Ten Questions for Richmond Fed Chief Jeffrey Lacker

WASHINGTON — Jeffrey Lacker is among a growing faction of regulators who believes the push for government-managed resolutions of failing bank behemoths misses the boat.

The president of the Federal Reserve Bank of Richmond said regimes such as the Orderly Liquidation Authority — mandated in the Dodd-Frank Act — could unduly favor creditors with government liquidity. Lacker, like other officials such as Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp., instead embraces steps to ensure large banks can be unwound without federal interference.

Lacker has emphasized another financial reform law statute requiring banks to submit plans — or "living wills" — on how they would be resolved in a more traditional bankruptcy, which includes formal repercussions for banks with deficient plans.

Still, with the Fed and FDIC recently criticizing the quality of living wills submitted last year, Lacker says systems such as OLA may be necessary "as an interim measure" until the banks' resolution plans show enough improvement.

In a broad-ranging discussion with American Banker, Lacker said OLA "will create some of the" problems that led to the crisis, "economies of scale" have helped larger banks weather the regulatory environment and policymakers should consider distinguishing between the biggest institutions and mid-size firms that now must follow many of the same rules imposed by Dodd-Frank.

Following is an edited Q&A:

You have expressed a preference for living wills — and using bankruptcy to resolve failures — over the Orderly Liquidation Authority in Dodd-Frank. Why is that a better approach?

I think OLA will create some of the issues and the flaws in the system that led to the problems that we had. I think a crucial part of the problem going in to 2007 was the widespread expectation that large financial firms would get support for their creditors, and I think that had a fairly large effect on the structure of these firms — the extent to which they were willing to run with thin capital buffers, the extent to which they were willing to rely on very short term wholesale funding, and the extent to which in general they were willing to leave themselves vulnerable to a loss of confidence.... Competitive forces drove their business models towards making them more vulnerable, because it drove them toward exploiting the perceived access they would have to government liquidity in a crisis. So it wasn't an accident the way things played out the way they did.

So that's why I think living wills are so important: to war-game through in a very planned way what would happen in a bankruptcy filing, to take nothing about the current structure and operations at the firm as given, but to try and deduce what changes need to be made so they could be taken into bankruptcy without government support, without extra liquidity support from the government, and without damaging the rest of the economy.

But can bankruptcy limit the systemic impact of failures?

There do exist [nonbank] institutions that we're pretty confident would be able [to handle bankruptcy]. If a modern American airline goes into bankruptcy, for example, it doesn't need government liquidity support, it doesn't damage the economy. It keeps flying, and people keep buying tickets.

Obviously the liquidity requirements of bankruptcy are going to be important. And I think the liquidity angle is the thing that makes so many people unfairly skeptical of this. I think people look at the liquidity needs and the way these firms are traditionally operated, and say, ‘That's an unreasonable amount of debtor-in-possession financing to assume you're going to be able to find.'... I think you can't just take their current liquidity profile as given. The exercise is to work backwards from resolvability without needing substantial government support to what their liquidity profile ought to look like.

Despite regulators' criticism of living wills, they stopped short of issuing "not credible" findings, which under Dodd-Frank start a series of formal corrective measures. Should they have made those findings?

I wasn't disappointed per se [at the lack of a "not credible" determination.] I think the most important thing about the announcement and the decision of the Fed and FDIC was the specificity of the guidance they provided the firms was much greater than we had provided before. It identified the key aspects [of the plans that] were obviously deficient, told them what direction to go in and what progress was needed. It provided them a map for how to go forward. I thought that was the most constructive and most important part of the announcements.

Just how deficient were the plans?

They were all better than no plan. It's important to recognize they have done a substantial amount of work. There is a much more comprehensive, in-one-place... map of the companies. They understand their legal structure and how that relates to the business structure much more deeply than they used to. They pulled together a lot of information that will be in one place and you can find things at your fingertips. But as the feedback indicated, there were substantial shortfalls. A lot of it had to do with assumptions... that seemed on the hopeful end.

The law allows regulators broad powers to force institutions with persistently subpar living wills to simply their structure, even requiring asset divestiture. Do you see those powers as ever being used?

It's too soon to say at this point one way or another. When [Dodd-Frank] was passed, I'm not sure how people were thinking about this. Up until this year, this has gotten less attention in the regulatory community than a broad range of equally urgent things that came out of Dodd-Frank. But it always struck me that this was going to... emerge and take on more importance as time went on, and I think we're seeing that. This is going to be front and center of a very important part of the regulatory landscape.

What happens if there's another Lehman Brothers tomorrow? Shouldn't the government have more tools at its disposal, like OLA, to contain the ripple effects of a huge failure?

I think that during this interim period, in which regulators are clearly unsatisfied with the resolution plans that have been submitted, we ought to think of the Orderly Liquidation Authority as an interim measure... until we get resolution plans in place that we have confidence in. Once we do, we can't invoke the orderly liquidation authority if bankruptcy would work, if bankruptcy is available as an option. And I think the Act envisions that that's what we want to work towards, a situation where bankruptcy is the first option, it's a viable one, it's one regulators have confidence in, because enough planning has been done and enough scrutiny of those plans has taken place.

Do you think a bank's asset size matters in terms of its ability to weather the current environment?

I think that one side effect of the sweeping revolution in regulations we've seen in the past several years has been a tilt in the economies of scale... just because of the size of the compliance burden.... There's a certain minimum level of expertise you have to acquire somehow in order to fix your systems, monitor them, make sure you comply. I think that is tilting the playing field for community banks and making a... larger size a little more attractive than it used to be.

Does that mean that we won't see more de novo banks until there is regulatory relief?

Broadly speaking, I think the consolidation trend is likely to continue. In that environment, you question where the demand for de novo [charters] would come from.... I expect over the next five to 10 years, the generational turnover in the leadership and management and... directors [at community banks] will lead to a steady repurposing of charters and continuation of the consolidation trend. Having said that, I have to say I think there will still be a place in the U.S. banking system for community banks for some time to come. They have some obvious comparative advantages in the lending market.

Do you believe in two-tiered regulation, or at least tailoring rules for smaller institutions?

I do. I do think that's important. I think we've been genuinely attentive to that and sincere about that — to adapting regulation to the appropriateness of the risks involved in the institution you're in. I think our people have tried really hard on that. There are some legislative notches that we have to respect that tie our hands. You hear people talk about how much their costs go up if they cross $10 billion. Some of that stuff is out of our hands, but to the extent we can I think we work hard at that.

Some have called for raising the current $50 billion asset cutoff that determines which large banks must follow certain rules. Do you favor such an increase?

I don't have a definite position on that, but I'm... open to considering adjusting that.... Again, it goes back to expectations of government support. What about Orderly Liquidation Authority? If they're below a new threshold, would we view them as eligible for treatment under the Orderly Liquidation Authority, in which the FDIC can use Treasury funds to protect their creditors? That would be a question for me.... I think there are clear qualitative differences between the top tier of banks, the SIFIs, and the major regionals, for example. The extent of their capital market and derivative activities is obviously very different. That warrants thinking about them somewhat differently to some extent.