Lacker Says Government Should Be Ready to Let Big Banks Fail

Federal Reserve Bank of Richmond President Jeffrey Lacker said plans to limit the size or change the structure of the largest financial institutions must be made with the intent of allowing a failure without government aid.

“It makes perfect sense to constrain the scale and scope of financial firms in a way that ensures that they can be resolved in an orderly manner, without government protection for creditors,” Lacker told a conference at the University of Richmond.

U.S. regulators and lawmakers are searching for ways to limit the risk that a large bank failure will result in another taxpayer-funded bailout. Senate Republicans and Democrats are discussing legislation that would boost capital standards, while Fed officials are discussing ways to limit the safety net and curb balance-sheet expansion at the largest banks.

While the Dodd Frank Act’s preamble says its intent is to “end ‘too-big-to-fail,’” some of the largest banks may still benefit from the perception that they would be rescued by the government, Federal Reserve Chairman Ben S. Bernanke told lawmakers in February.

“We need to be working in the direction of eliminating it entirely,” Bernanke told the House Financial Services Committee on Feb. 27.

Living Wills

The Dodd-Frank Act required firms to write living wills, or plans that describe how they would be wound down in the event of failure. Lacker said one flaw in the law is that it has provisions for temporary government support.

“The FDIC does have the ability to deviate in some important ways from what might occur under bankruptcy. In particular, it can make payments to creditors it deems ‘necessary,’ and it can draw on funds from the Treasury to do so,” Lacker said.

That provision “opens the door” for creditors to believe there is the possibility they could be bailed out leading them to “pay less attention to risk than they should.” The more widespread the expectations of support, the more pressure there will be on regulators to provide it, he said.

“A credible funding plan that avoids adverse effects, without resorting to government” financing “might seem daunting,” Lacker said at the University of Richmond. He recommended a private form of debtor-in-possession financing and said improving liquidity management at large banks.


“I see no other way to achieve a situation in which policy makers consistently prefer unassisted bankruptcy to incentive-corroding intervention and investors are convinced that unassisted bankruptcy is the norm,” Lacker told the conference.

The Richmond Fed president also said that requiring globally active firms to cut their businesses into subsidiaries “with separate capital and liquidity holdings” could also aid resolution.

“The ability to expeditiously sell material foreign operations would provide valuable flexibility,” Lacker said.

Lacker said he has been “chagrined” by the lack of reform for money market mutual funds. He called reform of the industry “a major piece of unfinished business” in part because of the perceived safety net that investors can always pull their money out at a dollar per share.

The KBW Bank Index, which tracks the shares of 24 large U.S. banking companies, rose 8.8 percent this year, compared with a 9.5 percent gain for the Standard & Poor’s 500 stock index.

Banks have boosted capital levels since the crisis as regulators demand larger buffers against loss. Bernanke said the aggregate Tier 1 common equity ratio at the 18 largest banks rose to 11.3 percent at the end of 2012 from 5.6 percent of risk-weighted assets at the end of 2008.

‘Better Position’

“Higher capital puts these firms in a much better position to absorb future losses,” Bernanke said yesterday at an Atlanta Fed conference in Stone Mountain, Georgia.

Senate Democrats and Republicans are drafting legislation that would require U.S. regulators to replace an international capital accord with even higher standards.

Under Basel III, banks must hold at least 7 percent of Tier 1 capital against a bank’s risk-weighted assets, plus as much as a 2.5 percent for some of the world’s largest and most complex banks.

Senators Sherrod Brown, a Democrat from Ohio, and David Vitter, a Republican from Louisiana, intend to introduce a bill this month that would require U.S. regulators to replace Basel III requirements with a higher capital standard: 10 percent for all banks and an additional 5 percent for institutions with more than $400 billion in assets.

Lacker didn’t comment on monetary policy in the text of his remarks. He said in a question and answer period with reporters that a gain of just 88,000 nonfarm jobs in March didn’t lower his forecast for 2013.

“My forecast is intact,” he said. “This recovery is one with some stretches of above trend growth, and some stretches of below trend growth.”

Lacker estimated the economy will grow between 2 percent and 2.25 percent this year.

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