After Years of Incompetence, the New York Fed Is Losing Power to Washington

If you ranked all of government's financial regulators on how they handled Wall Street's crime wave during the Great Recession and its aftermath, most of them would wind up tied for last place. But then just under them would be the New York Federal Reserve.

This is the agency Tim Geithner ran during the Bush Administration. It's the one that missed the housing bubble, bailed out AIG, and made sure all of the mega-banks owed money on credit default swaps got paid out at 100 percent. This is the agency a former employee named Carmen Segarra secretly taped to show how officials there rolled over for Goldman Sachs after finding evidence of potential wrongdoing. It's the one that learned about JPMorgan Chase's risky practices in the office that made the catastrophic "London Whale" trade four years before that blew up, and did absolutely nothing to investigate or put a stop to them. It's the one that got early reports of the Libor scandal , the largest rigging of interest rates in world history (literally, a trader at Barclays Bank told a New York Fed official, "We know that we're not posting, um, an honest rate."), and did nothing but write a letter to British regulators, telling them to deal with it.

In context, you can understand why the New York Fed would let Wall Street run roughshod over the country. It's part of the Federal Reserve system, a strange hybrid of government and private financial institutions. There's a Board of Governors, which is mostly made up of appointees chosen by the president and confirmed by the Senate, and then there are 12 privately-run regional federal reserve banks in major cities across the country. Those regional banks have supervisory responsibilities over the banks in their area. But the local banking industry in the region and other corporate interests choose the board of directors for the regional banks, and the board subsequently selects the president.

In the case of the New York Fed, that means Wall Street banks play an active role in choosing the head of the institution that then has to regulate them. Until 2013, JPMorgan Chase President Jamie Dimon sat on the board. This is really the textbook definition of cronyism, clearly evidenced in the results of the New York Fed over the last decade. Bill Dudley, the current president of the New York Fed, spent his career as a chief economist for Goldman Sachs.

So the news last week that the Board of Governors has gradually taken over regulatory power from the New York Fed matters. A secret directive, known as the "Triangle Document," handed control over bank supervision to the Board of Governors under its point person Daniel Tarullo, a critic of big banks who was instrumental in tightening borrowing requirements for financial institutions.

The change was actually put in place five years ago and slowly implemented, an example of the extreme secrecy at the Fed. According to the Wall Street Journal, New York Fed officials have been shut out of policy meetings and criticized by Tarullo for failing to stop bank misconduct. One banker told the paper that the New York Fed "doesn't breathe anymore without asking Washington if it can inhale or exhale."

In 2010, the Fed established the Large Institution Supervising Coordinating Committee (LISCC), an umbrella group overseeing supervision, the first line of defense in the regulatory process. This has to do with the day-to-day monitoring of banks for compliance with federal law and overall safety, which is often performed by examiners inside the banks themselves. Under the reorganization, the regional banks still carry out supervision, but the LISCC is now their boss, at least in the cases of large institutions.

And there simply aren't that many large financial institutions outside Wall Street; almost half of the federal bailout in 2008 went to institutions in the New York Fed's district. So you can see the LISCC's creation as a direct rebuke to the New York Fed. The agency's bank examiners don't even report to President Bill Dudley anymore, going instead to the LISCC, a committee Dudley does not sit on. Several examiners have left.

Given their aptitude in the past, we should be thankful for their departure.

Presumably at the direction of the LISCC, the New York Fed has pulled its examiners out of the offices of the major banks, instead coordinating them through an off-site headquarters. The LISCC itself also runs off-site "risk teams" that are constantly looking at large institutions. This makes sense: Working inside the bank that you're supposed to be monitoring has to be incredibly difficult, as you build personal relationships with people you may have to rat out later. Yet that was the New York Fed's structure for decades. The new organizational model allows for some perspective, and the ability to see correlated risks across multiple banks.

Critics of big banks may be rejoicing, but they also have to question the timing. If this has been policy for five years, why introduce it now? And why did it come from Wall Street Journal writer Jon Hilsenrath, seen as so tied into the central bank that he's been called "actually the chairman of the Fed"?

The answer may be found in an obscure Senate hearing earlier last month, where Senator Elizabeth Warren criticized the continued service of Fed General Counsel Scott Alvarez, one of the most powerful public officials that nobody's ever heard of. Alvarez, an acolyte of Alan Greenspan, shares the deregulatory, laissez-faire approach of his mentor, contradicting the stated goals of his superiors and continually stepping in to help the banks by weakening the Fed's oversight powers.

It's unclear what role Alvarez plays on the LISCC. But with Fed Chair Janet Yellen and the Board of Governors were under fire from Warren recently for still employing a pro-bank operative at the highest level of their organization, they have every interest to demonstrate their independence from Wall Street right now. Trotting out a five year-old reorganization plan to show how they demoted the New York Fed serves that purpose. Yellen gave a speech last week criticizing Wall Street banks for "brazenly" failing to follow the law and questioning the ethical values of the firms. Combined with the Hilsenrath article, which comes right out of the Board of Governors, you can see this as comprehensive image rehabilitation effort on behalf of the captains of American high finance.

But this shift in regulatory responsibility from NYC to DC should give us some pause. It means that any illegal post-crisis practices, from market-rigging to the Lodnon Whale, happened on the new regulatory overseers' watch, and that members of Congress concerned about the failures to supervise and regulate should have hauled in the Board of Governors for questioning, not the New York Fed.

Improving the process by which Wall Street banks are regulated makes obvious sense. But we have to be sure the new solution is better than the original problem.

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