BANKING : FIREFIGHTING AT THE NY FED / THE FINANCIAL TIMES COMMENT & ANALYSIS

December 4, 2014 7:36 pm

Banking: Firefighting at the NY Fed

Tom Braithwaite, Gina Chon and Henny Sender

Recent leaks have renewed questions about the ‘revolving door’ between the New York Fed and Wall St

 

©Bloomberg

Former Goldman Sachs economist, pictured at a Senate banking committee hearing in November, has pledged to toughen up the New York Fed

 

 

On the evening of November 18, some of the best-known financial policy makers of the last century gathered at the headquarters of the Federal Reserve Bank of New York to mark its 100th anniversary.

 

The celebration attracted famous former New York Fed presidents, including Paul Volcker, who went on to become the inflation-slaying chairman of the central bank in Washington, Gerald Corrigan and Tim Geithner, who was in charge during the last financial crisis before moving to the US Treasury.

They assembled at a building that is a veritable fortress in lower Manhattan: 22 storeys of sandstone, on top of vaults that contain 6,700 tons of gold, protected by iron bars and shotgun-wielding police officers. The event was held at an awkward time. At no point in its history has the New York Fed faced such existential threats — a reputational challenge that threatens to diminish its fearsome power.

Looming over the festivities was a congressional hearing scheduled for later that week where Fed officials correctly predicted that they would be hauled over the coals by politicians for being too soft on the Wall Street banks they are supposed to supervise.

Fuelling the politicians’ anger were clandestine tapes from Carmen Segarra, a disgruntled New York Fed examiner, who claims she was fired after pointing out weaknesses in the supervision of Goldman Sachs. She recorded her colleagues conducting what sounds like a meek cross-examination of Goldman over a questionable 2012 transaction but Bill Dudley, New York Fed president, insisted the 10 minutes of publicised recordings were not an accurate representation of how the agency handled the matter.

 

Some in the room knew there was worse to come. The next day, the New York Times revealed that another Fed official had passed on confidential information to a junior banker at Goldman. It was an investment banker at the company who raised the alarm. The New York Fed was forced, embarrassingly, to report its own staff to the Federal Bureau of Investigation and prosecutors, who are investigating.

 

The incident was extreme but, in truth, since it was established in November 1914 the New York Fed has always had an ambiguous role.

Design fault

 The Federal Reserve System was designed to avoid a concentration of power — delegating responsibility for monetary policy, financial stability and bank supervision to 12 “reserve banks” around the country from San Francisco to Boston. But in practice, as the founders feared, the New York Fed, with Wall Street on its doorstep and unique responsibility to transact with banks to implement monetary policy, has always been the superior regional institution.

To its defenders, the New York Fed showed its mettle in the last crisis. “They were hard-working and diligent and when they didn’t know something they sought experts to help them,” said one former government official from outside the organisation.

But its decisions, taken in conjunction with officials in Washington, were contentious — above all, letting Lehman Brothers fail and rescuing AIG.

According to several participants at last month’s centennial party, the former New York Fed presidents took polite potshots at each other. Mr Volcker and Mr Corrigan noted that in spite of the turbulence in the markets during their tenures, neither resorted to taxpayer-funded bailouts. Mr Geithner, who played a big role in the AIG rescue — characterised by his critics as a “backdoor bailout” of the insurance group’s bank counterparties — said, in what some in the audience took as a pointed response, that every crisis was different.

What is widely recognised is that there was a profound lack of oversight in the run-up to the last crisis, with examiners failing to understand the risks that were building.

The recent leaks have again raised questions over whether the New York Fed is too close to the banks and if a more profound overhaul of how the US government oversees the banking system is required.

Officials who rub shoulders with bankers are not badly paid by most standards. Mr Dudley, a former Goldman economist, earned $410,780 last year, according to the Fed’s budget, while the average pay for the other 514 New York Fed officers was $225,000.

