The below are edited remarks from a speech I delivered at the Rethinking Regulation Seminar hosted by Duke University’s Kenan Institute for Ethics on October 25th, 2016.
Today I will talk about an episode that occurred early in my tenure at the New York Fed. And I tell this story not simply because it is entertaining, but because it sheds light on the nature and practice of on the ground bank supervision. It also highlights key differences between the public’s perception of the role of bank supervisors, shaped in part by the media, and the actual practice of large bank supervision. These differences persist to this day, and in my opinion, pose a threat to the long-term credibility of federal banking agencies.
In the summer of 2011, I joined the New York Fed as a bank examiner after receiving my Masters in Public Policy from Duke. My first assignment was on the Goldman Sachs supervisory team, where four days a week I would spend my days inside the firm’s glittering glass tower along the Hudson river in lower Manhattan. For a young man from a small town in Minnesota, it was initially quite the shock. Here I was inside what felt like the epicenter of global finance, surrounded by immaculately dressed financiers who could have passed for actors in a soap opera. Of course by that point, Goldman’s reputation as the evilest of Wall Street villains was firmly established. They were so reviled by the public that Rolling Stone’s Matt Taibbi infamously referred to the firm as a “great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”
Although there was no way of ignoring Goldman’s reputation, I found my supervisory colleagues dedicated to assessing the firm based upon observable facts, and focused on ensuring that the firm adhered to the influx of new rules and regulations that emerged post-crisis, many of which were mandated by the Dodd-Frank Act. Our team leader at the time was Mike Silva, a long-time Fed employee, who had served as Tim Geithner’s chief of staff during the worst of the financial crisis when Geithner was president of the New York Fed. Prior to joining the Fed, Mike had flown F-14s in the Navy, and after the second gulf war broke out, he took a leave of absence to serve as an advisor to the Central Bank of Iraq in Baghdad. As a veteran myself, I found his commitment to public service inspiring, and I thought he was an effective leader who took an active interest in the work of every team member.
At the time, the New York Fed’s supervision department was growing rapidly due to the additional authority Dodd-Frank had granted the Federal Reserve. Although some new employees were fresh from graduate school, such as myself, many were hired directly from the financial services industry due to their experience and relevant expertise. I did not find this problematic, as these folks were hired to simply fill a need that Congress had created through Dodd-Frank. Many became dedicated public servants, and I know I personally benefited from their collective knowledge, which I absorbed over the years.
The majority of these industry hires enjoyed being out of the pressure-cooker environments they previously occupied, where the persistent drive for profit and market share led to long hours and missed family time. For these folks, life as a regulator brought welcome stability and work-life balance. However, it was clear that a small minority chafed at the new bureaucratic strictures they faced inside a regulatory agency. Used to the ability to act quickly and autonomously, these people became frustrated by the time consuming and multi-layered decision making process within the Federal Reserve. Most of them would quickly find jobs elsewhere.
One colleague who I thought fell into the latter category was Carmen Segarra. Carmen joined the Goldman Sachs supervisory team in October 2011 as a legal and compliance examiner, and a couple of things about her immediately stood out to me. The first was that she appeared overqualified for the position she was in. She attended Harvard undergrad and Cornell law school, and she had extensive legal experience on Wall Street, including stints at Bank of America, Citigroup, and Société Générale. Later I would discover that she had previously been a regular contributor to Fox News – experience not found on your typical bank examiner’s resume. Beyond her qualifications, the most striking feature about Carmen was her assertiveness. I recall during team meetings, she would often make broad pronouncements about things Goldman was or was not doing, without providing much by way of detail. It’s not that I assumed she was wrong, but it was hard to fathom how someone so new to the team could have acquired enough information to support these claims.
I did not work closely with Carmen during the short time we overlapped on the Goldman team. But for my colleagues who did, she clearly became a source of tension and frustration. From my perch, I thought perhaps it was just a clash of personalities, and that some of my longer tenured New York Fed colleagues were simply unaccustomed to Carmen’s hard-charging private sector attitude. But I realized there was more to it than that, when seven months after she arrived, Carmen was fired.
The news generated a lot of buzz within the supervision department, as it was extremely rare for someone to be let go. By that time, I had moved on to cover a different firm, and my former colleagues on the Goldman team did not have many details around the circumstances of Carmen’s dismissal. I knew there was more to the story, but I assumed I would never get the full version.
