In Rebuke to Cronyistic New York Fed, TBTF Bank Supervision Shifted to Fed Board of Governors

The Wall Street Journal has published an important account of a behind-the-scenes power struggle at the Federal Reserve over authority for regulation. The result that the New York Fed has had significant amounts of its authority shifted to the Board of Governors in Washington, DC. This is a major win for Fed governor Dan Tarullo, who has emerged as one of the toughest critics of big financial firms at the Fed in the wake of the crisis. It is also a loss for the banks, since the New York Fed is widely recognized as close to Wall Street. Moreover, the Board of Governors is more accountable to citizens (its governors are Federal employees, the Board of Governors is subject to FOIA, although confidential supervisory of all financial regulators is exempt), while the regional Feds can best be thought of as public/private partnerships with weak governance structures,* so this move in theory is also a gain in terms of accountability to the public. However, since Greenspan holdover, deregulation enthusiast and Dodd Frank opponent Scott Alvarez remains as the general counsel of the Board of Governors, it’s unlikely that any newfound serious intent by the Board of Governors will go all that far in practice, given the powerful role that Alvarez exerts over matters regulatory.

Moreover, as proof of how secretive the Fed is and how voters are kept in the dark, this change was designed five years ago and has been in the process of implementation since then. The consequence is that, as the Journal points out, the Congressional committees responsible for bank regulator oversight have wound up directing questions to the New York Fed, and in particular its president Bill Dudley, that should more properly have been aimed at the Board of Governors.

Here is the Wall Street Journal’s overview of the changes (hat tip Adrien):

The Federal Reserve Bank of New York, once the most feared banking regulator on Wall Street, has lost power in a behind-the-scenes reorganization at the nation’s central bank.

The Fed’s center of regulatory authority is now a little-known committee run by Fed governor Daniel Tarullo , which is calling the shots in oversight of banking titans such asGoldman Sachs Group Inc. and Citigroup Inc.

The new structure was enshrined in a previously undisclosed paper written in 2010 known as the Triangle Document. Under the new system, Washington is at the center of bank supervision, exercising control over the Fed’s 12 reserve banks, much as the State Department exerts control over embassies….

Officials in Washington say centralizing regulatory authority in D.C. gives the Fed a broader view of risks across the whole system and a more evenhanded oversight approach. As evidence of benefits from the stress tests Washington introduced, officials say the 50 largest U.S. banks increased their capital to $1.2 trillion by the end of the 2014 third quarter from $506 billion in early 2009…

The six-page document placed a new panel called the Large Institution Supervision Coordinating Committee, overseen by Mr. Tarullo, at the center of Fed supervision of banks. Supervisors at the 12 reserve banks operate under the “guidance and supervision” of the LISCC (pronounced “lissick”).

The major change is in the supervision of the biggest banks. Although the article does not mention this issue, the “broader review of risks across the banking system” language suggests that the power shift came about at least in part as a result of the creation of the Financial Stability Oversight Council. As Wikipedia describes its role:

The Dodd-Frank Act provides the Council with broad authorities to identify and monitor excessive risks to the U.S. financial system arising from the distress or failure of large, interconnected bank holding companies or non-bank financial companies, or from risks that could arise outside the financial system; to eliminate expectations that any American financial firm is “too big to fail”; and to respond to emerging threats to U.S. financial stability.

The chairman of the Fed sits on FSOC. The New York Fed has no formal role it it. From a simple organizational perspective, it’s hard to see how you can have the Fed chair be a key voice on FSOC yet be at a remove from the actual supervision of the biggest banks.

However, the reduction in the New York Fed’s authority has clearly also come about as a result of the (correct) perception that it is too close to the banks. It appears that the New York Fed’s cluelessness during the JP Morgan London Whale debacle was a major wake-up call. We pointed out at the time that JP Morgan’s risk controls fell alarmingly short of well-established trading room practice. For instance, major financial firms place risk control, which among other things, is responsible for reviewing how traders mark their position, in units outside the profit centers whose head reports directly to the CEO. By contrast, risk control for the CIO was located in the CIO. That is tantamount to choosing to put the foxes in charge of the henhouse. It means the value of positions can be, as occurred in this case, be fudged, which allows losses to balloon before they are caught.

