By Simon Johnson.  This is a long post, about 2500 words.

Over the last several weeks on this blog, I have expressed a broad set of concerns about governance arrangements at the Federal Reserve Bank of New York. I have made the specific case for Jamie Dimon, the chief executive of JPMorgan Chase, to step down from the New York Fed’s board because of the large, unexpected losses in his bank’s London proprietary trading operation – and the fact that these activities and their disclosure are now under investigation by the Fed.

On Monday I met with senior staff members of the Federal Reserve System to deliver and discuss a petition I created, signed by 38,000 people, requesting that Mr. Dimon resign or be removed from the New York Fed board. They were gracious in the time they afforded me.

More broadly, I see no grounds for optimism that Mr. Dimon will relinquish his Fed position any time soon. In addition, as a result of recent interactions with former officials and others who know the Fed intimately, I now have three additional substantive governance concerns for the New York Fed that merit further discussion. Let me pose them as straightforward questions that I hope the Fed – at the Board of Governors or New York Fed level – will answer publicly, and soon.

First and most important, why didn’t Mr. Dimon step down from the board of the New York Fed in March 2008, when JPMorgan Chase bought Bear Stearns with financial support provided, in part, by the Fed?

This transaction fundamentally transformed the relationship of Mr. Dimon and the New York Fed. It is very awkward for any director to enter into a significant commercial transaction with an organization that he or she is charged with overseeing.

This was a significant transaction for Mr. Dimon – representing a big expansion of his business. It was also a significant transaction for the Federal Reserve – both as a measure to stabilize the economy and in terms of the specific provisions of the financing it provided.

The authorities worked closely with JPMorgan Chase during this phase of the crisis. As the Fed chairman, Ben Bernanke, testified to the Joint Economic Committee of Congress on April 2, 2008:

“To prevent a disorderly failure of Bear Stearns and the unpredictable but likely severe consequences of such a failure for market functioning and the broader economy, the Federal Reserve, in close consultation with the Treasury Department, agreed to provide funding to Bear Stearns through JPMorgan Chase. Over the following weekend, JPMorgan Chase agreed to purchase Bear Stearns and assumed Bear’s financial obligations.”

JPMorgan’s downside risk in the latter arrangement was limited. On March 16, 2008, invoking Section 13(3) of the Federal Reserve Act, the Federal Reserve Board of Governors authorized the New York Fed to form a limited liability company “to facilitate lending in support of specific institutions.” As expressed on the New York Fed’s Web site:

“In March 2008, Maiden Lane L.L.C. (ML L.L.C.) was formed to facilitate JPMorgan Chase & Company’s (JPMC) merger with Bear Stearns Companies Inc. (Bear Stearns) and prevent the contagion effects of Bear Stearns’s disorderly collapse to the broader U.S. economy. ML L.L.C. borrowed $28.82 billion from the Federal Reserve Bank of New York (New York Fed) in the form of a senior loan, which, together with funding from JPMC of approximately $1.15 billion in the form of a subordinate loan, was used to purchase a portfolio of mortgage-related securities, residential and commercial mortgage whole loans and associated hedges (derivatives) from Bear Stearns.”

The precise terms of this arrangement were, appropriately, subject to detailed negotiation after the initial announcement (see this news release). Valuation of the relevant securities was presumably a hot and complex topic in this conversation, which ran from March to late June 2008. (JPMorgan Chase also acquired other Bear Stearns assets, in addition to what was covered by Maiden Lane.)

How was it appropriate for Mr. Dimon to remain on the board of the New York Fed while this negotiation was going on?

Keep in mind that before passage of the Dodd-Frank Act of 2010, Class A directors – such as Mr. Dimon – were involved in appointing the president of the New York Fed. In other words, Mr. Dimon (and his employees) were negotiating a multibillion-dollar deal with Timothy F. Geithner, then the president of the New York Fed and now the Treasury secretary (and his staff) – even as Mr. Geithner reported to Mr. Dimon in his board role.