My assumption was proven wrong when in October of 2013, Carmen filed a wrongful termination lawsuit against the New York Fed and three of its employees, including Mike Silva, in federal court. The suit alleged that Carmen was fired after she uncovered problems with Goldman Sachs’ conflict-of-interest policy and refused to back off her claims after being pressured to do so by her supervisors. According to her lawyer, Carmen’s dismissal violated the whistleblower protection provisions of the Federal Deposit Insurance Act, which were enacted in 1989 after the savings and loan crisis to protect the independence of federal banking regulators.
On the same day the lawsuit was filed, ProPublica and The Washington Post co-published a story detailing the lawsuit’s main allegations. Their reporting was assisted by Carmen herself, who provided the news outlets with a “detailed account of the events that preceded her dismissal” and “numerous documents, meeting minutes and contemporaneous notes that supported her claims.” The story created a minor stir within the finance community, but quickly faded into the background as the news cycle churned along. Within the New York Fed, senior management told employees that Carmen’s claims were baseless, and they were proven right when a federal judge dismissed the lawsuit in April of 2014.
I do not intend to provide a detailed legal analysis of the case, but I will note that the judge’s decision hinged upon the interpretation of what are known as Supervision and Regulation Letters, commonly known as SR letters. SR letters constitute a critical part of the supervisory toolkit and are frequently used by examiners to assess banks on a whole host of issues. Carmen alleged that Goldman’s lack of a firmwide conflict-of-interest policy violated SR letter 08-08, which governs compliance risk management programs at large banks. Carmen’s lawyer argued that SR letters constitute a regulation, and thus entitled Carmen to whistleblower protections under the Federal Deposit Insurance Act. The New York Fed countered that SR letters are simply advisory letters and not regulations – thus exempting Carmen from whistleblower status. The court sided with the Fed, concluding that SR letter 08-08 does not carry the force of law and that Carmen is thus not a “whistleblower.”
Carmen announced she intended to appeal the ruling, but within the New York Fed, we considered the matter closed. That was, until the morning of September 26th, 2014, when ProPublica published an exposé based upon 46 hours of secretly recorded audio collected by Carmen while conversing with her New York Fed colleagues and attending meetings with Goldman Sachs employees. Later that evening, the story entered the mainstream consciousness when the radio program This American Life broadcast an episode that included edited excerpts of the secret recordings.
The This American Life story primarily centered around the Goldman Sachs supervisory team’s investigation into a transaction Goldman set up to help the large Spanish bank, Banco Santander, improve its capital ratio. Goldman notified the supervisory team about the transaction prior to its closing, which Carmen considered to be unusual. A subsequent review by Carmen and her colleagues uncovered documentation which indicated that at one point, Goldman considered seeking a letter of non-objection from the Federal Reserve before executing the transaction. To Carmen and some of her colleagues, this was proof that the firm was aware the transaction could draw the ire of regulators. In the audio recordings, Mike Silva called the deal “legal but shady” and vowed to grill the firm on why they thought they needed the Fed’s non-objection before proceeding with the transaction. According to the radio program, when the moment of truth arrived and Silva and some of his staff, including Carmen, met with Goldman to quiz them on the Santander deal, he proved feckless and asked one meager clarifying question.
In an hour-long broadcast that used only 8 minutes out of the 46 hours of secret recordings, This American Life painted a damning picture of regulatory capture – regulators so close to the firms they supervise that they are unwilling to hold them accountable. To the media and public who had long viewed Goldman Sachs as enjoying too cozy a relationship with the government, the story was red meat. In a Bloomberg column, Michael Lewis referred to the recordings as “The Ray Rice video for the financial sector.” Other articles referred to Carmen as the whistleblower of Wall Street.
Naturally Congress took note of the scandal, and in November of 2014, New York Fed president William Dudley was called to testify in front of a Senate Banking Subcommittee. Dudley defended the Fed’s supervisory practices and reiterated his view that bank examiners did not enjoy too close a relationship with the firms they supervised. During the hearing, there was one particularly illuminating exchange between Dudley and Massachusetts Senator Elizabeth Warren. Warren pressed Dudley on what he considered to be the NY Fed’s main supervisory responsibilities, noting that she viewed federal regulators as being like cops on the beat, out to stop illegal or unsafe conduct, ideally before it happens. Dudley disagreed with this characterization, instead likening the Fed to a fire warden, whose job is to ensure financial institutions are well managed and strong enough that if they catch fire, they don’t burn down. It is important to understand these competing perspectives, and I will focus the remainder of my remarks on examining the distinction between what I will call “beat cop supervision” and “fire warden supervision.”
