January 22, 2013

Allegations that Timothy Geithner, then head of the New York Federal Reserve, may have told banks ahead of time about a surprise policy move in 2007 underscores the pressing case for reform to safeguard the integrity and independence of the central bank.

Specifically Congress needs to act to make the lines between the banking industry and the governance of the regional Federal Reserve banks cleaner, guarding against a "we are all boys in this together" attitude and ensuring a diversity of views from outside the financial services industry.

As revealed in transcripts released last week of Fed meetings from 2007, Richmond Fed President Jeffrey Lacker said Geithner, now the outgoing Secretary of the Treasury, discussed with banks an upcoming change in the discount rate, a move which proved highly price sensitive when it was publicly announced.

"From conversations I had prior to the video conference call on August 16, 2007, I was aware of discussions among a few large banks about borrowing from their discount windows to support the asset backed commercial paper market," Lacker said in the statement.

"My understanding was that President Geithner had discussed a reduction in the discount rate with these banks in connection with these initiatives." ()

Qualified banks can borrow from the Fed at the so-called discount window at the discount rate.

The Treasury has declined to comment beyond the transcripts, in which Geithner replied at the time about his discussions with banks:

"The only thing I've done is to try to help them understand - and I'm sure that's been true across the system - what the scope of that is because these people generally don't use the window and they don't really understand in some sense what it's about."

Clearly a bit of sunlight is needed on this particular episode, and doubtless some Congressional committee will take a look at it. While the President of the New York Fed, which has and should have deep links with banks and markets, will always have need of discussions with bankers, tipping a rate move in advance is highly improper, especially in times of financial market dislocation.

Moreover, seeing as how Geithner, both at the Fed and as Treasury Secretary, has seemed to consistently favor the interests of banks over those of his many other constituents, this is more than a little disturbing.

Geithner not only was instrumental in driving government support for shaky banks, in words, pledges and through programs like the Troubled Asset Relief Program, his management of mortgage relief efforts was more effective for banks in spreading out the pain of defaults than in aiding homeowners.

TANGLED LINES

Regardless of who did what to whom, there is a clear and easy opportunity to put the regional Federal Reserve banks on a more sound footing in their relations with the industry they must help to regulate.

As it stands, six of the nine directors on the boards of the regional banks are appointed by member banks, with the other three sometimes appointed from non-profits which can and often do solicit funds from banks. ()

So-called class A directors are chosen by and represent member banks. They are almost invariably working bankers. Class B directors are chosen by member banks to represent the public, a state of affairs which would never be tolerated in other areas of public life. Class C directors are appointed by Fed Governors to represent a range of other interests.

Seeing as how the boards perform many important functions, including helping to select governors, this creates at the very least the appearance of undue influence, undermining essential confidence in the independence of the system.

As a result of this state of affairs, Jamie Dimon, CEO of J.P Morgan, was until the turn of the year a class A director of the New York Fed, including during the time in which the central bank was monitoring JPM's disastrous "London Whale" trading escapade.

Dimon left at the expiration of his term and his seat is still unfilled. He resisted calls for him to step down early, and indeed was supported in doing so by NY Fed Board chairman class C board member Lee Bollinger, President of Columbia University, which has been financially supported by, yes, JP Morgan.

This prompted a variety of calls for reform, notably from MIT economist Simon Johnson, who argued that the boards should be made strictly advisory. This was justified at the time, and makes even more sense now. ()

Everyone involved may be behaving entirely ethically; it is of course impossible to determine from outside. This is why the situation cries out for reform.

Change the law so that Class B directors are appointed by the Fed itself with an eye towards bringing in a diversity of views on the economy. And make sure that Class C directors are not in any way dependent on the good graces of banks in their day jobs.

An independent Federal Reserve, accountable to the public at large and carrying their confidence, is a great thing and too valuable to risk.

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