Secret tapes of NY Federal Reserve spark debate on ‘regulatory capture’ and government-bank relation

In 2009, in the wake of the worst financial crisis since the Great Depression, the U.S. Congress started a formal inquiry on the financial regulators that were supposed to prevent financial meltdown, but failed to do so.

Congressional attention centered on the Federal Reserve Bank of New York (FRBNY), which stands just blocks away from the Wall Street banks publicly blamed for complacency and negligence that led to the collapse of the US housing market.

This put the Federal Reserve in the uncomfortable position of scrutinizing their own performance and taking a hard look at the reasons it could not stop a proliferation of poor-quality loans and shoddy mortgage practices among financial institutions.

In response, the president of the Federal Reserve at the time asked a Columbia University business professor, David Beim, to investigate what was happening at the agency, in a report commissioned by the government.

As this outside consultant started digging through the Fed’s pre-financial crisis practices, he found a long list of grievances, among them, a pervasive sentiment that most employees of the government agency had succumbed to what is referred to as “regulatory capture.”

The International Center for Financial Regulation defined regulatory capture most simply as the “private distortion of public purpose” – when the interests of a corporation or financial institution influence the actions, or rather, inaction, of regulators.

Beim’s report, initially made confidential by request, identified two main problems that a regulator may have – recognition and action.

Although the Federal Reserve and other regulators may have recognized patterns of risk that eventually ballooned into the crisis, action was necessary to change these situations. Employees believed that their supervisors paid excessive deference to banks, and therefore had less success in finding and reporting issues or following up on them with authority.

Beim’s interviews with employees at the Federal Reserve Bank of New York said it in many different ways, for instance:

  • “I don’t want to be too far outside from where management is thinking.”
  • “The organization does not encourage thinking outside the box.”
  • “Until I know what my boss thinks, I don’t want to tell you.”

Regulators were afraid – not necessarily of the institutions under their supervision, but also of their own supervisors. That deference to seniority may have played a role in undermining the US economic system, and Beim had heard it from the Fed’s own employees.

Secret recordings of meetings between the agency and a bank regulated by a former Federal Reserve examiner named Carmen Segarra are now leading to renewed scrutiny on “regulatory capture” and the degree to which regulator-bank relationships have changed after the financial crisis.

Hired, then fired

Beim’s report called for an upgrade in seniority, training and resources for examiners, and a demand for a more high level and skeptical view of an institution’s operations and their risks.

That resulted in the creation of a team of experts, including senior management at the Fed, who worked on recommendations to address how compliance teams, especially resident examiners, could do a better job.

Since 1997, regulatory agencies like the U.S. Treasury’s Office of the Comptroller of the Currency (OCC) and the Federal Reserve have instituted a resident examiner program at the nation’s largest and most complex banks. These in-house examiners are at more than a dozen institutions and number in the hundreds.

But in choosing someone to literally make a bank their home office, Beim felt it wasn’t a job for everyone and, in particular, regulators would have to choose examiners who weren’t afraid to ruffle a few feathers and upset the status quo. For example, one of the recommendations was about recruiting the right type of regulator: “It requires people willing to change the prevailing orthodoxy.”

In 2011, one of the members of senior management who had worked on the recommendations, Michael Silva, was also the head of an examination team. The subject was Goldman Sachs, a bank that had its share of notorious headlines in the post-crisis era.

Carmen Segarra was part of Silva’s team. She was a new hire with an Ivy League education and more than a decade of work in the compliance field at several banks. According to the employee profile the Fed recommended, she was an ideal candidate.

Segarra was fired not long after being assigned to examine Goldman Sachs. The FRBNY stated her termination was due to job performance issues. Segarra alleges, however, that her dismissal stemmed from a refusal to toe the line with the same culture of deference and passivity that was outlined in Beim’s report.

In supervisory meetings, she was told she had “sharp elbows” and was “breaking eggs,” according to notes that Segarra took. Not long after, she started secretly recording meetings, giving a glimpse into a regulatory agency and its relations with the institutions it supervises.

Three years after her time at the Federal Reserve, Segarra has now filed a wrongful termination suit against the Federal Reserve Bank of New York and three other supervisors, including Michael Silva. She is suing for monetary damages and her job back and contesting the agency’s assertion that her termination was for “bad performance.”

