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Fed Keeps Watch on Wall St. -- From the Inside

In the meantime, a special unit has been created in the New York Fed, answering directly to President Timothy F. Geithner. Information about its operations is closely held by Geithner and other senior employees in New York, such that even Federal Reserve governors and presidents of other regional Fed banks know little about what the new unit is doing.

The unit is composed of individuals from the bank supervision staff, whose normal work is to regulate commercial banks; the markets group, which monitors the behavior of all sorts of financial markets watching out for threats to their functioning; and the legal department.

The Fed staffers accompany SEC regulators in frequent visits to the major investment banks Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers. They typically speak to risk managers, auditors, comptrollers and sometimes senior executives.

"What they're doing is not so much regulation, telling the banks what to do, as the Fed is saying, 'I'm lending you money, I'm doing my due diligence,' " said Ernest Patrikis, a partner at law firm Pillsbury Winthrop Shaw Pittman and a former senior official at the New York Fed.

In the past, collaboration between the Fed and the SEC has been more haphazard. Officials of the two organizations would frequently talk on the phone and meet every few weeks to discuss risks being taken by Wall Street firms, over lunch in the cafeteria at the vault-like headquarters of the New York Fed, for example, or on a balcony there overlooking the narrow streets of lower Manhattan.

As concern grew about the risks taken by hedge funds in 2006, Fed officials and their SEC counterparts had a series of discussions in which each side explained to the other how the institutions they directly supervise -- commercial banks for the Fed and investment banks for the SEC -- measure and manage the risks they are taking by lending to hedge funds.

Now, the interaction is more constant. The SEC is crafting a formal memorandum of understanding that lays out their roles, but it is in an early stage. It will mainly seek to formalize the information-sharing and cooperation that is occurring already, SEC officials have said.

"The collaboration is wide open," said Robert L.D. Colby, deputy director of the SEC's market regulation division. "We're essentially operating as if we're all within one agency. We are telling them what we know and how we think, and they're reflecting back what they know and want to learn. You don't always ask the same questions, and sometimes you get information the other might not have picked up."

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