NEW YORK (Reuters) - A U.S. watchdog agency is preparing to investigate whether the Federal Reserve and other regulators are too soft on the banks they are meant to police, after a written request from Democratic lawmakers that marks the latest sign of distrust between Congress and the central bank.
Ranking representatives Maxine Waters of the House Financial Services Committee and Al Green of the Subcommittee on Oversight and Investigations asked the Government Accountability Office on Oct. 8 to launch a probe of "regulatory capture" and to focus on the New York Fed, according to a letter obtained by Reuters.
In an interview, the congressional agency said it has begun planning its approach.
The probe, which had not been previously reported or made public, is the first by an outside agency into the perception that government regulators are "captured" by and too deferential toward the bankers they supervise, so that Wall Street benefits at the public's expense.
Such perceptions have dogged the U.S. central bank since it failed to head off the 2007-2009 financial crisis that sparked a global recession. The Fed's biggest critics have since been Republicans looking to curb its policy independence, but the request by Democrats could cool its somewhat warmer relationship with the left.
"We currently do have some ongoing work looking at the concept known as regulatory capture. We're in initial stages of outlining that engagement," Lawrance Evans, director of the GAO's financial markets and community investment division, said in an interview.
The agency will conduct "an assessment across all financial regulators, and the Federal Reserve will be one institution," he said.
It was unclear whether the majority Republicans on the House committee, including Chairman Jeb Hensarling, backed the request from the minority Democrats.
The GAO has not yet determined what agencies might be involved beyond the Fed. The other main regulators that place supervisors inside financial institutions are the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency.
The worry is that these so-called embedded regulators working under the same roof as bankers will have clouded judgment as they watch for risky and inappropriate behavior.
"We will cooperate with the GAO as its work on this report proceeds," said Fed spokesman Eric Kollig.
The New York Fed, which acts as the central bank's eyes and ears on Wall Street, has come under fire for a series of oversights and perceived conflicts of interest in recent years. In one instance, a former New York Fed examiner launched a wrongful termination lawsuit and released some secretly recorded tapes that portrayed her colleagues as being soft on Goldman Sachs.
That in part prompted a congressional hearing in late 2014 in which Democratic Senator Elizabeth Warren warned New York Fed President William Dudley to fix his institution's "cultural problem" or, she suggested, he would have to go.
The New York Fed and OCC declined to comment on the lawmakers' proposals, while the FDIC did not immediately respond.
In the letter, Waters and Green said they are particularly concerned about reports of a "revolving door" between the New York Fed and the banks, and "a reluctance to challenge" them. The lawmakers want the GAO to use New York Fed actions between January 2008 and January 2015 as a "case study" for the broader investigation.
"Congress and the financial regulators must fully understand the regulatory gaps and weakness that exist," they wrote, requesting an analysis of six areas including the independence of regulators, their ability to escalate concerns, and incentives they face to take jobs at the banks they supervise.
The central bank, which gained more supervisory powers in the wake of the crisis, has long defended its work but has been open to adjustments.
A year ago, Chair Janet Yellen said the Fed takes "the risk of regulatory capture...very seriously and works very hard to prevent" it. Two internal reviews were launched and, in November, one recommended improvements.
Yet the Fed's relationship with Congress has only grown more testy.
Republicans have repeatedly complained about opacity and a lack of responsiveness to requests, and have pushed legislation that would have the GAO "audit" the central bank's policy decisions - a move that Yellen has strongly opposed.
Democrats have also grown more critical since the Fed raised interest rates in December.
At Yellen's congressional testimony last month, Waters, usually a staunch defender of the Fed chair, raised concerns over nearly $7 billion in interest the central bank paid to certain banks last year to help it tighten monetary policy.
The GAO, which reports to Congress, already evaluates the integrity of the Fed's operations including its supervision of some of the world's biggest banks.
The agency is now determining objectives and selecting a team, Evans said, and looking to "explore the issues in the request in a balanced, objective, fact-based, non-partisan, non-ideological way."
Once the probe is completed, the GAO would report to the lawmakers and give them 30 days before it publishes the findings.
Reporting by Jonathan Spicer; Editing by Chizu Nomiyama