US Federal Reserve Bank of Richmond President Jeffrey Lacker said the US should “set credible limits” on federal aid to financial firms rather than provide an open-ended safety net that encourages excessive risk taking.
“Deployment of the financial safety net is often viewed as an essential response to the financial crisis,” Lacker said yesterday in a speech in Beijing. “We need to give serious thought to the extent to which the safety net was actually a significant cause of the crisis.”
The central bank, aiming to stem the credit crisis and revive economic growth, has doubled its balance sheet to more than US$2 trillion in the past year while channeling unprecedented support to nonbank financial institutions. Major banks and other financial companies have reported more than US$1.4 trillion in credit losses and writedowns worldwide since the collapse of US housing prices.
PHOTO: BLOOMBERG
Lacker is a voting member this year of the Fed panel that sets interest rates.
The US economy has contracted since December 2007 and 5.7 million jobs have been cut, the worst decline of any recession since the Great Depression.
Lacker challenged the view that the crisis was caused by unregulated institutions and markets and said that risk-taking may have been distorted by reliance on the federal safety net.
Banks securitized mortgage loans and pushed them into off-balance-sheet vehicles. When short-term funding for these structures vanished, banks had to absorb the assets back on their balance sheets, constraining their capital and ability to lend to the broader economy. Lacker called them “boomerang assets.”
“Most of the fallout from the crisis can be traced back to this problem,” he said in the text of his remarks to the Asian Banker Summit. “A discretionary safety net in particular, creates incentives for ‘too-big-to-fail’ institutions to pay little attention to and under-price some of the biggest risks we face.”
Fed Chairman Ben Bernanke has defended the central bank’s emergency programs, saying on April 14 that “such a proactive policy response is well justified.”
The Fed has also set up programs to promote financing of consumer debt, student loans and small business loans.
The Federal Deposit Insurance Corp (FDIC) has guaranteed debt issues of banks. The Fed, the FDIC and the US Treasury entered into an agreement with Citigroup in November to insure about US$306 billion in Citigroup Inc assets against loss. The agencies arranged a similar deal on US$118 billion of Bank of America Corp assets in January.
US lawmakers and agencies have the option of improving financial regulation and oversight at the risk of stifling innovation, Lacker said. Or they can improve the way large failing institutions are handled through bankruptcy laws and resolution rules, he said. Any new regime should also contain “credible constraints” on use of the federal aid, he said.
“Any mechanism that allows the resolution authority substantial discretion in the use of taxpayer funding to shield creditors from losses would institutionalize the implicit safety net and exacerbate the incentive problems associated with” companies deemed “too-big-to-fail,” Lacker said.
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