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Why the Fed Is So Wimpy
JOHN MAULDIN | October 1, 2014
Another in what seems to be a small parade of scandals involving secretly recorded tapes of Federal
Reserve regulators emerged last week. What a number of writers (including me) have written about
regulatory capture over the past decade was brought out into the open, at least for a while. My brilliant
young friend (40 seems young to me now) Justin Fox, editorial director of the Harvard Business Review
and business and economic columnist for Time magazine, published a thoughtful essay this week,
outlining some of the issues surrounding the whole concept of banking regulations.
Yes, the latest scandal involved Goldman Sachs, and it took place in the US, but do you really think its
much diferent in Europe or Japan? Actually, there are those who argue that its worse in those places. Tis
does not bode well for what happens during the next crisis (and there is always a next crisis, hopefully far
in the future, though they do seem to come more frequently lately).
Writes Justin:
Te point here is that if bank regulators are captives who identify with the interests of the banks
they regulate, it is partly by design. Tis is especially true of the Federal Reserve System, which
was created by Congress in 1913 more as a friend to and creature of the banks than as a watchdog.
Two-thirds of the board that governs the New York Fed is chosen by local bankers. And while
amendments to the Federal Reserve Act in 1933 shifed the balance of power in the Federal
Reserve System from the regional Federal Reserve Banks (and the New York Fed in particular)
to the political appointees on the Board of Governors in Washington, bank regulation continues
to reside at the regional banks. Which means that the bank regulators bosses report to a board
chosen by the banks.
For those who would like a bit more bearish meat, I ofer you a link to John Hussmans latest piece, Te
Ingredients of a Market Crash.
Im in Washington DC today at a conference sponsored by an association of endowments and foundations.
Tey have a rather impressive roster of speakers, so I have found myself attending more sessions than
I normally do at conferences. Martin Wolf and David Petraeus headline a very thoughtful group of
managers and economists, accompanied by an assortment of geopolitical wizards. Ive learned a lot.
Outside the Box is a free weekly economic e-letter by best-selling author and renowned fnancial expert,
John Mauldin. You can learn more and get your free subscription by visiting www.mauldineconomics.com
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No follow-on note today. I need to get back to my classroom education
Your loving the fall weather analyst,

John Mauldin, Editor
Outside the Box
Why the Fed Is So Wimpy
By Justin Fox
Harvard Business Review HBR Blog Network
September 26, 2014
Regulatory capture when regulators come to act mainly in the interest of the industries they regulate is
a phenomenon that economists, political scientists, and legal scholars have been writing about for decades.
Bank regulators in particular have been depicted as captives for years, and have even taken to describing
themselves as such.
Actually witnessing capture in the wild is diferent, though, and the new Tis American Life episode with
secret recordings of bank examiners at the Federal Reserve Bank of New York going about their jobs is
going to focus a lot more attention on the phenomenon. Its really well done, and you should listen to it,
read the transcript, and/or read the story by ProPublica reporter Jake Bernstein.
Still, there is some context thats inevitably missing, and as a former banking-regulation reporter for
the American Banker, I feel called to fll some of it in. Much of it has to do with the structure of bank
regulation in the U.S., which actually seems designed to encourage capture. But to start, there are a couple
of revelations about Goldman Sachs in the story that are treated as smoking guns. One seems to have fred
a blank, while the other may be even more explosive than its made out to be.
In the frst, Carmen Segarra, the former Fed bank examiner who made the tapes, tells of a Goldman
Sachs executive saying in a meeting that once clients were wealthy enough, certain consumer laws didnt
apply to them. Far from being a shocking admission, this is actually a pretty fair summary of American
securities law. According to the Securities and Exchange Commissions accredited investor guidelines, an
individual with a net worth of more than $1 million or an income of more than $200,000 is exempt from
many of the investor-protection rules that apply to people with less money. Tats why rich people can
invest in hedge funds while, for the most part, regular folks cant. Maybe there were some incriminating
details behind the Goldman executives statement that alarmed Segarra and were lef out of the story, but
on the face of it theres nothing to see here.
