Efforts should focus on stemming negative spillover effects from failure of key financial institutions, according to Federal Reserve Bank of Minneapolis president Gary Stern.

“Maintaining the status quo with regard to [too big to fail] could well impose large costs on the U.S. economy. We cannot afford such costs,” Stern told the Senate Banking, Housing, and Urban Affairs Committee yesterday, according to prepared text released by the Fed. “I encourage you to focus on proposals that address the underlying reason for protection of creditors of TBTF financial institutions, which is concern for financial spillovers. I have offered examples of such reforms. Absent these or similar reforms, I am skeptical that we will make significant progress against TBTF.”

He added that the problem is “undesirable incentives.” When an institution that is too big to fail is in trouble, uninsured creditors expect government protection from loss.

“The key to addressing this problem and changing incentives, therefore, is to convince these creditors that they are at risk of loss,” Stern said. “If creditors continue to expect special protection, the moral hazard of government protection will continue. That is, the creditors will continue to underprice the risk-taking of these financial institutions, overfund them, and fail to provide effective market discipline.

“Facing prices that are too low, systemically important firms will take on too much risk. Excessive risk-taking squanders valuable economic resources and, in the extreme, leads to financial crises that impose substantial losses on taxpayers. Put another way, if policymakers do not address TBTF, the United States likely will endure an inefficient financial system, slower economic growth, and lower living standards than otherwise would be the case.”

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