But mixing with bankers makes some yearn for the bigger pay of the private sector. Staffers often take a job at the New York Fed in the belief that background will help them eventually get hired by Wall Street, according to a former Fed official, though others dispute this suggestion. But there is certainly some questionable activity around the well-oiled revolving door between the New York Fed and Wall Street banks.

For instance, in one 2010 email, seen by the Financial Times, a New York Fed staffer sent a note to a contact at Deutsche Bank using their private account, saying: “Please see my résumé attached. Please limit its circulation and let me know before sending it to others. Thanks for your help.” The Fed official never made the move to Wall Street and is still with the central bank.

Too close for comfort

“One of the strengths of the Federal Reserve banks is their close relationship with the local banks and understanding what’s going on in the local economy,” says Oliver Ireland, a partner at law firm Morrison & Foerster and former associate general counsel of the Fed board.

“The downside is that they could become too close to the banks or be perceived to be too close. Ultimately, it’s something of a no-win situation.”

Even Mr Geithner, now a partner at private equity firm Warburg Pincus, recognises the phenomenon. In his memoir Stress Test, he wrote: “The optics of the institution’s governance are awful. The Fed has always been vulnerable to perceptions of capture by the big banks.”

The problem is structural. The New York Fed is the US government’s eyes and ears on financial markets but is more than that. It is a player itself. Officials from the New York Fed regularly meet bankers as they monitor market conditions. They also approve the applications of primary dealers, who help the New York Fed’s open markets desk implement monetary policy and process auctions of US government debt.

Even if the system is not corrupted, it suggests partners rather than adversaries. “It’s more like a fire warden to make sure the institution is run well so it doesn’t catch on fire and burn down,” Mr Dudley said of the agency’s role during the November Senate hearing. “There is an enforcement element but I don’t think our primary role as supervisors are cops on the beat.”

The assembled Democratic senators wanted more cops, pointing to several apparent recent missteps. In October, for example, the Fed’s inspector-general singled out the New York Fed as having dropped the ball before JPMorgan’s “London Whale” trading fiasco.

 

“The New York Fed is very arrogant,” says Simon Johnson, a professor at the MIT Sloan School of Management. “When you talk to them in small groups, their attitude is ‘we’ve done nothing wrong and everyone should get off our case.’ They are living in a different reality so it’s not surprising this has caught up with them.”

But both bankers and Fed officials believe the criticism is out of date. Executives say the new Fed has become too tough and fear that under political pressure it will only get tougher. “There is less regulatory capture than ever before,” says one bank executive. “There’s regulatory disdain and contempt for the banks. We’ve embarrassed them horribly.”

Dudley gets tough

In the last year, Mr Dudley and other New York Fed officials have held meetings with Wall Street executives who received a “tongue lashing” at the gatherings, according to people familiar with the encounters, particularly over rigging of foreign currency markets. “Chief executives were told that they still don’t get it and that their banks better shape up before it’s too late,” said one of those present.

But the New York Fed is suffering a loss of credibility. At least two of its own staff have shown in the last few months they are willing to divulge supervisory information, which is traditionally held to be strictly confidential: Ms Segarra in what she portrays as a just cause to show the Fed’s lax oversight of Wall Street and, allegedly, Jason Gross, who, it is claimed, passed on confidential supervisory information to a friend at Goldman. Mr Gross has been dismissed by the Fed and his lawyer refuses to comment on the case.

Part of the debate at the New York Fed is whether to release more supervisory information to impose market discipline on banks by letting investors know more about their true state — and in the process boost the Fed’s image as a responsible watchdog. The downside is that banks might be less willing to own up to shortcomings if they are to be publicised. In November, the Fed in Washington announced a sweeping review of how it will supervise the largest banks. One of the results could be even more power centralised in Washington.

But even the recent sabre-rattling of Mr Dudley does not convince some officials, who contrast it with an interchange between Mr Corrigan and John Reed, Citibank chief executive at a time when the institution was close to failure in 1990. When Mr Reed protested that he would not cut the bank’s dividend, Mr Corrigan icily replied that he would then ”have a discussion with your successor”. Mr Reed cut the dividend. One central banker says such assertiveness is inconceivable under later presidents of the New York Fed.

