WASHINGTON — Credible resolution plans for large banks, known as living wills, are key to dealing with the too-big-to-fail dilemma without relying on public financing, and as a side benefit can instruct regulators on how to better supervise these firms, Richmond Federal Reserve Bank President Jeffery Lacker said Tuesday.

There will be challenges, including how to resolve multi-national financial institutions, and increased costs, including increased capital and insisting on separate subsidiaries in each country, but those trade-offs are necessary, Lacker said in a speech prepared for delivery to the Global Society of Fellows at the University of Richmond.

"In my view, it makes perfect sense to constrain the scale and scope of financial firms in a way that ensures that they can be resolved in an orderly manner, without government protection for creditors," Lacker said, but noted that this raises questions about which are the right limits.

"The only approach I can envision to answering such questions is resolution planning - that is, the hard work of mapping out in detail just what problems the unassisted bankruptcy of a large financial firm as it's currently structured might encounter."

Lacker acknowledged that "Credible living wills may require significant changes for financial firms. They could lead to more capital, less complex relationships among affiliates and perhaps even to smaller firms."

Multinational firms may be required to create full subsidiaries in each country and resolution plans for each, which also would impose costs, but he said "If subsidiarization is what it takes to make a resolution plan credible, however, then the resulting burden to private firms should be viewed as a measure of the subsidization attributable to their 'too big to fail' status. This is a good example of the types of trade-offs that the living wills work will help us understand."

Lacker warned that "'Too big to fail' is unsustainable," and said of the living wills, "I see no other way to achieve a situation in which policymakers consistently prefer unassisted bankruptcy to incentive-corroding intervention and investors are convinced that unassisted bankruptcy is the norm."

An added benefit of the detailed analysis required to produce the living wills - in the U.S. case adapted to three different scenarios - is that "These insights are being used to enhance supervision more broadly and promote industry best practices."

Then, "Armed with that understanding, we can bolster policymakers' confidence in the plans through appropriate preparations, including structural changes in the nature and organization of the business operations of financial firms.

"This confidence can move us closer to the day when bankruptcy is as much of a nonevent in finance as it is in the airline industry," Lacker said.

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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