Wednesday, August 19, 2015

7 Questions about the recent banking scandals that you were too afraid to ask

Banks and bank regulators have been in the news a lot lately. You may have heard stories about how banking regulators often get too cozy with the bankers they are supposed to keep an eye on. While this has been a pernicious issue for years, two recently publicized scandals have brought this problem into the news.

Both of these recent controversies surround two former employees of Federal Reserve Bank of New York (FRBNY), and their relationships with the megabank Goldman Sachs. These stories have revealed the blurry and often complex nature of the relationship between regulators and powerful banks. These stories also exemplify the persistent problem of something called “regulatory capture”, which, while sounding like a dusty legal topic, is actually a very important issue that can affect the whole economy.

The first of these two controversies arose in October, when a Carmen Segarra, a former employee of the Federal Reserve Bank of New York, released several audio clips that she had recorded while still employed at the Fed. These tapes included conversations between Segarra and her bosses at the FRBNY, as they discussed some controversial business practices being made by Goldman Sachs.
Segarra was frustrated with the light treatment and relaxed attitudes that her higher-ups had towards this behavior at Goldman, which she perceived to be unethical and potentially dangerous. Segarra was a permanent on-site examiner at Goldman Sachs during her brief tenure at the Fed, and claimed that the Fed's lackadaisical approach to supervision led her to record, and later release, these conversations. These substantial disagreements ultimately led to her dismissal from the Fed in 2012. Then in October of this year, she released a few minutes of her tapes and sat down for a lengthy interview with NPR.

Recently, news broke about unethical behavior of a former employee of the same Federal Reserve Bank of New York, who later went on to work at Goldman Sachs. This former examiner named Rohit Bansal was caught using data from his time as an examiner and his connections with the FRBNY to benefit his new role at Goldman Sachs.

1) So, what’s the problem here?

The audio tapes that Segarra released revealed that senior staff at the FRBNY frequently gave Goldman Sachs a lot of regulatory deference and went easy on Goldman employees when they made questionable business decisions. The tapes focused on conversations between Segarra and her colleagues, who were all part of the FRBNY’s examination team stationed at Goldman. The most revealing quote from the tapes comes from Segarra’s boss, who almost laughingly described one business deal of Goldman’s as “legal, but shady.” Expressions like these were exactly the reason Segarra recorded internal conversations at the FRBNY--which ended up coming in handy once she was fired. It’s clear from the rest of these tapes that Segarra’s willingness to stand up to Goldman’s behavior was resisted by her superiors and likely led to her termination from the Fed.

A few weeks later the New York Times reported on yet another scandal between Goldman and the FRBNY. The article revealed that a former FRBNY employee Rohit Bansal had been caught using private government data at his new job at Goldman. Bansal had worked for the FRBNY for several years, and by the time he left the Fed, he was the central point of contact for certain banks.  Once Bansal joined Goldman, he used his expertise, along with his relationship with a former FRBNY colleague, to illegally acquire confidential regulatory information about a client that Goldman was doing business with.

Once this leak was discovered, Goldman immediately fired Bansal, and FRBNY immediately fired the man who they believed to be the leaker. The severity of these leaks became obvious when only days after Goldman reported the breach, federal authorities, including the FBI, FDIC, and the US Attorney for the Southern District of New York, began an investigation into the matter to see if any crimes were committed.

2) I think I’ve heard of Goldman Sachs before, but what exactly is it?

Goldman Sachs is one of the largest banks that many people haven’t heard of. That’s because Goldman Sachs is not a commercial bank like Bank of America, Wells Fargo, or Citi, that consumers can directly do business with. Goldman is organized as something called a “bank holding company”, which is a fancy term for financial conglomerate. Goldman does many things, but hosting checking/savings accounts and making consumer loans are not among them. Goldman is actually an investment bank, which means it deals only with other companies, and not directly with consumers. Its major business lines include giving merger and acquisition advice, managing assets, engaging in private equity deals, and serving as a financial broker for other corporate clients.

3) What’s a bank examiner?

In the US, there are two major steps to regulation: rulemaking and supervision. Regulatory agencies first have to write the regulations for their respective industry, through a public process called “rulemaking”. Then, once these regulations are finalized, the agencies must also make sure that businesses are complying with them. This ongoing, complex, and often fuzzy process of ensuring compliance is called ‘supervision’, and its where these two recent scandals have occurred.
In general, government agencies that supervise banks, at both the state and federal level, have employees called ‘examiners.’ These examiners are people with expertise in accounting and regulatory compliance who go on-site to the banks that are under their supervision and conduct bank exams. During these exams, examiners comb through bank balance sheets, policies, practices, and interview bank employees--all to ensure that the bank is properly complying with regulations. Different agency examiners have different jurisdictions and look for different things-- for example, examiners from the Consumer Financial Protection Bureau might look to make sure a bank isn’t unfairly charging its customers, while examiners from the Federal Reserve might check to make sure the bank isn’t making too many risky loans.

While smaller banks might only go through exams occasionally, megabanks like Goldman Sachs have teams of examiners on site permanently, since their business practices and balance sheets are so large and complex that they require constant review. Carmen Segarra and Rohit Bansal were two such examiners.

4) But wait, isn’t the Federal Reserve a private bank?