That process began in 2009 when Dan Tarullo, Federal Reserve governor, came on board. He immediately saw the New York Fed’s closeness to the banks it supervises as a problem, according to people familiar with his thinking. He holds his sister institution in “unambiguous contempt”, according to one person who talks to Mr Tarullo regularly.

Under Mr Tarullo, oversight — including annual stress tests — has been increasingly centralised in Washington, leading some banks to focus more on having a good relationship with the Fed in Washington than in New York.
 
The shrinking power of the New York Fed has caused tensions between the agency staff and their counterparts in Washington, some of whom are criticised for their Beltway thinking that does not include knowledge of how Wall Street actually works.

One former Fed economist, now at a Wall Street bank, laments that it is lawyers in Washington led by Mr Tarullo who call the shots. He claims they do not look at possible side-effects of tougher regulation with an economist’s eye, and are less likely to solicit the views of the New York Fed because they are not as interested in the market impact. “They just shrug,” he says. “They don’t care.”

The banks complain it has led to mixed messages. “The local teams are not always necessarily in the loop,” says another former Fed official who switched sides to the industry, who says decision making has slowed as a result. “Unless we hear it from DC we’re not going to rely on it,” he adds.

Banks are braced for even harsher treatment by the New York Fed because of the spotlight on the agency. “This is going to move the Fed to being ever more aggressive,” said one former agency official. “There has been genuine embarrassment about the continued misconduct by banks, whether it’s Libor, commodity prices or forex. And with politicians coming down on them, no one wants to look soft.”

One bill before Congress would require Senate confirmation for future presidents of the New York Fed. Presently, it is the New York Fed board that chooses the person for that position. The Fed in Washington is also expected to attract more scrutiny when Republicans take over Congress next year.

“This is not over,” says Mr Johnson. “This is a governance issue and the New York Fed has to employ the same kind of scrutiny it imposes on the banks on itself. Actually, they need to be even tougher because they’ve shown they aren’t tough enough on the banks. They need to look in the mirror.”


Additional reporting by Michael Mackenzie

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Goldman letter: Banks and watchdog move closer in a crisis

As the financial crisis raged in September 2008, Goldman Sachs and Morgan Stanley sought sanctuary from the Federal Reserve.

 

The last two big independent broker-dealers were allowed to become bank holding companies, giving them access to government liquidity that could keep them afloat.

Goldman drafted its own statement, quoting Lloyd Blankfein, chief executive, as saying: “We believe that Goldman Sachs, under Federal Reserve supervision, will be regarded as an even more secure institution.”

 

According to people familiar with the matter, Goldman then drafted another release and sent it to the New York Fed. This one was to be used as the central bank’s own statement.

How you see that incident depends on where you sit. From the investment bank it was seen as prudent to try to ensure that the transformation was seen as strengthening Goldman, not as a sign of weakness. “It was realised that it was a bit presumptuous but there was a lot of concern that the Fed’s press release could cause problems,” said one person familiar with the incident.

From the outside world, it is striking that a bank could feel comfortable even trying to put words in the mouth of its regulator. From inside the New York Fed it was viewed as an example of the overweening arrogance of Goldman. It fell to Bill Dudley, then a senior official but not yet president, to reject the overture, which he did, strongly.

But from Mr Dudley, a former Goldman economist, down to the junior investment banker at the company, who was recently fired for allegedly receiving confidential information from his old employer at the New York Fed, there is a striking amount of traffic between the two institutions.

LinkedIn shows at least 40 profiles of people who list the New York Fed and Goldman in their job history.

“The fact that there is a revolving door should be unsurprising because this does require technical expertise,” says one former government official. “The Wall Street guys are the right guys to be involved because farmers and gas station jockeys don’t have the sophistication.”

That might excuse one direction of traffic but perhaps not the other. Banks value former Fed officials to help deal with a new level of supervision and there appear to be plenty of former officials willing to be paid to help.