Carmen’s main dispute with her bosses was about the lack of a conflict-of-interest policy at Goldman Sachs. Last Friday, Goldman Sachs issued a new conflict of interest policy that prohibits investment bankers from trading individual stocks and bonds – the same day that Carmen’s story broke on Propublica.

In-house, but independent?

Everett Stern, the whistleblower who helped build a case against HSBC for faults in the international bank’s anti-money laundering policy, said there shouldn’t be repercussions or retaliations on people who are speaking up about their own company or organization’s practices.

“There is a lot of heat to take from whistleblowing,” he told ACFCS. “In the case of this situation with Ms. Segarra, the government did not want to engage in a case that could possibly cause the takedown of the bank, which could possibly cause a financial crisis.”

Stern left HSBC while he was building a case with authorities, after allegedly being demoted and humiliated by supervisors. In 2012, HSBC Holdings, Inc. agreed to pay $1.92 billion for laundering money for drug trafficking organizations and not giving adequate scrutiny to trillions of dollars in suspect transactions as well as dealing with blacklisted regimes.

Bank examiners have had to walk a thin line between being close enough to the institution they are regulating to understand their practices, yet keeping a safe distance from the institution to avoid any conflict of interest.

The OCC has a strict five-year limit on the duration of an examiner’s stay at a bank. However, as a former regulator with more than 27 years of experience as a bank examiner another decade in the compliance and regulatory private sector, David Gibbons says the kind of attachment to an institution that could lead to “regulatory capture” could set in as early as 18 months.

Gibbons, who is a managing director at Alvarez and Marsal Financial Industry Advisory Services, was a regulator with the OCC in the northeast US. He notes that there are sound reasons for placing examiners directly within institutions.

“Institutions that have resident examiners are very large in scope and complexity, and it’s very difficult to get to know what the institution is doing and what risks emanate from that business without spending some time in there,” Gibbons said.

In February 2014, the OCC considered adding more examiners stationed inside large banks in order to increase compliance and understanding of Wall Street practices. This was a change from what post-crisis reforms thought would rid the financial system of the sometimes-murky relationships between the government and banks.

Bank examiners stationed inside banks were close to the action, but potentially too close, experts thought. Gibbons explained the disadvantage of that kind of relationship.

“Some of the downsides would be if you’re too familiar with the bank and too comfortable with the bank, you’re not seeing risks that are bubbling up that should be brought up to higher level supervisors, or worse than not seeing them, actually seeing them but not being as concerned about them as you may be because you’re comfortable with the bank,” he said.

‘An isolated incident’

Since the crisis, the Federal Reserve Bank of New York approximately doubled its staff for banks since the crisis with 15 to 40 examiners stationed at the largest banks. Segarra was part of that hiring spree, in an effort to improve communication with senior bank officials, monitor bank practices, and prevent another crisis.

Richard Riese, senior vice president of the American Bankers Association (ABA), an industry lobbying group, said that regulatory capture by and large does not exist.

“Supervision is a means of imposing expectations that go beyond regulatory requirements,” said Riese , who leads the Center for Regulatory Compliance at the ABA.

“There is certainly a renewal of mission of regulators [who] take great care in this, but they’ve always been professionally motivated and they’ve always done a good job,” Riese said.

Riese said that the dispute between Segarra and the Federal Reserve is an isolated incident that may not paint the most accurate portrait of the regulatory professional. However, he said that the pressures of a more intensive regulatory climate may not always lead to the most effective regulation.

“There has to be an understanding on both sides because there has to be efficiency so businesses and consumers get the benefit of regulation and aren’t harmed by imposing an inflexible regimen because inflexibility doesn’t really help people,” he said.

Perhaps the public regulatory sector could learn from private sector business practices, Beim suggests in his recommendations.

“Business organizations including banks have moved away from structured hierarchies in favor of more modern, flexible organizational forms, and FRBNY needs to adopt some of these attributes to be effective in grasping and acting on systemic issues,” Beim said. “The culture needs to encourage this kind of risk-taking rather than punish it.”