Should Bankers Serve on Federal Reserve Bank Boards?

A new GAO report finds conflicts-of-interest present. Does the system need reform?

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Just what the Federal Reserve needs: more controversy. A new Government Accountability Office report to Congress that investigates the central bank has some not-so-flattering conclusions. Some regional Fed bank board members are also bankers, which creates a potential conflict-of-interest. Of course, anyone who follows the Fed already knew, so this news isn't all that shocking. Still, the finding raises a question: should such conflicts-of-interest trouble us, and if so, how should they be remedied?

What the Report Says

Persistent Fed critic Sen. Bernie Sanders (I-VT) seized on the report to cite these conflicts-of-interest. An amendment by Sanders to the Dodd-Frank financial regulation bill actually called for this investigation in the first place. Here are some of the points he makes in a statement he released on Wednesday:

  • The GAO identified 18 former and current members of the Federal Reserve's board affiliated with banks and companies that received emergency loans from the Federal Reserve during the financial crisis including General Electric, JP Morgan Chase, and Lehman Brothers.
  • Many of the Federal Reserve's board of directors own stock or work directly for banks that are supervised and regulated by the Federal Reserve. These board members oversee the Federal Reserve's operations including salary and personnel decisions.
  • Under current regulations, Fed directors who are employed by the banking industry or own stock in financial institutions can participate in decisions involving how much interest to charge to financial institutions receiving Fed loans; and the approval or disapproval of Federal Reserve credit to healthy banks and banks in "hazardous" condition.

These points show that conflicted board members could benefit their firms through the power they wield at Fed banks. The thing is, the report also said that the firms these board members represented did not receive special treatment as a result of their presence at the Fed. For example, although their firms received emergency loans from the Fed during the crisis, so did dozens of other institutions.

The Fed Is There to Protect the Financial Industry

Worrying that Fed board members might be sympathetic to the problems that financial firms experience misunderstands an essential purpose of the central bank: to promote financial stability. The problem, however, is that the Fed also functions as a bank regulator. These two duties can conflict, and financial stability will likely always win out. To the extent that the Fed can assist banks to prevent a crisis, it must do so.

Having actual bankers on hand to provide their perspectives on the market and what's actually happening on the ground can help the Fed achieve that end. For this reason, there's a strong rationale in favor of keeping bankers on Fed boards. One of Sanders' other points complains that "there are no restrictions on directors of the Federal Reserve Board from communicating concerns about their respective banks to the staff of the Federal Reserve." Indeed, there shouldn't be any such restrictions if their perspectives hope to help achieve better financial stability. To that end, such voicing concerns could be invaluable.

Reform Is Necessary and Easy

Still, the ability for these bankers to directly affect decision making does invite the abuse. Even though it can prove useful to have top bankers on Fed boards help to shape its policies, they should not be able to affect decisions that may affect their respective firms directly.

Fortunately, a reform could be simple here, and the GAO report provides a discussion of some good models that other central banks use. Canada's model has some particularly sensible rules.

The Bank of Canada Act requires that directors: 

  1. Disclose any material interest in writing or in the minutes of board meetings, 
  2. Disclose the conflict as quickly as possible after the conflict is discovered or realized, and
  3. Not vote in any resolution or action related to the conflict.

Directors must also avoid or withdraw from participation in any activity or situation that places them in a real, potential, or apparent conflict of interest.

So these banker-board members can still provide their perspectives and even assist in rule making -- they just shouldn't be able to affect decisions that would directly benefit or harm their firm.

This arrangement would produce the best possible outcome. You would still have the expertise, market insight, and real world experience of these bankers benefit financial stability. But they would not have a voice in the ultimate decision process where conflicts-of-interest exist.

Image Credit:REUTERS/Jason Reed