Who Watches over the New York Fed?

We were all riveted last fall by the economic meltdown, which pulled down Lehman (now absorbed into Barclays (BCS)) and Merrill (now part of Bank of America (BAC)) and forced many of us to consider the previously inconceivable outcome of a total collapse of the capital markets.

Through it all, then-Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke, and then-head of the New York Fed Tiimothy Geithner, tried to orchestrate an acceptable soft landing for all market participants. Many of the most pivotal planning sessions during that dark time happened at the offices of the New York Fed.

Yet, who was watching over the New York Fed at the time? As it turns out, many of the market actors were central in the drama playing out, including Lehman head Dick Fuld, who was a New York Fed director then.

Did Dick Fuld really deserve to have a say on whether BofA should buy Merrill, or on the fates of AIG, Morgan Stanley (MS) and Goldman Sachs (GS)?

The board of directors of the New York Fed was poorly composed then, and it remains highly problematic today. Changes need to be made.

The New York Fed is basically the on-the-ground interface between Wall Street's biggest banks and the Federal Reserve. It plays part policy adviser, part diplomat and part message-runner between the two sometimes very different worlds. The bank plays a critical role in how policy is set and implemented.

During several critical moments last year (with the downfall of Bear and Lehman, the shotgun marriage between Merrill and BofA and later the pressuring of BofA to follow through with the merger) and no doubt in the future, the New York Fed has and will play a critical role in real-time decisions that can have ramifications on our markets and the broader economy for years.

It's reasonable to better understand who ultimately was responsible for directing and judging if Geithner was doing his job effectively last year. That responsibility falls on the New York Fed's board of directors.

That group is divided into three classes of directors: three Class A directors who are from member banks and who are elected by member banks; three Class B directors who are elected by member banks to represent the interests of the public, and three Class C directors who are elected by the New York Fed's board of governors (who are all appointed by the president) to represent the interests of the public.

The Class A directors have been problematic in the last eight months. First, Fuld was one of them last fall when his firm became the focal point of concern for the entire U.S. financial system. Later, Stephen Freidman, then-chairman of the New York Fed and formerly with Goldman Sachs, was forced to resign amid revelations that he had purchased stock in his old firm -- raising questions about his impartiality overseeing the entire financial system.

There's no evidence that either Fuld or Friedman took any actions that benefitted either of those firms in their New York Fed roles, but, in matters of corporate governance, appearances count. Currently, three of the nine seats on the New York Fed's board are vacant. It's not clear when they will be filled. Of the current directors, all three Class A directors are in place representing the interests of the member banks.

Jeff Immelt of General Electric (GE) is the only Class B director. His job is to represent the public in that role. However, it's clear that his day job of overseeing GE Finance also makes him sympathetic to the needs of the member banks. Only two of the three Class C seats are filled (Lee Bollinger, the president of Columbia University, and Denis Hughes, the president of the New York State AFL-CIO).

Based on this composition, you could fairly make the case that the current board of the New York Fed is more weighted to look out for the interests of the bankers than the interests of the taxpayers and the broader economy. That needs to be immediately corrected. That means getting more experienced business executives like Pepsi (PEP) CEO Indra Nooyi back on the board as a Class B director and replacing Jeff Immelt with another business executive who runs a company not as financially dependent as GE Finance.

Additionally, the open Class C position should be quickly filled with a director who is business savvy but will represent taxpayers first and foremost. Ideally, the Class C director should be someone who knows something about corporate governance and can bring that perspective to the New York Fed's board. Ira Millstein of the law firm Weil Gotshal & Manges would fit the bill nicely.

There have been other bothersome governance issues cropping up at the New York Fed recently. It was recently reported that former New York Fed President Geithner advised the current board members to select his former lieutenant, William Dudley, as his replacement.

Although this happens a lot in companies (think Citigroup's (C) Sandy Weill telling his board to replace him with then general counsel Chuck Prince), it is always a bad idea. Former CEOs and presidents can have cloudy judgment on these kinds of issues, affected by legacy or loyalty.

It's also been reported that it was due to Geithner's strong advice about hiring Dudley that former Class B director Nooyi recently stepped down from the board entirely. Take all these incidents together and you can't blame her.

The New York Fed plays a critical role in the healthy functioning of our capital markets. In my view, member banks deserve to have a seat at the table of the board of directors, but the majority of views should be separate from Wall Street and ensure that Wall Street's actions are serving the interests of the entire economy. The Federal Reserve and the U.S. government should immediately take steps to ensure that this organization's governance matches the standards they wish to see implemented in the big Wall Street banks they oversee.

Comments

[Marli:]

Superb article.
Quis custodiet ipsos custodes...

Jul 09 12:41 PM

[Nathaniel C:]

Who watches over the New York Fed? Their owners--the major banks. They have to protect their investment. The New York Fed is the bankers personal agent on the Federal Reserve. That is why the New York Fed is the most powerful branch.

Jul 09 02:11 PM

[Kinabalu:]

"the majority of views should be separate from Wall Street and ensure that Wall Street's actions are serving the interests of the entire economy"

I would agree with this conclusion. The problem is getting financial expertise on the Board and not political noise. My first reaction to seeing Denis Hughes on the board is negative. What does a journeyman electrician and union organizer know about the operation of a central bank.

Jul 09 02:54 PM

[Moon Kil Woong:]

Hmmm who watches the Fed in whole or in part?

Actually the timing of this article couldn't have been better. The Fed currently on the hill balking at being watched by the GAO as we speak.

Apparently they prefer to watch themselves and then report to Congress that they don't know anything like what trillions in bonds they bought, what trillions in backstops they issued, or their current value, the default, or risk premium they have assessed them at. Nor have they reported on what if any reserves they have set aside for them or their contingency if they default (why set aside anything since we just either make more or tell the treasury to loan us the difference).

Then after the meeting they smartly remind Congress they are not a arm of government and are an independent corporation with shareholders and have no rights to any "private corporate information" before they waltz into another meeting where they demand the right to regulate all too big to fail firms and claim no conflict of interest in regulating the failed banks who are their own shareholders.

So yes, the New York Fed has conflicts of interest; but isn't that expected considering the composition of the Fed itself which is like a trade union tasked at regulating its own members?

Jul 09 08:06 PM

[TinyTim:]

The Fed definitely needs a whole lot more transparency and if they don't feel like they're a part of government, get rid of 'em.
I like Ron Paul's (my man) proposal to audit them, just for the drama and entertainment value, then get rid of 'em.

Lastly, there are several other Fed districts around the country with supposedly equal weight to the NY Fed. Why does this not feel right?

Jul 10 04:19 PM