The directors of the Federal Reserve regional banks are selected by the very banks that the Fed is supposed to regulate. It's a bizarre entanglement of interests that helps explain the poor state of regulatory affairs on Wall Street.
And it's something that Richard Shelby -- the highest-ranking Republican on the Senate Banking Committee -- wants to change.
"It's an obvious conflict of interest. It reaches back to the 1913 act" that created the Fed, Shelby told HuffPost. "It's basically a case where the banks are choosing or having a big voice in choosing their regulator. It's unheard of. That is not widely known to the American people. It will be."
It's the kind of situation, Shelby said, that doesn't withstand public scrutiny. "It's something I'm very interested in changing, and I think the more it is illuminated, when people see what it is, they will see because it goes right back to the failure of the Federal Reserve to be a first-class regulator, and the role they played in the debacle," he said.
Shelby's vote is by far the most important on the GOP side when it comes to banking regulation reform. If a Democratic plan can get his support, it can generally become law. That Shelby is proposing the idea himself gives it a significant chance of passage.
Sen. Jack Reed (D-R.I.), a leading Democratic voice on banking issues, reacted positively to hearing of the Shelby proposal and suggested that, for example, the president of the New York Fed ought to be confirmed by the Senate. "All of this has to be looked at, and I think it's good that Senator Shelby put something on the table, because we can start looking at it," he told HuffPost.
The proposal could face resistance from the Treasury Department and Secretary Timothy Geithner, who is a creature of the Fed, having been president of the New York branch prior to his current position. Shelby said he floated the idea to Geithner over dinner once and the Treasury Secretary reacted coolly to the proposal. A Geithner spokesperson didn't immediately return a request for comment.
The best way to understand the bizarre structure of the Federal Reserve System is to check out the web addresses: .org versus .gov.
The Federal Reserve's Board of Governors is a public institution. Its website is www.federalreserve.gov.
The New York Fed is not: It is privately owned and operated by Wall Street banks and its website is www.newyorkfed.org.
The New York bank has nine directors. The three "Class A" directors are chosen by the banks that own it. The three "Class B" directors are also chosen by the banks to represent "consumers." Currently, the banks have chosen only one director to represent consumers; the other two seats are vacant. Who represents consumers? The CEO of General Electric, of course.
The final three spots -- "Class C" directors -- are stocked with representatives of the "public" and appointed by the board of governors.
Who does the Fed think should represent the public? Goldman Sachs. At least, that is, until the Goldman Sachs rep resigned amid controversy surrounding trades he had made. In May 2009, Stephen Friedman, a former Goldman chairman and still a member of its board, stepped down as head of the New York Fed's board of directors. His resignation came after he was found to have sold a ton of Goldman stock at a great profit after action by the New York Fed may have made that profit possible.
The media reported his resignation but left unanswered a real brainteaser. Friedman had been a Class C director: Why was Goldman Sachs tasked with representing the interests of the public? Much has been written about Goldman Sachs in recent months but even its most ardent defenders are hard-pressed to put the banking behemoth in any sentence that might also include, say, US PIRG or the Consumer Federation of America.
Friedman was replaced by Kathryn Wylde, president and chief executive officer of the Partnership for New York City, described in her bio as "a nonprofit organization of the city's business leaders." Again, she is a "public" representative. The two other public representatives: Lee Bollinger, Columbia University's president and Dennis Hughes, president of the New York State AFL-CIO.
"Anybody that can choose their own regulator has an advantage to begin with over the regulator," said Shelby.
On Tuesday, Democratic Sen. Jeff Merkley (Oregon) and Republican Sen. Bob Corker (Tenn.) introduced a bill to audit the Federal Reserve's response to the economic crisis. Merkley, told of Shelby's plan, said he was encouraged and would reach out to him.
Reed, too, said that the Fed's governance is fair game. "The whole governance and operation of the Federal Reserve has to be reviewed and should be reviewed. I don't think we can just assume, you know, business as usual," said Reed.
Senate Minority Leader Mitch McConnell (R-Ky.) said he wasn't opposed to the idea but wasn't ready to commit. "I haven't talked to [Shelby] about it. I will," he said. "I think we're going to look at all those issues in the context of the financial re-regulatory debate when that comes around."
Shelby agrees. "That should be part, in my view, of the overall regulatory overhaul," he said. "It's an obvious conflict of interest if I've ever seen one."
UPDATE: Shelby has Banking Committee Chairman Chris Dodd (D-Conn.) in his corner. "Senator Shelby and I agree that it makes no sense for banks to be able to appoint their own regulators. It's absolutely backwards, and we intend to change the system as we write the comprehensive financial reform bill," he said in a statement to HuffPost.