Feds are not governmental entities. In fact they are not “regulators” in the sense of the SEC or the Food and Drug Administration. The regional Feds do not report to a government official or agency. Majorities of their boards are chosen by the member banks themselves. Here is how the New York Fed Board breaks down.
Of course, the practitioner members have disproportional influence because of their superior information and expertise. And the business representatives must be sympathetic to the banks which elected them. It is not difficult to imagine how debates inside the New York Fed board play out.
The current president of the New York Fed is William Dudley, a former Partner and Managing Director of Goldman Sachs. As President of the New York Fed, he is a voting member of the Fed’s Open Markets Committee that controls monetary policy.
If New York Fed employees identify too closely with the big banks, should it be a surprise? Actually, it is remarkable that they manage to maintain any sort of independence at all, and the recordings demonstrate that they often try to do the right thing.
President Dudley had this to say about the current controversy: “I completely stand behind the integrity and work of our supervision staff. They are operating completely in the public interest.” The real question is how the New York Fed and its president view the “public interest,” given that the institution is constitutionally embedded in the banking system itself. It is ever so easy for a former Goldman partner and an organization that is a creature of the banking system to conflate what is good for the banks with what is good for the USA.
How important is the New York Fed.? As we have seen, it provides the daily oversight of all of the New York Banks, embedding observers in their offices. Its staff forms the first line of defense against panics arising from risky bank behavior.
In addition, it is unquestionably at the table when matters concerning the financial system are dealt with. Remember the meetings that dealt with the collapse of Lehman Brothers and AIG and eventually the bailout of the system. The public’s interest were represented by Treasury Secretary Hank Paulson, Fed Board Chairman Ben Bernake and New York Fed President Tim Geithner. Of these, Geithner had access to the information about the banks that were collapsing or teetering on collapse, to the extent there was any.
The New York Fed is massively important to the integrity of the financial system. It is a key factor in the system’s safety and soundness. It also influences whether the system works in the public’s interest or only its own. It cannot be made independent by internal programs to encourage open debate. Only an institutional change can accomplish that.
Senators Warren and Brown have called for an investigation in response to the recordings. Hopefully, their investigation will not be limited to those specific events, but will go to the real issue: not regulatory capture but “regulation” by the regulated industry itself.