Mr. Dimon, of course, does not run the New York Fed – in any well-run organization, management runs the show and the board is responsible for oversight, including the hiring and performance evaluation of the chief executive. In the case of the New York Fed, the Board of Governors is also involved. But any notion that the New York Fed’s own board of directors is “purely advisory” is completely at odds with the legal and practical reality. (By removing Class A directors from the selection of regional bank presidents, the Dodd-Frank legislation recognized this point, at least in part.)

As for the terms of Fed support, this was obviously more generous that what would have been provided by the market – in part because the Fed had become convinced that such action was needed to stabilize the broader market. From the Fed’s Maiden Lane page:

“The New York Fed lent ML L.L.C. approximately $28.82 billion. The loan has a 10-year term and accrues interest at the primary credit rate. JPMC lent ML L.L.C. approximately $1.15 billion. The JPMC loan has a 10-year term and accrues interest at the primary credit rate plus 450 basis points.”

(The primary credit rate was 2.5 percent when this deal was announced on March 24, 2008; this rate had previously been lowered on March 16, 2008, to 3.25 percent from 3.5 percent, at the express request of the New York Fed. I am not implying that the cut in the primary credit rate was related to the Maiden Lane transaction.)

To be clear, this loan has been repaid in full – in fact, just two weeks ago, the New York Fed was able to announce (on its Maiden Lane page): “The successful repayment of the loans marks the retirement of the last remaining debts owed to the New York Fed from the crisis-era interventions with Bear Stearns and A.I.G.” (This included repayment of loans made to Maiden Lane III, which was one of the financing vehicles created when A.I.G. was rescued.)

The full results of the Maiden Lane intervention are not yet known – and there may be some upside for the taxpayer: “Proceeds from future sales of ML L.L.C. assets will be used to repay the subordinated loan extended by JPMorgan Chase & Company, after which the New York Fed will receive all residual profits.”

At the same time, this kind of central bank support should make us all feel queasy. Adjusted for risk, will the Fed end up making an adequate return? Putting that thought differently – if the Fed did this 20 separate times, would it (and the American public) end up ahead or behind, taking into account the effects on broader financial stability?

Partly for this reason, the Dodd-Frank financial reforms modified the Section 13(3) powers of the Fed, so it can in principle no longer provide the kind of specific support manifest in the Maiden Lane support.

What exactly will happen in the next financial crisis, of course, remains open to question. In any case, any banker who receives extraordinary support from the Fed – beyond regular use of the discount window – should immediately resign from being on the board of a Federal Reserve Bank. I say this although the Government Accountability Office did not find specific wrongdoing or conflicts of interest in how crisis funding was handled; it did, however, make a number of suggestions (see Pages 143-4) for strengthening governance at the regional Feds. I am proposing to go even further.

(I would also point out that last October, Senator Sanders’ staff questioned GAO if they had requested from the Fed any e-mails, phone calls, letters or other documents from CEOs of institutions that received emergency Fed lending while serving as directors at the Fed banks.  Such documentation could prove if they used their influence as board directors to receive loans for their firms.  GAO staff said that they did not ask for any of that information.  The depth of the GAO investigation remains controversial.)

We should apply to ourselves the same principles that would be applied by the United States Treasury if it were involved in lending to any other country in financial distress, either directly or through the International Monetary Fund. There is no way that the United States government would countenance a prominent banker’s continued involvement in the governance of a central bank while that central bank is providing financial support to that banker’s company.

I also do not know of any other of the 12 regional Reserve Banks in the Federal Reserve System where a banker has or would remain on the board of directors while negotiating a deal of this scale and nature. Mr. Dimon’s arrangement seems to be unique to New York. But this is still a first-order concern; Mr. Dimon runs the largest bank in the country. If any company is too big to fail today, it is JPMorgan Chase.

Second, I would like to raise the following question about Stephen Friedman, who was previously a Class C director of the New York Fed – and chairman of its board during the intense financial crisis period, from January 2008 through early 2009. (Class C directors are appointed by the Board of Governors, not by bankers, and are subject to different rules.)

According to the rules established by the Federal Reserve Board (see Pages 4-5 of this currently available guide on the Fed’s “Directors—Eligibility, Qualifications, and Rotation,” for this quotation and the one that follows):

“By statute, no Class C director may be a stockholder of any bank. In addition, to give effect to this prohibition, it is the board’s policy that no Class C director may own stock in a bank holding company, foreign bank, Edge Act or agreement corporation, subsidiary of a bank holding company, operating subsidiary of a bank, D.F.M.U., or S.I.F.I. (collectively, together with banks, referred to as “financial stock issuers”).”

