Fed’s Lacker: “Too Big to Fail” Banks Need to Go

Speaking at a conference, in Richmond, Virginia, President of the Federal Reserve Bank of Richmond Jeffery Lacker called for a comprehensive end to “too big to fail.” In his remarks from April 9, Mr. Lacker sought to tackle the issue of weaning major financial institutions from government dependency, speaking of mutual expectations by creditors and lawmakers which “creates fragility” and “induces interventions.” According to Lacker, “First, creditors of some financial institutions feel protected by an implicit government commitment of support should the institution become financially troubled. Second, policymakers often feel compelled to provide support to certain financial institutions to insulate creditors from losses. Instances of such intervention reinforce creditors’ expectations of support and encourage reliance on highly liquid funding sources that make such support more likely.”

To tackle this problem, Lacker noted the need for an expansion of the “living wills” idea which has been included in the Dodd-Frank Act. While he acknowledged the provision in Dodd-Frank, he pointed to aspects of the law which undermine the effort to avoid taxpayer liability, specifically the establishment of the Federal Deposit Insurance Corporation’s Orderly Liquidation Authority (OLA). However, the OLA can make payments to creditors it deems “necessary,” drawing on treasury funds to accomplish this. Moreover, Lacker highlighted previous willing from the FDIC to do so. In this way, he feels, the effort to make the failure process for banks wholly private is undermined.

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Advocating bankruptcy as the ideal solution, he compared potential bank dissolutions to those of airlines; companies who declared bankruptcy while maintaining normal operations. He even went so far as to call this sort of process a “non-event.” As long as banks have access to funds from the likes of the OLA though, he feels creditors “believe they might benefit from such treatment and therefore to pay less attention to risk than they should. If expectations of support for financially distressed institutions in orderly liquidation became widespread, regulators would likely feel forced to provide support simply to avoid the turbulence of disappointing expectations.”

In Lacker’s view, other attempts to wind down banks are futile unless there is a clear view on the bank’s part for how they can resolve the own failures. Citing advocated attempts to place structural constraints on banks, he questions the practicality of this, while conceding that it makes “perfect sense.” Instead he argues, by forcing banks to draw up their own wills, they would essentially be placing the appropriate constraints of their own operations so that in the event of failure dissolution would be possible without government intervention. This process would therefore relieve policymakers and regulators the trouble of trying to come up with quantitative constraints on financial institutions, in turn avoiding the possibility that the government hinders market efficiencies.

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Concluding with some revealing numbers, Mr. Lacker emphasized that it is “essential” to end “too big to fail.” He cites fed economists, who found that “at the end of 1999, about 45 percent of financial sector liabilities were explicitly or implicitly government guaranteed. At the end of 2011, as a result of the precedents set during the crisis, they estimated the figure to have grown to 57 percent.” Unless the government acts to stop this trend, Lacker fears that taxpayer liability for large banks will only continue to increase.

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