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Te other smoking gun is that Segarra pushed for a tough Fed line on Goldmans lack of a substantive
confict of interest policy, and was rebufed by her boss. Tis is a big deal, and for much more than the
legal/compliance reasons discussed in the piece. Tats because, for the past two decades or so, not having
a substantive confict of interest policy has been Goldmans business model. Representing both sides in
mergers, betting alongside and against clients, and exploiting its informational edge wherever possible
is simply how the frm makes its money. Forcing it to sharply reduce these conficts would be potentially
devastating.
Maybe, as a matter of policy, the United States government should ban such behavior. But asking bank
examiners at the New York Fed to take an action on their own that might torpedo a leading banks profts
is an awfully tall order. Te regulators at the Fed and their counterparts at the Ofce of the Comptroller of
the Currency and the Federal Deposit Insurance Corporation correctly see their main job as ensuring the
safety and soundness of the banking system. Over the decades, consumer protections and other rules have
been added to their purview, but safety and soundness have remained paramount. Proftable banks are
generally safer and sounder than unproftable ones. So bank regulators are understandably wary of doing
anything that might cut into profts.
Te point here is that if bank regulators are captives who identify with the interests of the banks they
regulate, it is partly by design. Tis is especially true of the Federal Reserve System, which was created
by Congress in 1913 more as a friend to and creature of the banks than as a watchdog. Two-thirds of the
board that governs the New York Fed is chosen by local bankers. And while amendments to the Federal
Reserve Act in 1933 shifed the balance of power in the Federal Reserve System from the regional Federal
Reserve Banks (and the New York Fed in particular) to the political appointees on the Board of Governors
in Washington, bank regulation continues to reside at the regional banks. Which means that the bank
regulators bosses report to a board chosen by the banks.
Ten theres the fact that Goldman Sachs is a relative newcomer to Federal Reserve supervision it and
rival Morgan Stanley only agreed to become bank holding companies, giving them access to New York Fed
loans, at the height of the fnancial crisis in 2008. While its a little hard to imagine Goldman choosing now
to rejoin the ranks of mere securities frms, and even harder to see how it could leap to a diferent banking
regulator, it is possible that some Fed examiners are afraid of scaring it away.
All this is meant not to excuse the extreme timidity apparent in the Fed tapes, but to explain why its been
so hard for the New York Fed to adopt the more aggressive, questioning approach urged by Columbia
Business School Professor David Beim in a formerly confdential internal Fed report that Tis American
Life and ProPublica give a lot of play to. Bank regulation springs from much diferent roots than, say,
environmental regulation.
So what is to be done? A lot of the classic regulatory capture literature tends toward the conclusion that
we should just give up shut down the regulators and allow competitive forces to work their magic. Tat
means letting businesses fail. But with banks more than other businesses, failures tend to be contagious. It
was to counteract this risk of systemic failure that Congress created the Fed and other bank regulators in
the frst place, and even if you think that was a big mistake, theyre really not going away.
Outside the Box is a free weekly economic e-letter by best-selling author and renowned fnancial expert,
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More recently, theres been a concerted efort to take a more nuanced view of regulatory capture and how
to counteract it. Te recent Tobin Project book, Preventing Regulatory Capture: Special Interest Infuence
and How to Limit It, sums up much of this thinking. While Ive read parts of it before, I only downloaded
the full book an hour ago, so Im not going to pretend to be able to sum it up here. But heres a thought
maybe if banking laws and regulations were simpler and more straightforward, the bank examiners at
the Fed and elsewhere wouldnt so ofen be in the position of making judgment calls that favor the banks
they oversee. Ten again, the people who write banking laws and regulations are not exactly immune from
capture themselves. Tis wont be an easy thing to fx.
update: Te initial version of this piece listed the Ofce of Trif Supervision as one of the nations bank
regulators. As David Dayen pointed out (and I swear I knew at some point, but had totally forgotten), it
was subsumed by the OCC in 2011.
Justin Fox is Executive Editor, New York, of the Harvard Business Review Group and author of Te Myth
of the Rational Market. Follow him on Twitter @foxjust.
Copyright 2014 John Mauldin. All Rights Reserved.
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