Well, it’s complicated. Most people know the Fed as the organization that sets monetary policy and manages the currency, buts its lesser-known role as a powerful bank regulator is just as important. The Federal Reserve is actually a system, composed of 12 regional banks located in major cities across the US, and the Board of Governors, which is located in Washington, DC. The Board of Governors is just that-- a board of seven men and women who write regulations for the banking system, make policies for the 12 regional banks, and oversee their activities. These seven governors are nominated by the US President and confirmed by the Senate, just like the heads of other government agencies. The Board of Governors, more than any other part of the Federal Reserve System, most closely resembles a federal government agency. It has a “dot-gov” web address, pays its employees on a public pay scale, and regularly reports to and testifies before Congress.

The 12 regional banks, while they are ultimately controlled by the Board of Governors, function more like private banks and have their own boards of directors. The presidents of these banks are privately selected without input from the US President or Congress. Banks like Goldman Sachs, which are regulated by these regional banks, are also members of the regional banks, and have some influence into how these banks are run. The Federal Reserve’s examiners, like Segarra and Bansal, are employees of these regional banks.

The most powerful of the regional banks is the Federal Reserve Bank of New York (FRBNY), where both Segarra and Bansal were employed as examiners. The FRBNY, located in downtown Manhattan, is responsible for regulating and supervising banks in the New York area, which is to say, many of the world’s largest and most complex banks like Goldman Sachs.

Ultimately, the president of the FRBNY is the most responsible for the behavior of the examiners, and the banks they regulate. The president of the FRBNY is a very powerful position, so the person filling the chair is usually well known around Wall Street and Washington. For example, the last president of the FRBNY was Timothy Geithner, who went on to become Treasury Secretary during the first four years of the Obama administration (not surprisingly, Geithner’s predecessor at the Treasury was Hank Paulson, who had previously been the CEO of Goldman Sachs). The current FRBNY president is a guy named William C. Dudley, who formerly served as chief economist to….Goldman Sachs. Not surprisingly, Mr. Dudley’s name has shown up in the news a bit lately, and he also appeared before Congress a few weeks ago.

5) Is “regulatory capture” as scary as it sounds?

It can be! Regulatory capture is a term used to describe how regulatory agencies, like the FRBNY, can be ‘captured’ by the business that they are supposed to regulate. Capture is often demonstrated when government regulators go easy on businesses, potentially because they may be seeking higher-paying employment with these businesses in the future. This is a particular problem in the world of financial regulation, because government employees often make far less than the bankers they are regulating. It’s not uncommon for regulators to quit their regulatory jobs and go work for a bank, often for two or three times more than their government salary. So if regulators are going about their jobs with future employment in mind, it can compromise their ability to adequately enforce the laws on the books. Even the best written laws aren’t any good if they aren’t firmly enforced, so bad regulatory capture can put the banking system, and the entire global economy, at risk.

6) So what (if anything) is Congress doing about all this?

In mid-November the Senate Banking Committee held a hearing entitled “Improving Financial Institution Supervision: Examining and Addressing Regulatory Capture.” This hearing featured testimony from FRBNY President William Dudley, and lengthy questioning from several Democratic Senators. Most notably, Senator Elizabeth Warren (D-MA) grilled Dudley about the FRBNY’s capture problem, his role in these two scandals, and his seemingly dismissive attitude about them. Warren and Dudley went back and forth for much of the hearing, and the conversation got testy at times.

At the same hearing, Senator Jack Reed (D-RI) introduced a bill that would require the president of the FRBNY to be nominated by the President and confirmed by the Senate, much like the Fed’s Board of Governors is currently. Reed’s legislation would also require the head of the FRBNY to testify before the Senate Banking Committee and the House Financial Services Committee at least once per year. Other proposals that were raised at the hearing include removing the Fed’s regulatory and supervisory powers and giving them to another agency like the FDIC, which is not traditionally as cozy with the banking industry.

7) But I thought the financial reform law was supposed to change things!

Well, the 2010 Dodd-Frank financial reform law did do many good things. It created an entirely new and powerful agency, the Consumer Financial Protection Bureau, to focus solely on how financial institutions treat their customers. It also created an umbrella organization, called the Financial Stability Oversight Council (FSOC) to oversee the federal government's entire approach to financial regulation and coordinate activities among the different agencies.

That being said, the Federal Reserve as a system was not significantly modified by the Dodd-Frank law. Although the Fed was given expanded regulatory and oversight powers under the law, its structure and culture remain largely the same as before the financial crisis. Senator Jack Reed’s recent proposals, which were included in early drafts of Dodd-Frank but later removed, would allow Congress to keep a direct eye on the FRBNY, instead of only through the Board of Governors. Although unlikely to become law in a Republican controlled Congress, these proposals would bring a significant change to the current relationship between Congress and the Fed.  

The problem of regulatory capture clearly remains. Even though employees of the bank regulatory agencies usually make more money than other federal employees (because they are exempt from the traditional “GS” pay scale), they still make far less than their counterparts in the financial industry.  The allure of lucrative post-government employment is a difficult phenomenon to reverse, especially in the current political environment where government agencies are subject to continuous sequesters, shutdowns, furloughs, and pay freezes. However, perhaps more important than compensation is an agency’s culture and understanding of its role in the economy. Segarra herself put it best-- when asked what was ultimately lacking at the Fed, she replied “lack of backbone, transparency, thoroughness and perseverance.”