May 8 (Bloomberg) -- Stephen Friedman, chairman of the New York Federal Reserve Bank’s board of directors, quit effective immediately to avoid the appearance of a conflict of interest over his ties to Goldman Sachs Group Inc.

Friedman’s decision yesterday to move up his departure from the end of 2009 followed controversy about his continued role as a director on Goldman Sachs’s board and his purchases of the firm’s shares, which were criticized by a U.S. senator. Friedman is a former chairman of the investment bank.

The incident may prompt greater congressional scrutiny of the 12 regional Fed banks, and the appointment of their presidents, who have a voice in central bank policy decisions and aren’t confirmed by legislators.

“It’s going to be pretty tricky terrain for a while,” said Gregory Hess, an economics professor at Claremont McKenna College in Claremont, California. “At least for a period of time” the central bank will “want people who are really scrubbed clean of any potential source of bias,” he said.

Goldman Sachs became a bank holding company in September, a change that would have normally barred Friedman from continuing to serve in his New York Fed post. Officials gave him a waiver so he could remain in the job, which has mostly an advisory role.

Acting Chief

Denis Hughes, formerly the board’s deputy chair, is serving as acting chair, the New York Fed said in a statement. Friedman led the search committee for the bank’s new president after Timothy Geithner’s departure to become Treasury Secretary. The New York Fed appointed William Dudley, a former Goldman Sachs economist, as president in January.

Friedman, 71, served as director of the National Economic Council in the Bush administration from 2002 to 2004, and as chairman of the President’s Foreign Intelligence Advisory Board.

“Although I have been in compliance with the rules, my public service-motivated continuation on the Reserve Bank Board is being mischaracterized as improper,” Friedman said in a letter to Fed officials, posted yesterday on the New York Fed’s Web site. “The Federal Reserve System has important work to do and does not need this distraction.”

At the annual meeting of Goldman Sachs today in New York, company Chief Executive Officer Lloyd Blankfein rejected calls to remove Friedman as a director, saying he’s “accused of no wrongdoing.”

Shareholder activist Evelyn Y. Davis said Friedman was a “disgrace” to the board. Friedman said the Fed waiver didn’t limit his role as a director or shareholder of Goldman Sachs.

‘Very Tempestuous Time’

“It was a very tempestuous time,” said Friedman, who stood up to address the meeting. “I felt it was my obligation to stay” and help select Geithner’s successor, he said.

Thomas Baxter, general counsel of the New York Fed, said in the Fed’s statement that Friedman’s purchases of Goldman Sachs shares in December and January “did not violate any Federal Reserve statute, rule or policy.”

Senator Richard Shelby of Alabama, the ranking Republican on the Senate Banking Committee, said Friedman’s stock buying was “deeply disturbing,” according to an article this week in the Wall Street Journal.

Resigning is the “right thing for him to do,” said former St. Louis Fed President William Poole, who is now a senior fellow with the Washington-based Cato Institute. “At the St. Louis Fed, we absolutely would never have considered making an exception.”

‘Totally Inconsistent’

Poole, a Bloomberg contributor, said he was “astonished” to learn of Friedman’s situation. “It does seem to me to be totally inconsistent with the plain language of the Federal Reserve Act.”

The Senate passed a nonbinding budget amendment by a 96-2 vote last month that in part called for “an evaluation of the appropriate number and the associated costs” of the regional Fed banks. The measure was proposed by Shelby and Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat.

Massachusetts Representative Barney Frank, chairman of the House Financial Services Committee, said last year that he planned to probe how the district Fed chiefs are appointed and their role in setting interest rates.

The New York Fed is one of 12 regional Fed banks which, along with the Board of Governors, make up the Federal Reserve system. They are private entities, each run by a nine-member board of directors.

Friedman, who runs the investment firm Stone Point Capital LLC in New York, was chosen for a three-year term as a Class C director of the Fed bank board in 2008, one of three directors appointed by the Fed’s Board of Governors to represent the public.

Represent Public

Fed rules bar bank executives or stockholders from serving as Class C directors. Along with Class C directors, Class A directors are elected by and represent member banks; and Class B directors are elected by member banks to represent the public. The chairman of the board is a Class C director.

“To have the New York Fed chairman making decisions about a company in which he owns shares is unconscionable,” said Marilyn Cohen, president of Envision Capital Management in Los Angeles. “Friedman understood that it’s over.”

Hughes is president of the New York State AFL-CIO, a position he’s held since 1999.

Friedman’s departure creates a third vacancy on the New York Fed’s board. Other members include JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon, General Electric Co. CEO Jeffrey Immelt and Columbia University President Lee Bollinger.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net.

Last Updated: May 8, 2009 17:05 EDT