During the financial crisis that began in the summer of 2007, the Federal Reserve System took unprecedented steps to stabilize financial markets and support the liquidity needs of failing institutions that it considered to
be systemically significant. Federal Reserve System staff often designed and implemented the emergency programs over the course of only days or weeks as they sought to address rapidly deteriorating market
conditions. To varying degrees, these emergency actions involved the Reserve Banks in activities that went beyond their traditional responsibilities. In particular, FRBNY, which implemented most of the assistance, faced a number of operational challenges related to implementing and overseeing several broad-based emergency programs, the three Maiden Lane portfolios, and other assistance to AIG and Citigroup. FRBNY hired vendors to help manage the complexities associated with its assistance to individual institutions and its
interventions in new markets, such as the markets for commercial paper and asset-backed securities. In addition, FRBNY had to create new policies, procedures, and controls to manage key risks within and across
the programs.
Over time, FRBNY and the other Reserve Banks took steps to improve program management and oversight, in many cases in response to recommendations made by their external auditor, Reserve Bank internal audit functions, or the Federal Reserve Board’s RBOPS. For example, FRBNY greatly expanded its risk management function in 2009, by, among other things, establishing a new risk management division and
creating a Risk Analytics group within this division to validate the valuation work performed by vendors on the Maiden Lane portfolios.
Expanded staff expertise in this and other areas has allowed FRBNY to be a more knowledgeable customer of vendor services. In addition, in May 2010, FRBNY issued a new vendor management policy to outline
guidelines and requirements for assessing and overseeing the risks posed by vendor firms. However, the Reserve Banks have not yet fully incorporated some lessons learned from the crisis into their policies for
managing use of vendors, risk of losses from emergency lending, and conflicts of interest. Such enhanced policies could offer additional insights to guide future Federal Reserve System action, should it ever be
warranted.
Vendors have been a critical component of helping create and operate the emergency programs, with most of the fees concentrated among a few contracts that were awarded without competition. While the Reserve
Banks followed their acquisition policies regarding vendor selection, the largest contracts were awarded under an exigency exception to the competition requirement in those policies. The acquisition policies did not
provide additional guidance on awarding contracts under exigency exceptions such as seeking as many proposals as practical or limiting the duration of contracts to the period of the exigency. Given the nature of the events leading to the emergency programs, it is reasonable to expect that future emergencies could follow a similar pattern of sudden financial shocks that leave the Reserve Banks little time to develop and implement
responses, including hiring vendors. Because exigent circumstances may limit the Reserve Banks’ ability to follow their normal acquisition procedures, taking steps to ensure that they seek as much competition as
is practicable is critical to the vendor selection process.
The emergency programs brought FRBNY into new relationships with institutions that fell outside of its traditional lending activities, and these changes created the possibility for conflicts of interest for both FRBNY
employees and vendors. FRBNY recognized the importance of identifying and managing conflicts related to employees’ access to sensitive information and to employees’ financial interests that were not specifically
prohibited in its Code of Conduct but could be affected by their participation in matters concerning these emergency programs. However, while FRBNY staff told us that they believe their existing policies and
guidance are sufficient for managing employee conflicts during a crisis situation, these policies may still allow for situations to arise in which the appearance of a conflict of interest for an FRBNY official could raise
questions about the integrity of FRBNY’s programs and operations. This possibility is of particular concern given the extraordinary sensitivity and potential importance of emergency lending activities. While FRBNY’s
current standards are consistent with 18 U.S.C. § 208 and its regulations, the lack of more specific procedures for managing conflicts during emergency lending activities exposes FRBNY to the risk of the
appearance of conflicts which can compromise FRBNY’s effectiveness by causing observers to question its integrity. The Federal Reserve System plans to update the Reserve Banks’ codes of conduct to reflect its
broader role in regulating systemically important institutions. These planned efforts present an opportunity to consider how recent experiences with managing employee conflicts might inform changes tothese policies. With respect to vendors, FRBNY has not yet finalized a policy for managing risks related to conflicts of interest in connection with its emergency programs. In contrast, Treasury articulated a detailed policy for managing TARP vendor conflicts of interest in January 2009.
FRBNY created a new vendor-management policy in 2010, but this policy is not sufficiently detailed or comprehensive in its guidance on steps FRBNY staff should take to help ensure vendor conflicts are mitigated. FRBNY staff have said they plan to develop a documented policy that codifies practices FRBNY put in place during the crisis. The lack of a comprehensive policy for managing vendor conflicts could expose
FRBNY to greater risk that it would not fully identify and appropriately manage vendor conflicts of interest in the event of future crisis situations.
While the Federal Reserve Board’s emergency lending programs included multiple loss-protection features and have not incurred losses to date, opportunities exist for the Federal Reserve System to improve its
risk management practices related to crisis lending. First, for TAF and the programs for the primary dealers, Reserve Banks’ existing policies lacked specific guidance on how staff should exercise discretion and document their actions to restrict or deny program access for otherwise eligible institutions that posed higher risk of losses. FRBNY staff recognized the importance of monitoring and restricting higher-risk institutions for these programs because institutions could pose unacceptable risks even though they continued to meet eligibility requirements. Since these programs closed, Reserve Banks have enhanced their guidance for
monitoring exposures to depository institutions and primary dealers, but revised guidance continues to lack details applicable to a crisis-driven lending situation. In addition, FRBNY staff indicated that the Federal
Reserve System has not assessed the consistency of TAF restrictions across the 12 Reserve Banks. Without more detailed procedures, Reserve Bank staff responsible for implementing future emergency programs may not take consistent and appropriate steps to mitigate the risks posed by higher-risk borrowers. Furthermore, without documentation and analysis of decisions to apply restrictions to particular borrowers and the processes that led to those restrictions, the Reserve Banks lack assurance that they are applied consistently across borrowers. Second, neither the Federal Reserve Board nor FRBNY quantified stress losses across all of the emergency programs and assistance. While FRBNY tracked potential losses under stressed scenarios for some programs, including CPFF and the Maiden Lane portfolios, FRBNY staff said they did not quantify stressed losses for TAF, TSLF, or PDCF. In a future crisis, without a more comprehensive view of risk exposures within and across Reserve Banks, the Federal Reserve Board may lack critical information needed to make decisions about authorizing and modifying its emergency lending activities.
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