When I think of a fire warden, I think of three main responsibilities:
- Ensuring that buildings are constructed and laid out in such a way that it reduces the likelihood that a fire will start and minimizes the damage if a fire does start;
- Making sure that a building has working fire alarms, sprinklers, and fire extinguishers so that if a fire does start, it can be put out quickly; and
- Conducting periodic fire drills to ensure all building inhabitants know what to do in case of a fire.
Current prudential banking supervision, especially as practiced by the Federal Reserve, fits the fire warden analogy nicely:
- Regulatory capital is like raw building material. It serves as an indicator of a bank’s health and ensures that a bank won’t collapse if it does get into trouble.
- Liquidity acts like a fire extinguisher, ensuring that a bank has sufficient assets on hand which it can quickly monetize to meet the demands of creditors during a period of market or firm-specific stress.
- Capital stress testing, like the Federal Reserve’s annual CCAR exercise, and resolution plans, also known as living wills, function like fire drills. Stress testing ensures that banks have enough capital to withstand a severe economic downturn and living wills require banks to develop plans for how they can be unwound in an orderly fashion if they reach the point of imminent failure.
While I was at the New York Fed, we spent the vast majority of our time doing fire warden supervision, largely due to the requirements imposed on us by Dodd-Frank. But how do you measure the success of this type of supervision? Proponents of the approach would point to the current health of U.S. banks and their ability to maintain the critical provision of credit during periods of recent market stress as evidence of its success. That U.S. banks emerged relatively unscathed from the collapse of derivatives broker MF Global, the European debt crisis, and the Brexit vote is considered proof that fire warden supervision works.
If you subscribe to the beat cop notion of bank supervision, your view will be significantly less rosy. Beat cop supervision implies that regulators should be aggressively probing banks so they can uncover evidence of wrongdoing. To the beat cop supervisor, no infraction is too insignificant to go unpunished, and legality matters not. If an activity or transaction simply looks wrong, the supervisor should intercede and stop it. To the beat cop theorists, the list of post-crisis supervisory failures is long. They ask why, for example, supervisors didn’t prevent, or stop sooner the rigging of interest rate and foreign exchange rate benchmarks; J.P. Morgan’s London whale; Credit Suisse’s facilitation of tax fraud; and Wells Fargo’s opening of millions of unauthorized customer accounts.
It is difficult to reconcile these competing perspectives. Looking at the Goldman Sachs and Banco Santander transaction, Warren believed that the New York Fed should have stepped in to stop the deal because it served no economic purpose other than helping Santander “evade” European capital regulations. To Dudley, the deal did not pose a threat to Goldman’s safety and soundness and was deemed perfectly legal by the New York Fed legal department; therefore he saw no need to aggressively interfere.
Some of you may ask, why can’t federal banking supervisors play the role of both fire warden and beat cop? After all, there are three federal agencies dedicated to banking supervision – the OCC, Federal Reserve, and FDIC – surely they must have the combined capacity to do so. I would argue that it’s not a matter of capacity, but of tools and capabilities. Bank supervisors don’t have the ability to go undercover or conduct sting operations, they don’t have unfettered access to each bank’s management information systems, and perhaps most importantly, they don’t have a robust whistle-blower program to incentivize individuals to come forward and disclose evidence of wrongdoing inside a bank. In essence, they are a cop without a utility belt.
Unless Congress passes legislation to expand the supervisory toolkit and provide additional clarity on the roles and responsibilities amongst the three federal banking agencies, fire warden supervision and beat cop supervision will continue to exist in tension with one another. This will lead to the continued erosion of the public’s confidence in financial regulators, as the inevitable bank scandals of the future will once more beg the question – “how could they miss this?”
After the ProPublica and This American Life stories came out, life inside the New York Fed’s supervision department became a bit hectic. The Federal Reserve Board of Governors ordered multiple reviews of our supervisory practices to ensure that divergent views were being heard. I was interviewed by a trio of investigators who asked for my thoughts on the New York Fed’s culture. I expressed my concern that we were focused too much on consensus building, but I believed in the purpose of our mission, and I knew we would get better.
As an epilogue to my story, Mike Silva left the Fed in December of 2013 to enter the private sector. Most of us assumed his decision was influenced by the media coverage. Last September, an appeals court upheld the district court’s decision to dismiss Carmen’s claims against the New York Fed and three of its employees, including Silva. The court found that Carmen’s attempt to sue individual defendants in this case was “entirely speculative, meritless, and frankly quite silly.” The ruling received barely a mention in the financial press.