WASHINGTON — Living wills would provide a failing financial institutions with a "first and most preferable option" to government assistance, Richmond Federal Reserve Bank President Jeffrey Lacker said Tuesday.

"Clearly, the Dodd-Frank Act envisions bankruptcy without government support as the first and most preferable option in the case of a failing financial institution, and for good reason, in my view," Lacker said in testimony prepared for the House subcommittee on Regulatory Reform, Commercial and Antitrust Law.

A resolution plan "is a description of a firm's strategy for rapid and orderly resolution under the U.S. bankruptcy code, without government assistance, in the event of material financial distress or failure," he said. It spells out the firm's organizational structure, key management information systems, critical operations and a mapping of the relationship between core business lines and legal entities.

"The heart of the plan is the specification of the actions the firm would take to facilitate rapid and orderly resolution and prevent adverse effects of failure, including the firm's strategy to maintain critical operations and funding," Lacker said.

Lacker quoted Richmond Fed research estimating one-third of the financial sector's liabilities are perceived to benefit from implicit protection, based on government actions and policy statements.

"Adding implicit protection to explicit protection programs such as deposit insurance, we found that 57% of financial sector liabilities were expected to benefit from government guarantees as of the end of 2011," he said. This figure was about 45% at the end of 1999.

This belief of guarantees from the government "distorts incentives and exacerbates moral hazard," he said. "Eliminating the ability to provide ad hoc support to firms in financial distress would cement our commitment to orderly unassisted resolutions in bankruptcy, thereby contributing to a more stable and competitive playing field."

The Richmond Fed Bank president didn't address monetary policy or current economic conditions in his testimony, but rather stuck to a topic he's addressed before, most recently at a Washington D.C. conference hosted by the Richmond Federal Reserve Bank.

"Robust and credible resolution plans will position us to wind down the Orderly Liquidation Authority and other financing mechanisms such as the Federal Reserve's remaining 13(3) powers to lend in 'unusual and exigent circumstances,'" Lacker said.

In addition to the benefits of having "an objective basis for decisions about how the structure, financing or activities of large financial firms need to be altered in order to assure orderly unassisted resolution," Lacker said the process of creating the living wills "should illuminate efforts to identify ways in which the bankruptcy code could be improved to make the resolution of financial firms more orderly."

The alternative to robust plans for resolution in bankruptcy, Lacker said, "is to institutionalize the capacity to provide public sector rescues for financial firm creditors outside of bankruptcy," but he calls this "a far less desirable path."

Lacker added that bankruptcy code must deal with the ever-changing aspect of financial institutions, saying "it would be a mistake to assume that the behaviors of financial firms and their creditors will remain unchanged.

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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