In a week dominated by the government shutdown, the most interesting financial regulatory story to come out of the US was the lawsuit by former employee Carmen Segarra against the New York Fed. The lawsuit, which was first reported by Propublica on October 10 and widely covered afterwards, alleges that the NY Fed unjustly fired Segarra because she refused to agree that Goldman Sachs complied with a Fed requirement that it should have a firm-wide conflict-of-interest policy.

The lack of such a policy became apparent to Segarra in late 2011 when she examined Goldman’s role in advising energy company El Paso on its sale to Kinder Morgan, a company in which Goldman held a stake. The filing implies that Goldman exerted pressure on Segarra via her New York Fed colleagues, including relationship manager Michael Silva, a powerful figure who used to be Tim Geithner’s chief of staff and whose name appears in many emails relating to the bailout of AIG.

Since we have only one side of the story, we can’t say too much about the lawsuit beyond what has already been reported. The New York Fed is refusing to say much on the grounds that its relationship with Goldman is confidential, and on October 15 lost a bid to have the court proceedings sealed. Goldman says it does currently have a conflict of interest policy, and that it doesn’t have knowledge of internal Fed discussions (Interestingly, the PR who told this to Bloomberg, Andrew Williams, was a NY Fed spokesman until January 2009).

However, when I read the lawsuit I was reminded of what I wrote in Chapter 5 of The Devil’s Derivatives. According to a source who used to work in the market risk team at the Federal Reserve Board in Washington DC, the New York Fed’s relationship managers for large Wall Street banks such as JPMorgan and Citigroup were uncomfortably close to these banks before the financial crisis. My source listed examples where these relationship managers either blocked access by the FRB to these banks or dismissed FRB concerns about risk ““ concerns that were vindicated in the crisis.

Given these issues one might have expected the New York Fed to have its regulatory autonomy reined in by the FRB after the crisis. Instead, the NY Fed found its importance vastly increased as Goldman and Morgan Stanley became bank holding companies and thus fell directly under NY Fed supervision. Sarah Dahlgren, a relationship manager strongly criticised by my source, was promoted to run the NY Fed’s expanded bank supervisory team, a key Wall Street role that arguably makes her the second most-powerful woman in the Federal Reserve System after Janet Yellen.

This expansion in powers shouldn’t concern anyone, according to the official version of events. According to this narrative, the FRB’s point man on bank supervision, Daniel Tarullo, has fixed the kinds of problems highlighted in my book and centralised FRB control of regional Fed bank supervisors. In a recent speech, Dahlgren – who is Silva’s boss – gives the impression that the NY Fed is moving in lockstep with Tarullo, improving its supervision of Wall Street banks and setting an example for regulators globally.

That is why Segarra’s lawsuit and Propublica’s story is well-timed, because it blows a hole in this convenient narrative, one that already took a knock when the NY Fed failed to spot the compliance failures that led to the London Whale’s losses. It suggests an alternative narrative in which the NY Fed followed Tarullo’s party line by hiring risk specialists like Segarra, only to punish them once they identified problems at a powerful client that Silva the relationship manager was determined to protect. It suggests that the insularity and determination of the NY Fed to protect its fiefdom and stay friends with its ‘clients’ is as problematic as ever. And it suggests that as much as Goldman, the NY Fed needs to have a conflict-of-interest policy too.

The dilemma for the NY Fed is that to disprove this narrative in court, it may have to annoy Goldman by disclosing more information it promised would stay confidential. Then again, at least that would demonstrate its independence from the banks it regulates.

Update: Carmen Segarra’s lawsuit was dismissed by a New York judge in April 2014