Saturday, September 27, 2014

Regulatory Capture At The NY Fed Caught On Audio Tapes

Regulatory capture is a well known problem in government.  Books have been written on this problem and some have argued that the financial crisis might have been prevented if the NY Fed had not been captured by the banks that it is supposed to supervise.  The CEO's of the major Wall Street banks serve on the NY Fed's Board of Directors.  That puts the management of the NY Fed in a difficult position.  The president of the NY Fed has necessarily developed a personal relationship with the management of the banks that it regulates.

The incoming President of the NY Fed hired a professor from Columbia to make recommendations that might help the Fed to do a better job of supervising the banks.  The professor determined that the culture of the NY Fed needed to change.  It had a culture of consensus which had serious effects on how the NY Fed regulated the banks.  The Fed made an effort to fix this problem by hiring employees who would be strong enough to buck the culture of consensus.  This is a story about one of the employees who tried to buck the culture.  It turns out that the culture of consensus is not easily changed.  The culture of consensus is a specific form of regulatory capture.

This article documents  how the NY Fed responded to two problems at Goldman Sachs.  It shows how the culture of consensus at the NY Fed operates as a form of regulatory capture.  The first problem was about a deal that Goldman made with Banco Santandor which is one of the largest banks in Spain.  It asked Goldman to put some of the bank's assets on its books so that it could satisfy the capital requirements of its regulator in Europe.  The amount of capital required is directly related to the quantity of assets held by the bank.  The culture of consensus is apparent in the transcripts of the conversations that took place when a new hire tried to buck the system to expose a deal that might be legal but was clearly a shady deal.

The second problem was a conflict of interest at Goldman Sachs.  It was advising Kinder Morgan on is acquisition of El Paso.  Kinder, course wanted to purchase El Paso at the lowest possible price.  It was also an adviser to El Paso on the deal.  Clearly, El Paso wanted to get the best price that it could get on the deal.  This seemed to a classic conflict of interest problem to the new hire at the NY Fed.  She found however, that Goldman did not have a firm wide conflict of interest policy.  It had several very general conflict of interest statements in several of its divisions.  None of these statements were consistent with the NY Fed's criteria for an effective conflict of interest policy.  The culture of consensus at the Fed prevented her from putting it on record that Goldman did not have an acceptable conflict of interest policy.  She was told that her statement had to be "vetted" at the Fed because the Fed would lose credibility with Goldman if it did not accept Goldman's claim that it had a conflict of interest policy.  One would think that such a policy would have kept Goldman from advising both sides of a deal on an acquisition.  Apparently, there is no conflict of interest when Goldman can collect fees from both parties to the deal.  Its also clear that employees at the NY Fed who do not comply with the culture of consensus cannot survive.  The new hire was fired because she resisted the culture that she was hired to help change.

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