The federal government is too heavily involved in backstopping financial institutions, Richmond Federal Reserve Bank President Jeffrey Lacker warned Tuesday night.

Lacker said the financial crisis, which he partially blamed on the Fed, led to an escalation of government support of banks liabilities that he called "unsustainable."

He ranked the resulting potential for financial instability "second only to the looming federal fiscal imbalance" in remarks prepared for delivery to his alma mater, Franklin & Marshall College in Lancaster, Pa.

As the housing bubble burst, causing some financial firms to fail and others to shun their counterparties, a widening of credit spreads led the Fed to step in and play its "lender of last resort" role. After slashing the discount rate in August 2007, it went on to set up the Term Auction Facility, the first of a number of emergency liquidity facilities.

At the time, Lacker recalled, he "questioned the presumption that the markets were suffering from a problem for which increased Fed credit was the solution."

Rather, he believed "the deterioration in housing market conditions was causing a fundamental revaluation of housing-related financial instruments. Because exposures to this revaluation were distributed throughout the financial system, uncertainty about the creditworthiness of counterparties had increased substantially, and this caused investors to demand higher-risk premiums in compensation."

If financial markets were "responding in a plausibly efficient manner to a significant revision in expectations about the underlying economic fundamentals," then the Fed's subsidized lending "is likely to have simply undercut the private lending that would have taken place," Lacker said.

He went on to charge, admittedly "in hindsight," that the Fed's crisis response created expectations that worsened the crisis in 2008, as "each new move to expand institutions' reliance on Fed lending also had the effect of increasing expectations of official support in the months ahead."

Lacker contended that "the signal sent by the Fed's lending actions in August 2007 dampened the willingness of troubled institutions, such as Bear Stearns and Lehman Brothers, to seek safer solutions to the strains they were facing - whether by raising capital, selling assets or reducing reliance on short-term funding."

And he said, "the assisted purchase of Bear Stearns seems likely to have influenced in turn the perceptions of government support for other large financial institutions, which seems likely to have affected how such firms were positioned as the events of the fall unfolded."

Lacker said "a more measured response by the Fed in August 2007 could have resulted in significantly less instability in 2008..."

As a result of the Fed's actions during the crisis, Lacker estimated that the percent of financial sector liabilities that "benefit from perceived government support" has risen to 57% from 45% in the past decade.

"In my view, this growth in government support for the financial sector is not sustainable," he said, adding, "As economic policy challenges go, I would rate this as second only to the looming federal fiscal imbalance."

Lacker, who opposed Fed easing measures last year as a voting member of the Fed's policymaking Federal Open Market Committee, did not talk about current monetary policy in his text.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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