GAO Study Finds Potential Conflicts of Interest at the Fed

Econintersect:  A report has been published by the GAO (General Accounting Office with the innocuous title:  “Federal Reserve Bank Governance:  Opportunities Exist to Broaden Director Recruitment Efforts and Increase Transparency.”  The title serves as a cover to a report that discusses what appears to be an old boys’ club of the financial elite.  The Federal Reserve charter stipulates that the various Federal Reserve boards will have representation from all industry groups, including labor and consumers.  The report states that these two groups were less represented than others in the years studied, 2006-2010.  The report further identifies situations where board members with industrial and banking affiliations participated in decisions that benefited those organizations.

As stated initially, the title is innocuous, but the contents are not.From the GAO report (page 32):

When the Federal Reserve System played a key role in providing assistance to financial institutions during the 2007-2009 financial crisis, Reserve Bank board governance came under scrutiny because, among other things, a number of director-affiliated banks and nonbank financial institutions participated in the Federal Reserve System’s emergency programs. Since then, Congress, the Federal Reserve Board, and Reserve Banks have made a number of changes to the policies and procedures that address Reserve Bank governance. However, without more complete documentation of the directors’ roles and responsibilities with regard to the supervision and regulation functions, as well as increased public disclosure on governance practices to enhance accountability and transparency, questions about Reserve Bank governance will remain.

Conclusions of the GAO report (emphasis added by GEI News):

The Federal Reserve System was designed as a decentralized entity with a governmental institution and 12 separately incorporated Reserve Banks. Under this public-private partnership, the Reserve Bank directors serve a role in bringing information from their communities to inform the monetary policy deliberations of the central bank and helping oversee the operations of the Reserve Banks. The directors, like the Federal Reserve Board, are also part of the governance framework of the Reserve Banks. However, the operations and governance of the Federal Reserve System came to the forefront during the 2007-2009 financial crisis when it played a prominent role in stabilizing financial markets through the use of its emergency lending authorities. These unprecedented actions resulted in Congress and the public raising questions about the Reserve Banks’ governance practices and potential conflicts of interest involving the directors.

Specifically, some questioned how well the Reserve Bank boards represent the public, which in part could be measured by the economic and demographic diversity of the directors. Our analysis shows that from 2006 through 2010 labor and consumer groups tended to be less represented than other industry groups on both head office and branch boards. While the Federal Reserve Board encouraged the Reserve Banks to recruit directors from consumer and labor organizations, restrictions on directors’ political activities appeared to be a challenge in recruiting representatives from these organizations, who tend to be politically active. Our analysis also shows that while there is some variation among the Reserve Banks in the representation of women and minorities at head office and branch boards, overall, it has remained limited. Although it is difficult to know whether the board’s decisions would have been different had there been greater diversity on the boards, the public that the board represents is becoming increasingly diverse. Officials from most Reserve Banks generally focus their search for candidates on senior corporate executives, who are perceived to have a relatively broad perspective on the economy.  However, seeking directors from among senior or chief-level executives may contribute to the limited diversity on the boards because as our analysis of EEOC data shows, diversity at the senior executive level is more limited than at the senior manager level across industries. To the extent that director searches are limited to chief-level executives, the Reserve Banks not only limit the diversity of the pool of potential candidates but also risk limiting the perspectives shared about the economy in the formation of monetary policy.

The statutory requirement for three classes of directors was intended to provide representation of both stockholding banks and the public. However, the existence of Class A and to a lesser extent Class B directors on the boards creates an appearance of a conflict of interest, particularly in matters involving supervision and regulation. Moreover, directors from all three classes could have past and current affiliations with financial institutions. These affiliations have given rise to relationships that pose reputational risk to the Reserve Banks. While director conflicts can be identified and managed, interconnectedness between directors and financial institutions cannot be eliminated; therefore, ongoing challenges remain. For example, the credibility of the Federal Reserve System will be affected by the perceived effectiveness of its ability to manage conflict issues. While the Federal Reserve System has recognized the importance of public perception and made changes to Reserve Bank governance practices, more could be done to increase the flow of information on the directors’ roles to the public and strengthen controls. Specifically, greater transparency could assist the public in understanding the roles and functioning of the Reserve Bank boards, such as clarifying the limited nature of Reserve Bank directors’ involvement in supervision and regulation operations with a statement in the Reserve Bank board bylaws could help to improve the public’s confidence in Reserve Bank governance. While waivers are one way the Federal Reserve System mitigates conflicts involving Federal Reserve Board eligibility requirements, not all Reserve Banks have procedures for requesting a waiver from the Federal Reserve Board. Moreover, if waivers are granted, there is no requirement to make that information public. Failing to make the process and decisions more transparent can decrease confidence in the Federal Reserve System and has resulted in questions about the integrity of Reserve Banks’ operations and the appearance of conflicts of interest.

Finally, while the Federal Reserve System has taken steps to increase transparency of governance practices as well as transparency overall, Reserve Bank governance practices were generally not as transparent as those of other central banks and financial institutions that we studied. In a time when the Federal Reserve System’s emergency actions have resulted in relationships between Reserve Banks and directors and the relationships between directors and financial firms being questioned, more transparent governance practices are essential to the effective and credible functioning of the Reserve Banks and the Federal Reserve System as a whole.  While the Federal Reserve System has taken some steps to increase the transparency of its governance practices, such as conducting quarterly press conferences after the FOMC meetings, additional actions such as making key governance documents easily accessible to the public could enhance transparency and protect organizational reputation.  Moreover, without more public disclosure of governance arrangements, such as board of director bylaws and director eligibility and ethics policies, there may be continued concerns about Reserve Bank governance and the integrity of the Federal Reserve System.

Recommendations:

While the Federal Reserve System recently has made changes to Reserve Bank governance, it can take additional steps to strengthen controls designed to manage conflicts of interest involving Reserve Bank directors and increase public disclosure of directors’ roles and responsibilities. As such, we recommend that the Chairman of the Federal Reserve Board take the following four actions:

1. To help enhance economic and demographic diversity and broaden perspectives among Reserve Bank directors who are elected to represent the public, encourage all Reserve Banks to consider ways to broaden their pools of potential candidates for directors, such as including officers who are below the senior executive level at their organizations.
2. To further promote transparency, direct all Reserve Banks to clearly document the roles and responsibilities of the directors, including restrictions on their involvement in supervision and regulation activities, in their bylaws.
3. As part of the Federal Reserve System’s continued focus on strengthening governance practices, develop, document, and require all Reserve Banks to adopt a process for requesting waivers from the Federal Reserve Board director eligibility policy and ethics policy for directors. Further, consider requiring Reserve Banks to publicly disclose waivers that are granted to the extent disclosure would not violate a director’s personal privacy.
4. To enhance the transparency of Reserve Bank board governance, direct the Reserve Banks to make key governance documents, such as such as board of director bylaws, committee charters and membership, and Federal Reserve Board director eligibility policy and ethics policy, available on their websites or otherwise easily accessible to the public.

In official comments to the GAO upon review of the report, The Fed acknowledged that improvement was needed and would be pursued in the areas highlighted in the report.

In part motivated by this report, Sen. Bernie Sanders (I, VT) has organized a blue ribbon committee to advise on drafting legislation to reform the Federal Reserve.  Sen. Sanders has written a scathing indictment of the Fed based on the GAO report.