Federal Reserve Bank directors say a Senate plan to kick bankers off the boards of regional Fed banks is an overreaction to one headline-grabbing incident and could harm the U.S. central bank.

Federal Reserve insiders worry that planned changes to the century-old U.S. central banking system -- comprising 12 regional banks and a 7-member Washington-based Board of Governors -- would make it more centralized, less independent, and less effective.

A provision in a wide-ranging regulatory reform bill near completion in Washington would ban bankers from serving on the boards of their regulators.

Alarm about possible conflict of interest at the Fed broke out after Goldman Sachs converted to a Fed-regulated bank to withstand the financial crisis.

This put then-New York Fed chairman Stephen Friedman -- a Goldman director and former chairman -- in violation of the Fed's rules. Friedman requested a waiver for owning Goldman shares in 2008 and as he waited for the waiver, he bought more shares.

While his actions were not illegal, Friedman stepped down following public furor.

This legislation, the way it's proposed, is an overreaction to a particular unique situation, and to have bankers removed from these boards is a travesty, said Mark Hewitt, chief executive of Clear Lake Bank and Trust Co in Iowa and a director at the Federal Reserve Bank of Chicago.

The situation maybe left a funny taste in someone's mouth, but that's not what's happening in Chicago, he said.

The Senate bill still has to be reconciled with a House of Representatives version that does not contain that provision. Lawmakers will meet in June to try to merge the bills.

Proponents say the plan addresses the concern that bankers have too much influence over the regulatory system, a sense that has been heightened by the financial crisis.

Directors have no say in day-to-day bank supervision or monetary policy and several directors warned the provision may rob policy-makers of crucial insight that only bankers, with their broad range of contacts, can provide.

We are right out there, day after day, in the trenches dealing with hundreds if not thousands of clients on what is going on in the economy, said Ted Peters, chief executive of the Bryn Mawr Trust Company, a community bank in Bryn Mawr, Pennsylvania, and a Philadelphia Fed director.


The current Fed system is far from intuitive, born of a compromise between bankers and politicians in 1913.

Each Fed-regulated bank owns a share of stock in its regional Federal Reserve bank. The member banks pick three bankers and three non-bankers to represent them on the board. The final three directors are chosen by the Fed's politically appointed Board of Governors in Washington.

Under the Senate reform, all members of the 12 regional banks' boards of directors would be chosen by Washington.

Lawmakers want to ensure regional Fed presidents are not beholden to local bankers. The boards of directors of regional banks pick their Fed presidents, subject to approval from Washington. In other words, bankers have a say in who heads their regulator.

I think Congress is going a bit overboard on the fears the bankers have undue influence over the Fed, said Stephen Axilrod, a former staff director of monetary policy at the Fed and author of a book about the central bank. The proposal would be a sharp contrast to the Fed's history, he said.

Some Fed insiders say they are frustrated that the actions of one former Wall Street banker tarnished the Fed's institutional reputation.

The Fed tightened its conflict of interest rules after the Friedman incident and Bryn Mawr's Peters said the rules are very clear.

Friedman just didn't want the rules applied to him. This guy was a typical Wall Street guy and he was a little arrogant, Peters said.

In the Fed's 97-year history there has been only one Fed director charged with insider trading.

In 1989, New York Fed director Robert Rough was sentenced to six months in jail for regularly leaking information on the Fed's discount rate to a brokerage firm.

Charles Horn, a partner at law firm Mayer Brown said there is a possibility of a conflict of interest on Fed boards but it could be dealt with in a less absolutist way. For example, bankers can recuse themselves if an issue comes up.

Bryn Mawr's Peters says he uses the same judgment in his day job as a community bank chief.

We have people who we know who come in for loans, or maybe it's the church we go to, or maybe it is a relative. We, day in and day out, as community bankers, have this conflict and we know when to be involved and when not to be involved.

Alongside the requisite three bankers, regional Fed boards contain a colorful mish-mash of business leaders.

A sugar beet equipment-maker sits on the Minneapolis Fed's board while a partner in a ranch -- founded by a former boy drummer for the Confederate Army -- offers insight on the economy to the Dallas Fed's El Paso board. Chief executives from Southwest Airlines, Nordstrom's and Anadarko Petroleum are also among regional Fed bank board members.

Richard Evans, head of San Antonio-based Cullen/Frost Bankers and a former Dallas Fed director, said bankers in the regions are better placed to pick board members than the Board of Governors in Washington.

My passion is to know customers, and you can't know customers in Washington DC, said Evans. Who do you think would know who are the most honest people? Washington, or dividing it up into 12 regions and picking people who are close to you?