Dudley's Awful Metaphor and What It Means for the Fed
Senate Democrats hammered William Dudley, president of the Federal Reserve Bank of New York, at a highly anticipated hearing on Friday, demonstrating the growing pressure the central bank is under to take harsher actions against banks and restrict examiners from defecting to institutions after leaving service.November 21
The Federal Reserve announced two separate reviews Thursday to ensure that supervision of the largest banks is being handled correctly.November 20
The investigative story alleging weak supervision by the Federal Reserve Bank of New York has sent shockwaves through the regulatory community, but whether it will lead to any change of course in policy is still an open question.September 30
WASHINGTON It is a well-worn cliché to describe federal regulators as a "cop on the beat."
The analogy is imperfect because enforcement is just one piece of what regulators do in addition to assessing risks, writing new rules and the like. Still, it's rare to see a top official object to the metaphor, particularly in front of members of Congress. But that's just what New York Fed President William Dudley did on Friday after Sen. Elizabeth Warren described his role in those terms.
"I don't think our primary purpose as supervisors is a cop on the beat," Dudley replied. "It's more like a fire warden; make sure that the institution is well run so that, you know, it's not going to catch on fire and burn down. And managed in a way that if the institution is stressed that it doesn't collapse and threaten the rest of the financial system."
It's a response that's likely to come back to haunt him. It temporarily stunned Warren, D-Mass., and with good reason. In describing his role as a fire warden, Dudley reached for a metaphor with probably more meaning than he intended, and one with potentially disturbing implications.
The job of a cop on the beat is pretty straightforward. They are there to keep the peace, look for wrongdoing, and punish offenders when necessary.
But the role of a fire marshal is very different. A fire marshal's job is to protect a building and its inhabitants and save them at all costs, even from the consequences of their own errors. If a man lights his house on fire, the marshal's job isn't to punish him or even make sure it doesn't happen again. The fire marshal's role is instead to deal with the fire, rescue everyone, and put it out before it can spread.
That sounds noble, and in real life it is. But when discussing bank regulation, it raises the uncomfortable specter of bailouts and other supervisory intervention taken not to prevent problems, but instead to contain them. A fireman is a reactive role, not a proactive one. If the regulators are fire marshals, then their focus is always going to be on saving the institution in an effort to prevent more systemic problems to save the people inside, even if it means protecting them from their own actions. In other words, a bailout, just like the ones we had in 2008.
The fireman role is also problematic because it's almost entirely divorced from enforcement and punishment, in which the fact of what caused the fire, is secondary or maybe even tertiary to the goal of putting it out.
That may explain why Dudley appeared curiously passive when he described his role in pursuing wrongdoing.
"Our main goal is to ensure the safety and soundness of the institutions that we supervise," he said. "If in the process of doing that we see behavior that we think is illegal, then our job is to refer it to the enforcement agencies."
The comment appeared to anger Warren.
"But you don't think you should be doing any investigation? You should wait to see if it jumps in front of you?" she asked.
To be sure, Dudley appeared to be grasping for a different analogy than a cop in an attempt to show that the supervisory job is not primarily focused on enforcement.
Yet the reason Dudley was testifying in front of the Senate Banking Committee was to respond to fears that the culture at the New York Fed was too deferential to the institutions it regulates. And playing the role of fireman to Wall Street would only seem to feed that perception more, not less.
There are signs that Dudley's view of the New York Fed as a firefighter is also cultural and not merely a one-off remark. Dudley's predecessor, Tim Geithner, routinely described his role during the crisis as that of a fireman.
"The larger point, as President Obama later said, was that you shouldn't refuse to deploy fire engines to a burning neighborhood in order to highlight the dangers of smoking in bed," Geithner wrote in "Stress Test," his account of the crisis. "The President told me to focus on firefighting."
Later, when discussing why bailouts were necessary, Geithner invokes the analogy again.
"The natural human instinct in a financial crisis, and especially the political instinct, is to avoid unpopular interventions, to let the market work its will, to show the world you're punishing the perpetrators," Geithner wrote. "But letting the fire burn out of control is much more economically damaging then taking the decisive actions necessary to prevent it from spreading beyond the weakest institutions into the core of the system."
Such actions may have been necessary during the crisis. But in the wake of the many mistakes made by big banks London Whale, massive mortgage servicing flaws, the manipulation of foreign currency exchanges and interest rates it should be clear that we don't need regulators to be firemen anymore. We need them to be cops.