How Not to Regulate

This past weekend's This American Life/ProPublica report confirms the worst of what many already suspected: The New York Fed has little independence from the industry it is supposed to control.

Carmen Segarra (Nabil Rahman/ProPublica)

A confidential internal report. Secret recordings. An award-winning journalist and the best radio show on the air. This weekend, Jake Bernstein of ProPublica and the team of This American Life presented a fantastic piece about how managers at the world’s most important financial regulator suppress dissent and ingratiate themselves to the big banks they are supposed to oversee.

For those who follow the doings of the New York Fed, none of this will come as a great surprise. But it does add remarkable color and detail, thanks largely to the tape recordings of former New York Fed employee Carmen Segarra, to what was already widely known within the industry.

The underlying point of the piece is that the very culture of the New York Fed ensures lax regulation—a scenario often called “regulatory capture,” defined by This American Life’s Ira Glass as “when a regulator gets too cozy with the company he’s supposed to be monitoring.” When senior New York Fed officials want their staff to go easy on Goldman Sachs they don’t even need to lift a finger. The institutional culture takes care of it for them.

All of this is to say that the New York Fed is effectively captured. It consistently takes the side of the major banks it regulates, whatever the motives happen to be. Many have observed this before. For some people, like Tim Geithner, that’s justified, because what’s good for Wall Street (whether it be non-regulation of derivatives, emergency bailouts, or minimal capital requirements) is good for America. For others, like my colleague Simon Johnson (who has written about this repeatedly) and me, that’s a problem, because megabanks that can blow up the global financial system need closer and tougher supervision.

Michael Silva was the head of the New York Fed’s supervisory team at Goldman Sachs; his team was located in Goldman’s offices, not at the Fed. According to the companion ProPublica report, Silva raised questions about a transaction that Goldman was doing to help disguise Banco Santander’s capital position, but was “reined in” by New York Fed general counsel Tom Baxter. Later, when Segarra, then a New York Fed examiner, wants to write in a report that Goldman does not have a conflict-of-interest policy that meets regulatory standards, Silva pushes her into dropping it. He eventually fires her.

What kind of institution is the Federal Reserve Bank of New York? It’s a bank with a monopoly that isn’t supposed to seek profits; a bond-trading desk that follow orders from the Open Market Committee; and a regulatory agency charged with overseeing bank holding companies, including the most complex financial institutions in the world.

There are two basic dynamics that inhibit the Bank in that third role. One is the revolving door: If you are a regulator at a Federal Reserve bank, your long-term wealth-maximizing strategy is to play nice with the banks you oversee and get a job with one of them later. Bernstein’s “quick internet search” found seven former Fed bank examiners who now work for Goldman alone.

But the ProPublica/This American Life piece is at its strongest when illuminating the second dynamic: groupthink. The New York Fed is a classic bureaucratic institution, where there is little upside to being bold (you can’t invent a new product or expand into a new market) and lots of downside to being seen as out of line. As David Beim, author of the confidential internal report, says to This American Life, the core problem at the Fed is “What the culture expected of people and what the culture induced people to do.” (I recently wrote a paper on this topic, called “Cultural Capture and the Financial Crisis,” but it is part of a book that is unfortunately no longer available for free on the Internet.)

This institutional suppression of dissent manifests itself in a variety of ways. One is the assimilation of bank examiners into banking culture. As Bernstein says on the radio show,

Examiners see bank employees every day at work. It’s just human nature to try to get along with them. And many examiners feel that the easiest way to get information is by cultivating a friendly relationship. . . . Beim says it’s tricky walking the line between being friendly and being captured.

The other cultural influence, however, is internal to the Fed itself. In Beim’s words,

It goes like this: “Don’t want to be too far outside from where management is thinking. The organization does not encourage thinking outside the box. After you get shot down a couple of times, you tend not to go there anymore. Until I know what my boss thinks, I don’t want to tell you.”

Working daily alongside Goldman bankers in a hierarchical organization that was headed for the past decade by one president whose signature policy assumed that the American economy depended on bailing out Wall Street banks and another who came from Goldman—what do we expect from the New York Fed’s regulators? Segarra, the would-be hero of the story, is ultimately unable to call Goldman out for its poor conflict-of-interest policy—and even if she had been able to write the report the way she wanted, she conceded that her superiors could change her conclusions if they wanted to.

New York Fed President William Dudley may not like the publicity. But this latest story just shows that, from his perspective, the system is working as planned. One job of the New York Fed, according to its defenders, is precisely to protect the largest banks—on which all of our fortunes depend, remember—from know-nothing populists like me. It’s good that the culture and the bureaucracy stifle dissent, because that means Dudley never has to write a memo specifically asking his staff to back off on Goldman. Even a set of secret recordings, though embarrassing, never reveal anyone doing anything fraudulent or criminal.

For the banks, of course, this is the most advanced and effective regulatory capture possible. No one has to be paid off, no one has to break the law, and no one asks too many questions.