Jeffrey M. Lacker

Good afternoon. I'm honored to speak to this Subcommittee about the federal government's financial safety net and how the Dodd Frank Wall Street Reform and Consumer Protection Act seeks to address it.

At the outset, I should point out that within the Federal Reserve System the Board of Governors has sole authority to write rules implementing the requirements of the Dodd-Frank Act. Federal Reserve Banks supervise financial institutions under authority delegated to them by the Board of Governors. In keeping with Board of Governors guidance, I will not discuss any current or potential Federal Reserve rulemaking. I also should say that my comments today are my own views and do not necessarily reflect those of the Board of Governors of the Federal Reserve or my colleagues at other Federal Reserve Banks. My views have been informed by both my leadership of the Fifth Federal Reserve District over the last seven years and my experience as a research economist, studying banking policy for the prior 25 years.

The Dodd-Frank Act was a response to the most dramatic financial turmoil our country experienced in generations. In my view, the crisis resulted largely from a mismatch between a regulatory structure designed for the explicit safety net (consisting mainly of deposit insurance) and the extent of moral hazard induced by a much broader implicit safety net. Given precedents dating back to Continental Illinois in the 1980's and beyond, market participants made inferences about what government protection might be forthcoming in future instances of financial distress—that is, which institutions were likely to be viewed by authorities as "too big to fail." This lack of clarity about the safety net grew in the decades leading up to the crisis—and came about because policymakers hoped that "constructive ambiguity" would dampen the markets' expectations of bailouts, but preserve their option to intervene if necessary. Other factors contributed to the crisis, but I believe the ambiguity of safety net policy was a major driver.

Researchers at the Federal Reserve Bank of Richmond have estimated, based on conservative assumptions, that the implicit safety net covered as much as 40 percent of all financial sector liabilities by the end of 2009. When combined with the explicit protection in place for depository institutions and other firms, the broader federal financial safety net now covers 62 percent of the financial sector, compared to about 45 percent a decade earlier. (See Table.)

Dodd-Frank contains provisions that will help close the gap between the scope of prudential regulation and the scope of the implicit safety net. It allows the Financial Stability Oversight Council to designate large non-bank financial firms as "systemically important" and subject them to more rigorous constraints on risk-taking. The Act also seeks to limit the implicit safety net by empowering the FDIC to liquidate troubled nonbank firms and placing new constraints on the Fed's lending powers. But the FDIC retains considerable discretion in the use of funds to limit losses to some creditors, and the Treasury can invoke orderly resolution for firms that have not been subject to enhanced regulation. The Fed also retains some discretionary power to lend to non-bank entities. This creates continued uncertainty about possible rescues, as well as gaps in our ability to provide clear, credible constraints on the safety net.

In the near term, I believe regulators have a firm grasp on the industry, and are taking strong steps to tighten risk management at regulated firms, but there are risks in the long-term because firms seen as enjoying broad safety net protection will have strong incentives to take on excessive risks. And firms will have an incentive to by-pass regulation, if they can still enjoy some degree of implicit protection. This desire to operate just outside the perimeter of regulation, but within the implicit safety net, will present ongoing supervisory and regulatory challenges—and may make it difficult to prevent or limit the magnitude of future crises.

Continued ambiguity thus would pose risks to financial stability and the economy, including the risk of new costs to taxpayers. But I believe the risks to the effectiveness of our financial system are even more significant. Over time, the devotion of resources to by-passing regulations can create new sources of financial instability and divert resources from the pursuit of financial innovations that are genuinely beneficial to consumers. In the long run, economic growth and job creation would likely suffer.

Creating clear and credible safety net constraints is likely to be difficult. One approach is to tightly limit discretion—including discretionary use of public funds to shield creditors. The Act takes important steps in that direction, yet substantial discretion remains around preferential treatment for certain creditors.

A far more challenging approach is for regulators to retain discretion, but establish a credible commitment to following clear, pre-announced rules in times of crisis. For example, limiting FDIC resolution authority to firms that are regulated as "systemically important" would help block regulatory by-pass. The credibility of such a commitment would require policymakers to allow significant creditor losses in cases in which they otherwise might have provided support.

Some believe that without intervention the economy is too vulnerable to spillover damage from the financial system. I've argued that such spillovers are in large part the consequence of ambiguous government rescue policy. If we can establish clear expectations about the federal financial safety net and live up to our commitment to limit rescues, then we can have more confidence that our financial system will contribute positively to economic growth.

Thank you. I would be pleased to take your questions.

Video of Lacker's testimony