The Federal Reserve System was established in 1914 in a truly American way – it was the brainchild of a committee authorized to set up a central bank. Balancing the populist fears of Wall Street control against the concerns of the financial sector, the US central bank was established as 12 regional banks, each run by a president elected by the regional banking industry, and a central Board of Governors, appointed by the President and confirmed by the Senate. The power-sharing between the Board and the regional banks was for quite some time unclear and for the decade before the stock market crash of 1929, the System was de facto run by Benjamin Strong, the President of the Federal Reserve Bank of New York. Over time, partly by law, partly by custom, power has shifted largely to the Board. For example, regional banks no longer have the authority to set their own discount rates. During the recent financial crisis, we have seen this in extremis, as much of the crisis response was conducted at the Board, occasionally without real-time inclusion of regional members of the FOMC (leaving them to be briefed after the fact).
But this regional structure has now raised its head again in an ugly way that could actually have been much worse, and the NY Fed and Wall Street are at the center of it. As is now being widely reported, the New York Fed helped management at Lehman Brothers exploit an accounting loophole and use a financial transaction to hide debt from its owners and the financial market in general. The transaction, which I will not describe here (see this report with annotations here), was fraudulent, seemingly actionable, and possibly criminal. It uncovers a significant conflict of interest in the structure of the Federal Reserve System, which, since it has not played a role in the financial crisis and great recession, has been largely overlooked.
The conflict: the regional Federal Reserve Bank regulates the banks in its region, and the banks in the region “own” the regional Fed and choose the president who runs it. As the Federal Reserve puts it:
“ . . .the Reserve Banks issue shares of stock to member banks. . . The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.”
What other regulatory agency operates in this way? Not many. While the regulated are often disturbingly involved in the choice of regulator, ownership of the regulators is extreme.
The problem with this structure is not in the regulation of poorly run, unlucky, or unprofitable banks in the System. Since banks insure each other, they all share the losses of an insolvent member, and so are all interested in regulators who protect them from the losses of others. But that changes if they all want to take the same risks to make profits and when the taxpayers will step in on the downside. And that changes if some large and powerful bank is in trouble. And that changes if the private banks’ management teams are in conflict with their owners or the rest of us more generally. In the case of Lehman, all three factors seem to have been in play – the bank was a major player, the government was potentially holding the downside, and “hoodwinking” investors seemed like it could help the Fed and private NY banks.
In some sense we might be surprised that this conflict was this not a bigger problem. But incentives are not destiny. In general, the people and the culture of the Federal Reserve System did a good job of regulating the parts of the banking system for which they were responsible, when elsewhere there was colossal failure. And while I applaud their work, I worry about the future. I would like to see a system in which the regulated do not elect the regulator. Seems like an obvious potential weak link in oversight, especially now that we have clear that the government, even the conservative Bush administration, will step in and bail out banks.
In a perfect world, the bipartisan outrage at the NY Fed’s actions (for example, by the House Financial Services Committee here) can move us to a more robust and centralized system. We will see.