Two Steps Forward And One Step Back For The Federal Reserve

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz professor of entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

This week the Federal Reserve took a major step toward establishing a more sensible set of rules for global banks operating in the United States. Yet in a separate and almost simultaneous smaller announcement, the Fed announced a change to the board of the Federal Reserve Bank of New York that sent all the wrong signals regarding whether the United States will really end up with more effective oversight for its financial system.

The Fed should put its new global banking rules into effect but rethink its criteria for who should sit on the New York Fed board.

First, let me take a moment to congratulate the Fed on the good news: “Enhanced Prudential Standards for Bank Holding Companies and Foreign Banking Organizations.” This may seem arcane and it is certainly technical, but the Board of Governors of the Federal Reserve, based in Washington, has moved to close important loopholes that previously allowed foreign banks to operate in the United States in a fashion that proved dangerous.

The new rule also covers American bank holding companies; most of these rules have been in the works for a while. The more important development is to require that large foreign banks fund their American operations and manage their risks here in a more responsible manner.

In the past, some foreign banks — Deutsche Bank springs to mind — ran their American businesses with much higher debt levels relative to equity funding (they had very high “leverage,” in the jargon) than was allowed for American banks and similar financial institutions. This will no longer be allowed, according to the Fed’s release:

Foreign banking organizations with U.S. nonbranch assets of $50 billion or more will be required to establish a U.S. intermediate holding company over their U.S. subsidiaries. The foreign-owned U.S. intermediate holding company generally will be subject to the same risk-based and leverage capital standards applicable to U.S. bank holding companies. The intermediate holding companies also will be subject to the Federal Reserve’s rules requiring regular capital plans and stress tests.

If this language seems too dry, just remember the facts. In 2008, through its intervention in A.I.G. and in other ways, the Federal Reserve became a lender of last resort to large foreign banks, as well as to American financial institutions; see Pages 26 and 43 in a helpful presentation provided by Better Markets, a pro-reform group. Providing such guarantees without being able to impose effective oversight (including limits on leverage) is a recipe for moral hazard and careless behavior more generally. The Fed is now, somewhat belatedly but in a welcome fashion, recognizing these realities.

I could quibble — for example, with this provision: “The final rule also generally defers application of the leverage ratio to foreign-owned U.S. intermediate holding companies until 2018.” The long phase-in seems more generous than wise. But on the whole, this rule is a positive development.

Unfortunately, this good news was partly spoiled by the unrelated announcement that a vacancy on the board of the New York Fed would be filled by David M. Cote, chief executive of Honeywell. (Mr. Cote is the only candidate in an election to fill that vacancy; the vote is by what is known as Group 2 banks, which means those “with capital and surplus of $30 million to $1 billion” that belong to the Second District of the Federal Reserve System, served by the Federal Reserve Bank of New York.)

I have nothing personal against Mr. Cote, whom I have never met. But I must point out that he is not only a former board member of JPMorgan Chase, he was also on that board and a member of its risk committee from July 2007 through July 2013, a period that spanned the London Whale trading losses debacle and other egregiously unacceptable behavior that has resulted in record fines and settlements for the company (including accusations of manipulating energy markets, ignoring warning signs about Bernard Madoff’s Ponzi scheme and much more).

To be clear, not all of this happened when Mr. Cote was on the board — some of it goes way back — but it all surfaced while he was a member of the board’s risk committee, which neglected its responsibilities to investigate, correct and prevent such risks. (Mr. Cote’s experience with JPMorgan Chase is not mentioned on the New York Fed’s ballot, although it does list his other prominent public positions.)

At its shareholder meeting last year, two JPMorgan Chase directors received such low levels of support that they subsequently resigned: Mr. Cote and Ellen V. Futter, president of the American Museum of Natural History.

As reported by The New York Times, at least one influential shareholder group explicitly recommended voting against Mr. Cote and Ms. Futter because of concerns about their stewardship and ability to oversee risks. Looking at the breadth and depth of legal failures, it’s hard to deny that there was a systematic breakdown of compliance and risk control — and that the board failed in its responsibilities to shareholders and more broadly. (James S. Crown, who was also criticized, remains on the board and is currently chairman of the risk policy committee.)

The New York Fed is full of smart, highly professional people who work hard to make the financial system more stable. At the same time, both the New York Fed and its Board of Governors, which is responsible for all aspects of how the New York Fed operates, including who sits on its board, seem to have a tin ear with regard to governance issues and how these can threaten the Fed’s independence. (As with all other regional Federal Reserve Banks, the New York Fed board and senior staff members pick potential board members, all of which are subject to approval by the Fed’s Board of Governors in Washington.)

For example, Jamie Dimon, the chief executive of JPMorgan Chase, was on the board of the New York Fed when his company bought Bear Stearns in early 2008. Financial support for this deal was provided by the Federal Reserve System, through the New York Fed.

I have talked to people involved in this transaction, and there are various opinions regarding the extent to which the New York Fed was in control of operational details relative to merely carrying out a plan provided by the Board of Governors in Washington.

In any case, the striking fact is that Mr. Dimon subsequently remained on the board of the New York Fed despite what, in any other context, would be regarded as a related party transaction. To be clear, I have never accused Mr. Dimon of doing anything illegal or improper. But in the rest of American society — both in the for-profit and nonprofit sectors — a board member would surely resign in such a situation without any shame or embarrassment. (Mr. Dimon eventually left the New York Fed board at the end of 2012, when his term expired.)

If Mr. Dimon did not want to resign, why did the Board of Governors not ease him out? This question became even more pointed — including in my post in this space — when the New York Fed had a leading role in investigating the London Whale trading losses that became public in 2012.

And given persistent legitimate concerns regarding how the financial system is overseen — including the role of the New York Fed — why would the Board of Governors agree to install someone closely associated both with JPMorgan Chase and with one of the biggest failures of risk management in recent years?

I’m glad that the Fed’s Board of Governors is moving the regulation of foreign banking organizations in the right direction. But it also has to focus on important details, such as who sits on the board of the New York Fed.