The too big to fail issue has not been solved, Federal Reserve Bank of Richmond President Jeffrey M. Lacker said Tuesday.
"[O]ur response to the crisis has failed to address what remains the most critical issue facing our financial system: institutions that are deemed 'too big to fail,' or, more precisely, too big to fail without a government-funded creditor rescue," Lacker told an audience at Stanford University, according to prepared text of the speech, released by the Fed.
The problem, according to Lacker is "two mutually reinforcing conditions seriously distort the incentives of financial market participants to monitor and control risk." Creditors are secure with "an implicit government commitment of support should the institution become financially troubled" and "policymakers often feel compelled to provide support to certain financial institutions to insulate creditors from losses."
Removing the expectation of government support, and following through by allowing failures, will limit risk-taking and give incentives "to avoid fragile financing arrangements," he said. "If we can make unassisted failures manageable, then policymakers could credibly commit to forgoing rescues, thereby improving private sector incentives."
The steps needed to allow failure, include: "rigorously" implementing the Dodd-Frank Act provision "that requires large and complex financial institutions to create resolution plans, also known as 'living wills'"; "critically examine the bankruptcy code itself and look for ways to better adapt it to the business of large financial firms, particularly those that rely heavily on short-term funding to finance longer-term assets"; "identify regulatory or legal impediments to private sector arrangements that would reduce instability," for example "money market mutual funds, which benefited from substantial official support at the height of the crisis in 2008"; and ensure that market participants know "government-funded rescues will not be forthcoming."
