Living Wills Only Fix to 'Too Big to Fail': Fed's Lacker

WASHINGTON — Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond, said Tuesday that plans to safely unwind banks without a government rescue is the only way to rid of "too big to fail."

Despite reforms under Dodd-Frank, including a new orderly liquidation authority, the perception of "too big to fail" continues to persist because of features under Title II that "recreates the capabilities and incentives that originally gave rise to excessive government rescues," Lacker said. As a result, the market and others are convinced more needs to be done.

"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 said in a speech at a conference at the University of Richmond. "Such maps would provide an objective basis for judgment about how the structure or activities of such firms need to be altered in order to give policymakers the confidence to choose unassisted bankruptcy in the event of distress, but without going too far and unnecessarily eliminating efficiencies associated with economies of scale and scope."

Regulators, including Federal Reserve Board Chairman Ben Bernanke, have stressed that policymakers would continue to do whatever is necessary to end the perception of "too big to fail."

Lacker said two conditions must be met to address the issue. First, creditors must not expect government support during periods of financial stress and secondly, policymakers must allow financial firms to fail without government support.

"The living wills program will require a great deal of hard work and detailed analysis," said Lacker. "I see no other way to reliably identify exactly what changes are needed in the structure and operations of financial institutions to end 'too big to fail.' 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."

However, Lacker said there were several challenges to address before the living will project can be a success.

For example, he cited the challenges policymakers face in unwinding globally active financial firms and funding concerns. One way to fix that problem is to require global firms to form distinct legal subsidiaries with separate capital and liquidity holdings so they can be resolved separately.

The bigger challenge facing resolution planning, he said, concerns funding.

"The FDIC's authority to lend to distressed institutions under its OLA amounts to government-provided DIP financing," said Lacker. "The beneficial feature of privately provided DIP financing is the presumption that, because it's provided by market participants but also approved by creditors and the court, it's fairly priced and thus unsubsidized and does not unduly disadvantage any particular class of creditors."

Lacker said Richmond Fed economists previously estimated by the end of 1999 roughly 45% of financial sector liabilities were explicitly or implicitly government guaranteed. That number rose to 57% by the end of 2011.

"This fraction is likely to continue to grow unless we end 'too big to fail,'" said Lacker. "And to end 'too big to fail' we need to do the hard work of learning what it takes to make all firms safe to fail without government rescues."