Who Will Watch The Watchers at the Fed?

It will come as no surprise to anyone who's read even one of my posts if I say that I'm a big believer in regulation.

But only if the regulators actually regulate.

This would seem obvious.

Not so, in the Through-the-Looking-Glass world of the New York Federal Reserve Bank, at least not according to the reports last week from Jake Bernstein at ProPublica and Ira Glass at This American Life, reprised in an article by Nathaniel Popper and Peter Eavis in today's New York Times.

The short version is this: Shortly after the 2008 financial crisis, and near-meltdown of the U.S. economy, questions began to arise as to why the New York Fed -- which is responsible for regulating Wall Street's big banks -- had not seen the crisis coming, had not done anything to prevent the disaster. Was the Fed, people asked, just a little too cozy with the institutions it was supposed to watch?

Or, as someone asked long, long, long ago: Quis custodiet ipsos custodes? (It was the Roman poet Juvenal who posed the question: Who will watch the watchmen?) (How often do I get to use my classics degree in real life, eh? Actually, writing this blog, I get to use it a lot -- most recently, I think, here. Sigh.)

The Fed itself commissioned a report, in 2009, to see what went wrong, and what it could do better. One of the biggest problems uncovered in the report was "regulatory capture". As explained by Mr. Glass on his radio show, 

Regulatory capture is when a regulator gets too cozy with the company he's supposed to be monitoring. He's a watchdog who licks the face of an intruder, and plays catch with the intruder, instead of barking at him. 

Or, as Mr. Bernstein put it in his article:

The New York Fed had become too risk-averse and deferential to the banks it supervised. Its examiners feared contradicting bosses, who too often forced their findings into an institutional consensus that watered down much of what they did.

Either way, the Fed was seeing questionable behavior, but not acting on that knowledge. The report recommended new hires, who would be independent-minded and capable of resisting that "capture". One of those new hires, Carmen Segarra, lasted only seven months  in 2011-2012 before she was fired. She sued last year, claiming that her employment has been terminated because she was too tough on the bank, Goldman Sachs, to which she was assigned (New York Times article on the suit from October 2013, here). That suit was dismissed earlier this year (New York Times article from April 25, here).

Interest heated up again when ProPublica and This American Life published secret recordings that Ms. Segarra had made while she was working for the Fed. As the Times reporters put it,

While Ms. Segarra’s suit was dismissed, the newly released recordings suggest that her supervisor at the New York Fed went easy on Goldman, even after saying he wanted “to put a big shot across their bow” on a deal in which Goldman was suspected of helping make Banco Santander look financially stronger than it was.

The New York Fed has issued a statement (at the ProPublica website, here) that "categorically rejects the allegations being made about the integrity of its supervision of financial institutions." But enough questions are being raised by both House and Senate committees. Yesterday, Massachusetts Senator Elizabeth Warren released this statement:

When regulators care more about protecting big banks from accountability than they do about protecting the American people from risky and illegal behavior on Wall Street, it threatens our whole economy. We learned this the hard way in 2008. Congress must hold oversight hearings on the disturbing issues raised by today's whistleblower report when it returns in November - because it's our job to make sure our financial regulators are doing their jobs.

One of the biggest problems here is the revolving door between regulators and banks, similar to the revolving door between Washington's legislators and lobbyists. If your next (Big!) paycheck is likely to come from the organization you're "supervising" ... just how tough are you going to be?