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Fed, Heal Thyself

It is breathtaking to read about Federal Reserve Chairwoman Janet Yellen berating Wall Street banks, as reported by Victoria McGrane in today’s Wall Street Journal, “to follow the law and to operate in an ethical manner.”  Ms. Yellen’s speech to the Citizens Budget Commission in New York City is an apparent reference to the various probes of banks’ misdeeds around interest-rate manipulation, tax avoidance and other unnamed sins.

The audacity of Federal Reserve officials Yellen and William Dudley, president of the Federal Reserve Bank of New York, to point fingers at others for ethical and legal lapses is clearly an effort to divert attention from the Federal Reserve’s own failings and their deep disinterest in addressing them seriously.

The problems of regulatory capture at the Fed are now well documented, between a confidential study commissioned by the Fed and recently released tape recordings of Fed agency staff interactions. As reported by Jake Bernstein of Pro Publica, Columbia University professor David Beim found that:

“The most daunting obstacle the New York Fed faced in overseeing the nation’s biggest financial institutions was its own culture. 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.”

Knowledge of these ethical lapses wasn’t intended for public consumption. Beim was hired to produce a confidential report to New York Fed President Dudley. Three years after the Beim report, it was clear little has changed at the Fed.  An examiner hired to keep an eye on large banks was fired when she questioned the behavior of her colleagues. The examiner was so alarmed by what she observed that she recorded 46 hours of conversations. Bernstein explains that, “The recordings make clear that some of the cultural obstacles Beim outlined in his report persisted almost three years after he handed his report to Dudley.”

It’s not surprising that a large, powerful, independent government agency that faces little oversight would suffer from deep ethical problems. What’s so galling is the anemic response of top Federal Reserve leaders to address them.

Yellen’s response to the Fed’s ethical failings is to point to a committee of Fed insiders, the Large Institution Supervision Coordinating Committee.  The suggestion that a Fed committee can effectively oversee Fed behavior is either dangerously naïve for someone of Ms. Yellen’s responsibilities or cynical in the extreme. At the very least an inter-agency group of financial regulators should be established to monitor each other.

The cultural problems across the Fed system Chairwoman Yellen inherited have built up over years. She can’t fix them alone or quickly. But if she wants to have the moral standing to lecture others on institutional ethics, she will need to do more to put the Fed’s own house in order.

7 Comments Post a comment
  1. Gilbert W. Chapman #

    Thank you for an excellent article . . . Guess Ron Paul was right after all . . .

    For years I’ve contended the Dallas Fed has had the only two ethical chairs (McTeer and Fisher), while the New York Fed, Boston Fed, and San Francisco Fed have all had, let’s just say, less than honorable presidents . . . Just think of ‘Timmy’ when he ran the New York Fed . . . Need I say more ?


    March 4, 2015
    • Other reserve banks were guilty of rhetorical inconsistency, too, including Dallas at some of the times you mentioned.–Walker Todd


      March 4, 2015
      • Gilbert W. Chapman #

        No doubt you are most likely correct . . . It’s just that I always felt the Dallas Fed’s chairs were a notch above most, if not all, of the others . . . Particularly when compared to the likes of ‘Timmy’, not to mention our old buddy ‘Ayn Rand Alan’ 🙂


        March 4, 2015
  2. The Yellen speech comes about 35 years too late at FRBNY. Beginning around 1980, and no later than 1982, there was a major effort to persuade supervisory staff to become partners with the banks and, increasingly, to tolerate, even to encourage, their excursions into investment banking. Recent speeches along a similar line by President Dudley have a false ring for FRBNY veterans for the same reason. To date, no tough supervisor has been praised (while living) for his toughness, and no apologies have been offered to those whose careers were damaged by their supervisory toughness. What lesson does the remaining supervisory staff draw?

    Those who resist audits of the Fed need to think about this: What the Fed really needs is a policy consistency audit, what the economists would call a “rhetorical consistency” audit. When a Yellen or a Dudley makes speeches like this, what does the auditor find to document that the expressed wishes in fact are being carried out in the field? Has anyone been punished for failing to adhere to the stated policy? Has anyone been rewarded for his supervisory competency? If not, then why should Fed managers not assume that ignoring their leaders’ speeches is the best way forward? If not, then why should intimidated Fed supervisory employees not assume that their best hope lies in either their silent acquiescence or their cheerleading?

    Col. Harwood used to hold, according to what I hear, that the illusion of competent supervision so lulls an unsuspecting public that the public is surprised when illustrations of supervisory incompetency emerge. The safer assumption is either supervisory incompetency (at least, for the assigned tasks) or the subtle corruption of what George Stigler and Janet Yellen called “regulatory capture.”

    A knowledgeable Fed veteran of my acquaintance, upon reading a President Dudley speech warning bankers to change their behavior, put it to me this way: “That is like a Chicago alderman issuing a warning to Al Capone.” — Walker Todd


    March 4, 2015
    • Gilbert W. Chapman #

      And to think . . . All anyone at the Fed has to do is memorize Walter Bagehot’s book, “Lombard Street”, and apply the principles he articulated in 1873.

      It always amazed me that Bernanke quoted him on several occasions, but did just the opposite of what Bagehot advocated.


      March 4, 2015
  3. Here is the key para. from Yellen’s speech, buried on pp. 11-12 of the PDF version of the speech:
    To be effective, regulation and supervision must be independent of the entities subject to oversight. You may know or have heard the term “regulatory capture.” Regulatory capture is when a regulatory agency advances the interests of the industry it is supposed to oversee rather than the broader public interest it should represent.11 Regulatory capture, which may occur in the oversight of any industry, can happen in both intentional and inadvertent ways. The most blatant ways involve tangible conflicts of interest–for example the expectation government officials might have of future rewards

    11 A body of economic literature addresses regulatory capture, with perhaps one of the most influential works being George J. Stigler (1971), “The Theory of Economic Regulation,” Bell Journal of Economics and Management Science, vol. 2 (Spring), pp. 3-21. See also Ernesto Dal Bó (2006), “Regulatory Capture: A Review,” Oxford Review of Economic Policy, vol. 22 (Summer), pp. 203-25.

    – 12 –

    from the industry they oversee. But experience and extensive research shows that regulatory capture also occurs in less tangible ways, when close contact and familiarity between individuals leads those enforcing the rules to sympathize with those they oversee. Whatever the source, the risk of regulatory capture is something the Federal Reserve takes very seriously and works very hard to prevent. We enforce strict ethics rules and promote strong values among our employees, among them a commitment to public service. It is important that anyone serving the Fed feel safe speaking up when they have concerns about bias toward industry, and that those concerns be addressed.

    –Walker Todd


    March 4, 2015
    • Gilbert W. Chapman #

      Yellen could have simply stated, “The relationship between the Fed and the large banks is an example of embedded ‘Crony Capitalism’, that began a few months before the Federal Reserve System was created some 100 years ago.”


      March 4, 2015

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