Fed's Jeff Lacker: financial reform "is the question of our time"

As reported by the American Banker, Jeff Lacker, president of the Federal Reserve Bank of Richmond, sees financial reform as "the question of our time".  He thinks that the policy of financial failure containment is wrong and wants to see a financial system where banks can fail and their investors absorb the cost of this failure.

Mr. Lacker would be a natural for supporting the FDR Framework and its role in supporting the policy of financial failure prevention.

The FDR Framework, which is the basis for our financial system, combines the philosophy of disclosure with the principle of caveat emptor.  This promotes market discipline by making investors responsible for the losses on their investments.

That Lacker's answers differ from those held by a majority of his Federal Reserve colleagues will surprise few. ... And on banking policy, he's convinced the Dodd-Frank Act of 2010 handed way too much power to federal regulators. 

At its core, Dodd-Frank is all about substituting the combination of complex rules and regulatory oversight for the combination of transparency and market discipline.

As the current financial crisis has shown, the combination of complex rules and regulatory oversight is not up to the task of preventing a financial crisis.

"I worry about people taking away from the crisis the lesson that what's key is to respond with maximal force and to provide regulators with maximal discretion across the widest possible terrain," Lacker says. 

"Enhancing the scope for intervention and enhancing the tools just spreads the poison that boxes us in, in a crisis."

Please re-read the highlighted text as Mr. Lacker is making clear that the current financial crisis is not over and the policy of financial containment has made the situation worse.

That neatly sums up the divide among policymakers that has emerged since the 2008 crisis.  

One camp — the one that's firmly in charge — believes the path to financial stability is paved with rules, oversight and enforcement while the other is desperately searching for ways to rebuild market discipline....

Please re-read the highlighted text again as it nicely summarizes the battle over substituting complex rules and regulatory oversight for the combination of transparency and market discipline.

But Lacker ... wants the government to reverse years, even decades, of rescuing any large financial company that gets into trouble. He wants to tie the government's hands so regulators have no funds to finance these bailouts. Only then, he argues, will market participants believe bailouts are over and begin to discipline financial companies themselves. 

"The linchpin seems to be the credibility about what we say about who we will rescue," Lacker explains. "We deliberately fuzzed that up in the '80s and '90s with constructive ambiguity. We wanted to maintain the fiction that we would not intervene, but at the same time we tried to preserve the flexibility, the discretion to intervene. 

"Well, markets see through that."...

Your humble blogger disagrees with Mr. Lacker over what is the linchpin to credibly end bailouts.  I think the linchpin is requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is only with this data that the market participants have the information they need to independently assess the risk of each bank, to take responsibility for any losses on their exposures to a bank and to exert market discipline.

Without ultra transparency, banks are 'black boxes' and market participants are dependent on the bank supervisors to assess and properly convey the risk of the banks.

One of the lessons learned during the financial crisis is that bank supervisors are more concerned with the issue of safety and soundness of the banking system than accurately conveying what is going on inside a bank.

With the discretion to not fully disclose the risk of each bank comes the moral obligation to bailout the banks and by definition their investors who relied on the bank supervisors' representations about the risk of the banks.

The best way to convince markets that the era of bailouts has ended is to let a big financial company fail, he says. 

"Credibility is going to require us to take actions that will be painful to some, painful to financial markets," including "guiding a large financial institution through the bankruptcy process, unaided with government taxpayer funds."

Actually, the best way to convince markets that the era of bailouts has ended is to require ultra transparency.

With ultra transparency, investors once again become responsible for their losses.

Asked if the government could simply stand by when markets freeze up, Lacker questions the question. 

"Freeze up is a loaded term. There is a lot of implicit theorizing going on when people use metaphors like pipes and ice when they talk about markets," he says. "People on the sell side in a crisis often throw around the phrase that things are frozen or clogged or jammed or dysfunctional, and it's really just people not getting the prices they want. 

"As a government official I think we ought to be really shy about coming to the judgment that some market isn't doing what it ought to do, that we know better than market participants what a piece of financial paper ought to be worth."...

Sometimes the market really does freeze and when it does it is always the result of opacity.

For example, the unsecured interbank lending market froze at the beginning of the financial crisis and remains frozen because banks with deposits to lend could not and still can not determine the risk and solvency of the banks looking to borrow.

For example, the sub-prime mortgage-backed securities market froze and remains frozen because nobody knows how the underlying collateral is performing.  The same lack of information on collateral performance has also limited the number of deals since the beginning of the crisis in the broader private label mortgage-backed securities market.

Yes, there are some gamblers in the form of hedge funds who are buying these securities, but the truth is they are blindly betting on the contents of a brown paper bag and hoping a bigger fool will buy the securities from them.

Unlike Hoenig and Fisher, Lacker is not arguing for a breakup of the largest banks. "I'm an agnostic on that," he says. "If you want to break up the banks, fine. But how do you know how far and when to stop?" 

Ultra transparency takes care of this issue because market discipline in the form of linking a bank's cost of funds to the risk it takes will put pressure on the banks to reduce risk.

How the banks reduce risk is management's decision.

The critical point is that risk in the banking system are reduced.

He doesn't support reinstating the walls between commercial and investment banking either. 

"Those schemes fail to limit the safety net without achieving a measure of commitment not to rescue creditors of large firms whether they are on one side of the Glass-Steagall wall or the other," he says. "It treats a symptom but it doesn't really address the fundamental problem, which is that commitment, the inability or unwillingness to commit to limiting rescues." 

That's the fundamental reform Lacker keeps coming back to: breaking what he calls the "rescue-regulate-bypass" cycle where government officials rescue firms, then regulate them and then stand by while businesses find ways around the oversight. 

Lacker began beating this drum before Dodd-Frank was even enacted, saying in March 2010. 

"Regulatory improvements alone, as essential as they are, won't be enough. This cycle of crisis, rescue and bypass is destined to recur, and with ever more force, unless we alter what market participants believe will happen when a financial firm becomes distressed." 

And the only way to alter what market participants believe will occur is to provide market participants with ultra transparency.  Then, market participants have a stake in making sure that banks don't fail as they become responsible for the losses.