Another factor that contributed to Tarullo winning this internal power struggle was the Carmen Segarra whistleblower case, where a former New York Fed employee charged the bank with supine supervision of Goldman, and later released 46 hours of tape recordings she had made in secret to substantiate her charges.

The article mentions one very important change in passing:

The New York Fed, as it loses power, is adjusting its approach in some ways. It is pulling examiners out of offices at the banks they review and relocating them to a building near New York Fed headquarters.

This is far more positive and powerful than it appears. Having regulators housed at the banks they supervise is a recipe for capture. The supervisors wind up having much closer personal relationships with the banks that with their nominal employers.

And the Board of Governors is cracking down to the degree that the Journal reports of problems in morale and turnover, which is what you get when a new regime comes in and tries to make major changes in a diseased culture. As the Journal reports:

He [Tarullo] was hard on New York’s team of examiners from the start. He chewed out their supervisors during discussions in late 2009 of a plan by Citigroup to repay its $45 billion federal bailout, said people involved in the discussions….

New York Fed supervisors doubted Citigroup could raise as much money as Washington wanted it to raise before starting repayment. Mr. Tarullo said New York wasn’t pushing Citigroup hard enough. One person involved in the talks said Mr. Tarullo’s message to New York officials was that he was tired of cleaning up their messes.

During discussions the same year over what became the Triangle Document, New York Fed bank examiners, led by supervisor William Rutledge, fought for more representation on committees but lost, according to people who took part. Mr. Rutledge, now at Promontory Financial Group, which advises firms on dealing with regulators, said he supported the reorganization…

Nine of the Federal Reserve Board’s members are on the 16-person committee; the New York Fed has three representatives, and they answer to Washington. Mr. Dudley isn’t on it.

“This reserve bank doesn’t breathe any more without asking Washington if it can inhale or exhale,” said one person prominent in the banking community.

However, this part isn’t too encouraging:

Mr. Tarullo has empowered economists in both New York and Washington, while weakening examination teams. His top lieutenant, economist Michael Gibson, and Mr. Gibson’s deputy, Timothy Clark, have central roles at the LISCC and in running the Fed’s current stress tests of the largest 31 U.S. banks.

As we know, empiricism is not the strong suit of economists. It would be much better if the Fed had dedicated itself to the task of how to create better regulatory oversight. The risk of relying even more on economists, as opposed to regulators, who should act as financial services gumshoes, is relying unduly on model-based approaches which can have defects or be gamed.

Thus while this is generally a step in the right direction, the open question is whether these steps are adequate. As one can see from its monetary policy, which has worked out swell for the top 1%, the central bank is far too tied into orthodox, meaning elite, views of what its priorities should be. The Fed, for instance, appears to have no concern about the fact that the economy is overfinancialized and reducing the size and profitability of that sector should be a high priority. However, that point of view is anathema to the Board of Governors’ general counsel Scott Alvarez, who is unapologetic about how the deregulation over which he presided produced the financial crisis and continues to exercise outsized influence over regulatory policy.

As we’ve regularly argued, large banks get so much support from the state that they cannot properly be considered to be private entities. They now represent the worst form of socialism for the rich. They should be regulated like utilities. Having utility-like profits and pay would mean that real economy rather than casino economy jobs would look more attractive to ambitious, highly-educated candidates.

Thus the Board of Governors move, while salutary, is likely to turn out to be what the Japanese call “a height competition among peanuts,” where the changes look significant to insiders but are recognized as trivial to more objective observers.

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*The regional Federal reserve banks are not “owned” by member banks; the stock they hold in non-voting preferred stock that conveys no rights as far as governance is concerned. The regional Fed “boards” were originally constituted as a way for the regional reserve banks to get information from prominent, well connected local business men on economic conditions in the days when there was little in the way of economic data. However, there has been disconcerting mission creep at these boards, with them obtaining some powers that are ones normal private sector boards would have, like recommending candidates for the president post (which is still subject to review and approval by the Board of Governors, and unlike a private board, the regional Fed boards cannot remove a Fed president or set his compensation).