Fed's Lacker Says Regulatory Overhaul Fails to Curb Safety Net

Federal Reserve Bank of Richmond President Jeffrey Lacker said proposed U.S. laws to overhaul financial rules keep too much of a safety net in place for firms and probably won’t break a “vicious circle” of crises.

“My early assessment is that the House legislation -- and to some extent even the Senate version -- creates enough discretionary rescue powers to dampen market discipline and sustain the vicious circle that brought us an expansive financial safety net,” Lacker said yesterday in a speech in Washington.

The Senate approved legislation on May 20 overhauling Wall Street regulation by creating a consumer protection agency, a mechanism for liquidating large failing financial firms and a council of regulators to monitor companies for threats to the economy. Lawmakers are working to reconcile differences with a House bill approved in December.

Lacker has called several times for curbing the potential aid available to firms in a crisis. The government safety net covered 59 percent of financial-industry liabilities at the end of 2008, up from 45 percent in 1999, Lacker said. The increase has been a “direct result of the ambiguity of unstated, implicit guarantees,” he said.

While the bills in Congress aim to break the cycle of crises, in part by letting regulators seize and liquidate failing firms, the “protection of short-term creditors weakens the incentives of the most critical liability holders,” Lacker said.

Regulatory Strategy

Instead, policy makers should be willing to pursue a regulatory strategy that imposes short-term pain to achieve long-term benefits similar to former Fed Chairman Paul Volcker’s efforts to break the back of inflation in the early 1980s, Lacker said. Volcker raised the federal funds rate to as high as 20 percent, pushing the economy into the 1981-82 recession.

“We will not break the cycle of regulation, by-pass, crisis and rescue until we are willing to clarify the limits to government support, and incur the short-term costs of confirming those limits, in the interest of building a stronger and durable foundation for our financial system,” Lacker said at a conference hosted by the George Washington University and International Monetary Fund.

“Measured against this gauge, my early assessment is that progress thus far has been negligible,” said Lacker, 54, who has led the Richmond Fed since 2004. His bank is responsible for oversight of bank-holding companies in its district, including Bank of America Corp. in Charlotte, North Carolina, Capital One Financial Corp. in McLean, Virginia, and BB&T Corp. in Winston- Salem, North Carolina.

Need to ‘Disappoint’

Responding to audience questions, Lacker said “we’re going to have to disappoint those expectations” that the government will bail out a company.

At the same time, former Treasury Secretary Henry Paulson was probably too late when he signaled in September 2008 that the U.S. wouldn’t save Lehman Brothers Holdings Inc., Lacker said. “The weekend before is probably not the best time to choose where to draw the line,” Lacker said.

Lacker said a provision in the Senate legislation to make the New York Fed president a political appointee is a “mistake” and would politicize monetary policy.

Lacker, who doesn’t vote on interest-rate decisions this year, didn’t discuss the outlook for the economy or monetary policy in his speech. Speaking with reporters afterward, he said the Fed should pare its balance sheet “sooner rather than later.”

Lacker said his support has waned for the Fed’s commitment to hold interest rates low for an “extended period.”

‘Marginally Comfortable’

“A couple weeks ago I was still comfortable with that language. Decreasingly so,” he said. “That’s where I am now, just sort of marginally comfortable with that language.”

The inflation rate will probably be at 1.5 percent for the remainder of this year, he said to reporters.

“We’re going to see some low inflation numbers, for overall inflation, for the next couple months,” he said. “Over the course of this recovery, in the next couple of years, I think inflation risks will shift toward the upside.”

Before the speech yesterday, Lacker said in an interview with Bloomberg Television that Europe’s sovereign-debt crisis may reduce U.S. economic growth by as much as 0.2 percentage point.

As European countries attempt to address their debt levels, “the hiccups along the way could cause some shocks that maybe have a larger effect on growth,” Lacker said.

To contact the reporters on this story: Scott Lanman in Washington at slanman@bloomberg.net; Joshua Zumbrun in Washington at jzumbrun@bloomberg.net.

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