Bernanke Says Failing Bank Process Needed to Reduce Moral Hazard

Federal Reserve Chairman Ben S. Bernanke said a process under development that would allow regulators to take down a failing bank will help ensure investors discipline weak firms and prevent them from taking risks without consequence.

“As we try to make the financial system safer, we must inevitably confront the problem of moral hazard,” Bernanke said today in remarks at an International Monetary Fund conference in Washington. “Market discipline can only limit moral hazard to the extent that debt and equity holders believe that, in the event of distress, they will bear costs,” he said, in remarks that did not address the outlook for the economy or monetary policy.

Bernanke said regulators have been working to devise so-called orderly liquidation authority, that would allow a systemically important financial institution, or SIFI, to be closed down without the chaos that surrounded the failure of Lehman Brothers Holdings Inc. and bailout of American International Group Inc. in September 2008.

“In the crisis, the absence of an adequate resolution process for dealing with a failing SIFI left policy makers with only the terrible choices of a bailout or allowing a potentially destabilizing collapse,” Bernanke said. “A credible resolution mechanism for systemically important firms will be important for reducing uncertainty, enhancing market discipline, and reducing moral hazard.”

Bernanke led the central bank through a financial crisis and 18-month recession, that was the longest and deepest since the Great Depression. The Standard & Poor’s 500 Index reached a 12-year low in March 2009. Joblessness peaked at a quarter-century high of 10 percent in October 2009. By March 2010, 10.1 percent of all mortgage loans were delinquent, according to data from the Mortgage Bankers Association.

The 59-year-old Fed chief devoted most of his remarks to comparing what happened five years ago to “a classic financial panic” like the banking panic in 1907 that led to the creation of the U.S. central bank 100 years ago.

Before it's here, it's on the Bloomberg Terminal.