By Nicholas Dunbar
The opinions expressed are his own.

Much of the financial crisis can be blamed on bankers who created complex products that allowed them to exploit and monetize less sophisticated investors, borrowers and bank shareholders. However, no account of the financial crisis is complete without an account of the inept regulators who permitted these activities to flourish, causing the crisis to become much worse than it might have been. Among these regulators, most surprising is the story of the New York Fed, supposedly the most sophisticated in its approach to risk. As I recount in this excerpt from my book, The Devil’s Derivatives and as staff at the Federal Reserve Board in Washington DC discovered, the New York Fed was in thrall to what in 2007 was the largest US bank – Citigroup – with disastrous results. -Nicholas Dunbar

The Federal Reserve may have been at the top of the U.S. regulatory pecking order, but within the Fed itself, the New York branch was top dog when it came to regulating banks. This was hardly surprising given the dual importance of Wall Street as the engine room of the bond markets and as the base for the largest multinational U.S. banks. It was only natural that industry risk-management innovations like VAR were first identified by staff in the New York Fed’s markets divi- sion, such as Peter Fisher, who transmitted the ideas to the rest of the regulatory community.

Ever since the regulatory blessing of VAR in the mid-1990s, the New York–based multinational banks had been growing rapidly. By 2003, when William McDonough retired as New York Fed president and was replaced by Timothy Geithner, an ambitious former Treasury and International Monetary Fund bureaucrat, bank supervision was equally important to markets.

If any U.S. commercial bank needed to be challenged, it was Citigroup. In 1999, when then-chief executive Sandy Weill had needed an act of Congress in order to fuse the SEC-regulated Salomon Brothers with Fed- and OCC-regulated blue-chip lender Citibank, he had taken care to reassure his new shareholders and supervisors about the importance of governance. A veteran ex-AIG and Chemical Bank executive, Petros Sabatacakis, was appointed chief risk officer of the new conglomerate and ordered to rein in the freewheeling Salomon traders. Sabatacakis was so tough in applying position limits that on the trading floor he was known as “Dr. No.”

Then came Enron and the dot-com bust. Sabatacakis may have ensured that the bank (unlike Chase Manhattan) avoided significant losses in the shakeout, but Citigroup’s conflicted role in bond underwriting, derivatives, and investment research left it open to the charge of having facilitated massive fraud at Enron and WorldCom. That led to the New York Fed and the OCC censuring the bank in July 2003, as part of a settlement in which it didn’t have to admit wrongdoing. Weill was forced to quit as chief executive (while remaining chairman).