By Steven K. Beckner
CHARLOTTE, N.C. (MNI) – Richmond Federal Reserve Bank President
Jeffrey Lacker blamed government guarantees, incentives and regulations
for contributing to the financial crisis Thursday night, and he doubted
very much that laws and regulations enacted since the crisis will
prevent further bouts of financial instability.
Indeed, he said the world should expect another crisis that is
“just as wrenching” as the last one “before long.”
Lacker said financial market participants, politicians and the
general public should not be deluded into thinking that tighter
government regulations can substitute for market discipline born of
doubt as to whether the federal government — and the Federal Reserve —
will come to the rescue of firms that take excessive risks.
He called for a restoration of market discipline and of a belief
that government will not necessarily bail out failing firms or their
creditors.
He heaped scorn on the 2,319-page Dodd-Frank Wall Street Reform and
Consumer Protection Act, enacted in 2010, calling it “a patchwork of
provisions, motivated by an array of conflicting crisis narratives, and
supplemented by an assortment of banking provisions largely unrelated to
the crisis.”
In particular, he said the law’s restrictions on Fed so-called
13(3) lending to nondepository institutions in “unusual and exigent
circumstances” don’t go far enough.
Lacker, a voting member of the Fed’s policymaking Federal Open
Market Committee this year, did not talk about the economy or monetary
policy in remarks prepared for the The Banking Institute of the UNC
School of Law.
Pointing to the plethora of law-making and regulatory activity
since the crisis, Lacker acknowledged that there has been “considerable
progress.” But he added, “We should be under no illusions that the steps
taken so far will provide durable and reliable protection against future
instability.”
“My view is that without a robust program for repairing the
fundamentally flawed relationship between government and the financial
sector, the odds are quite high that before long we will face an episode
of financial distress just as wrenching as the one we just experienced,”
he said.
Dodd-Frank “does some very good things and some arguably
counterproductive things, but it leaves many important things undone,”
he said.
Worst of all, he said the law reinforces the government’s penchant
for aiding financial firms deemed “too big to fail” — now known as
“systemically important financial institutions.”
What is needed, Lacker argued, is a program that “emphasizes the
role of the financial safety net in weakening market discipline and the
role of ambiguity about the safety net in amplifying the effects of
financial stress and inducing public sector rescues.”
Lacker blamed the financial crisis in good part on the expansion of
the federal safety net and the explicit as well as implicit extension of
federal guarantees to a greater and greater portion of the financial
industry.
“When a government guarantee program creates an opportunity to
profit from taking risks that are to some extent borne by taxpayers,
competition will generate a rush toward that opportunity, inflating the
risks born by the taxpayer and depriving other sectors of resources they
deserve,” he said.
More specifically, Lacker targeted government sponsored enterprises
Fannie Mae and Freddie Mac and the role they played in the housing boom
and bust.
He traced the expansion of government assistance to financially
distressed firms back to the Penn Central bankruptcy in 1970 and later
Continental Illinois. He said “the presumption of support for large
financial institutions was further bolstered by repeated regulatory
forbearance for large bank holding companies with exposures to emerging
market debt in the 1980s.” The growth of Fannie and Freddie added to the
problem.
By 2007, the financial system was ripe for collapse, he suggested.
“I believe the recent crisis was the culmination of a sequence of
precedent-setting interventions that led the creditors of many large
financial firms to expect protection in the event of financial
distress,” he said. “This regime reached the point where federal
guarantees — implicit and explicit — covered nearly 60% of the
liabilities of financial firms in the U.S.”
“Government guarantees are dangerous without limits on
risk-taking,” he said. “The market discipline that is lost when insured
creditors do not feel themselves to be at risk must be replaced by
official regulation and supervision.”
“But it would be a grave error, in my view, to rely too heavily on
our ability to offset the effects of implicit safety net guarantees
through more strenuous regulation,” he warned. “Sooner or later that
approach is likely to fail.”
Rather than rely on the judgment of regulators, Lacker said a new
approach should be tried.
“Instead of placing all of our eggs in the basket of tighter
regulation, we should place significantly greater reliance on the
powerful decentralized forces of market discipline to constrain the
risk-taking of large financial institutions,” he said.
Lacker said restoring market discipline will require “a credible
restoration of the belief that financial firms’ creditors will not
benefit from public sector support in the event of financial
distress.”
Because past government bail-outs have been motivated by fear of
the disruptive impact of bankruptcies, he said it will be necessary to
“make unassisted financial firm failures less disruptive — and thus
less aversive to policymakers.”
He said one task is to “critically re-examine the bankruptcy code
from a post-crisis perspective, to look for ways to better adapt it to
the business of financial firms, particularly those firms that rely
heavily on short-term funding to finance holdings of longer-term
assets.”
Lacker noted that “many short-term financing instruments and
derivatives are exempt from bankruptcy’s automatic stay,” and he said
“such treatment is argued to have over-encouraged the use of such
instruments, and thereby enhanced the growth and fragility of the shadow
banking sector.”
Lacker also endorsed the idea of “living wills” — pre-planned
strategies for orderly winding down a firm that becomes insolvent.
Lacker said “a key characteristic of a regime relying more heavily
on market discipline is a widespread belief that policymakers will not
rescue the creditors of failing financial firms.”
The Fed took extraordinary actions and stretched the limits of its
statutory authority in lending to non-banks during the crisis, and
Dodd-Frank limits such lending in the future — but not enough for
Lacker.
“These restrictions do not go far enough, in my view, and I would
favor further tightening restrictions on Federal Reserve lending by
eliminating section 13(3) entirely,” he said. “This would be consistent
with reducing the discretionary scope for inappropriate central bank
credit allocation and thereby enhancing the separation between monetary
and fiscal policy.”
Lacker also alleged that the Dodd-Frank’s title creating an
“Orderly Liquidation Authority” that gives the Federal Deposit Insurance
Corporation discretion to aid creditors of failing financial firms
“undercuts the objective of greater financial stability by promoting
uncertainty about public support.”
Money market funds and their regulation also came under Lacker’s
scrutiny.
Money market funds got help from the Fed in 2008 after the collapse
of Lehman Brothers but Lacker suggested that their fragility resulted
from government policy.
“These funds have been allowed to use amortized cost accounting and
fixed net asset values, rather than marking assets to market as do other
mutual funds,” he said. “In exchange, their asset holdings are
restricted to short-term financial instruments. This allows the money
funds to operate very much like bank accounts, but without the overlay
of banking regulation and supervision.”
“The regulations also stipulate that if the value of a fund’s
assets falls below the value it has promised to investors — that is if
they ‘break the buck’ — then the fund must be liquidated,” he said.
Lacker said “these two features combine to prevent funds from
temporarily suspending full payment in the event of difficulty, a
strategy that has allowed institutions in many settings to staunch
destabilizing ‘runs.'”
“Current regulations essentially prevent money market funds from
structuring themselves in ways that reduce their fragility and
vulnerability to runs,” he said. “We should eliminate regulations that
keep these intermediaries from reducing their vulnerability.”
** MNI Washington Bureau: 202-371-2121 **
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