Risk-taking and the "safety net"
The Dodd-Frank Act changes the responsibilities of the Fed and other agencies, prescribes new regulations for "systemically important firms" and creates new procedures for handling those firms when they fail. One important aspect to any change in the regulatory environment is the extent to which it provides clear and credible limits to the federal financial safety net.
The federal financial safety net – the protection, both explicit and implicit, that the federal government extends to firms in danger of failure and their creditors – arguably has increased risk-taking by many financial institutions and reduced their creditors’ incentive to appropriately assess risk and related costs. In addition, the likely provision of federal financial assurance may have reduced the incentive of an institution to hold adequate reserves in the case of a liquidity crisis.
A limited safety net – one designed to protect relatively small depositors against default – is desirable. But the bounds of the safety net have extended well beyond that, and in ways that are ambiguous to market participants. The safety net should be reined in. Its scope should be limited and made transparent.
The establishment of a "resolution authority" within the FDIC gives the FDIC substantial discretion to use money borrowed from the U.S. Treasury to provide loans or guaranties to certain kinds of failing financial companies. This authority is designed to help stabilize those companies and provide a more orderly and less disruptive alternative to bankruptcy. The rule-writing process for the resolution authority may help clarify how the FDIC can credibly commit public funds while simultaneously limiting the eligible firms and imposing appropriate losses on creditors.
History suggests that financial failures are inevitable. But with adequate market discipline, any disruptions can be relatively short-lived and contained. Discretionary federal financial assistance to failing financial companies and their creditors could intensify the instability.
Speech by Jeffrey Lacker, Sept. 14, 2009
Choices in Financial Regulation
Annual Report, 2008
The Financial Crisis: Toward an Explanation and Policy Response
Cato Journal, Winter 2002
How Large Is the Federal Financial Safety Net?
Richmond Fed Economic Brief, November 2009
Rolling Back the Financial Safety Net
Economic Quarterly, Spring 2009
Should Increased Regulation of Bank Risk-Taking Come from Regulators or from the Market?
Economic Quarterly, Fall 1999
Limited Commitment and Central Bank Lending