(A D.F.M.U. is a designated financial market utility and a S.I.F.I. is a systemically important financial institution; both are categories introduced by the Dodd-Frank legislation, to extend the reach of federal regulators in general and the Fed in particular.)

This looks like a fairly comprehensive ban on holding financial stock, and the same requirements were in effect in 2008, although there are reasonable exceptions for stocks as held typically by diversified mutual funds:

“Class C directors are not disqualified by virtue of indirect ownership interests in financial stock issuers through limited types of widely held, diversified investment vehicles. In particular, Class C directors may hold interests in financial stock issuers through ownership of shares of a mutual fund so long as the mutual fund is registered under the Investment Company Act of 1940 and does not have a stated policy of concentrating in the financial services sector. Class C directors also may own shares of financial stock issuers through other diversified investment funds. For these purposes, an “investment fund” means a mutual fund, common trust fund of a bank, pension or deferred compensation plan, or any other investment fund which is widely held (i.e., more than 100 participants) and where the director has no ability to exercise control over the fund’s investment decisions. “Diversified” means that the fund holds no more than 5 percent of the value of its portfolio in the stock of any one financial stock issuer, and no more than 20 percent in the financial sector.”

But Mr. Friedman at that time was – and still is – a senior executive at Stone Point Capital, where, as a member of the six-person investment committee, he is involved in the fund’s investment decisions. Stone Point Capital specializes in financial-sector investments. For example, its portfolio in 2007 included Atlantic Capital Bank – a commercial bank situated in Georgia, owned by a Dallas-based bank holding company – as well as other financial services companies.

How was Mr. Friedman allowed to own these shares while being a Class C director? Was this a decision of the Federal Reserve Board of Governors or the New York Fed? (I’m not accusing Mr. Friedman of any wrongdoing; I’m confident he had permission to own bank stock. I’m asking who gave him permission and on what basis.)

Mr. Friedman bought Goldman Sachs stock after the moment when that company was effectively rescued by the Federal Reserve – by being allowed to become a bank holding company in September 2008. Mr. Friedman is a former chairman of Goldman Sachs and was a director of Goldman at the time.

A great deal of concern has been expressed about the timing of Mr. Friedman’s stock purchase, for example relative to Goldman falling under the supervision authority of the Fed, and he subsequently resigned before the expiration of his term. I am not implying that these events were related.

My concern is more fundamental. I don’t understand how a Class C director could have thought it was acceptable to buy any financial services company stock – the prohibition is on owning stock directly in any financial services company, not just for banks that belong to the Federal Reserve System.

Third, I have a further question about the role of Lee C. Bollinger, the president of Columbia University, who is a Class C director and current chairman of the board of the Federal Reserve Bank of New York. (I discussed his position more broadly in my June 14 review of Federal Reserve governance.)

According to the Federal Reserve Act (Section 4.20): the chairman of the board of directors of a Federal Reserve Act “shall be a person of tested banking experience.”

Mr. Bollinger is a distinguished First Amendment lawyer and an experienced university administrator. However, he does not have banking experience of any kind. He has not written or spoken publicly about banking or finance matters. As far as I can ascertain, the only interview he has ever given on anything related to banking was his recent conversation with The Wall Street Journal – the primary point of which was to defend Mr. Dimon staying on the New York Fed board. (I have asked Mr. Bollinger’s staff for any of his interviews, speeches or articles – academic or otherwise – on financial matters; they have been most cooperative but have not found anything that I missed.)

Please explain to me how having Mr. Bollinger as chairman of the board of the New York Fed is consistent with the Federal Reserve Act.

Taken together, these three questions raise a much bigger issue. If the intent and letter of the Federal Reserve Act are being followed in some ways and not in others – without proper notification to Congress or written rules available to the public explaining regarding exemptions and exceptions – how exactly does this help maintain the legitimacy of the Federal Reserve System?

An edited version of this blog post appeared this week on the NYT.com’s Economix blog.  It is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

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