Fed's Jeffrey Lacker: Rescue policy worsened financial crisis in 2007

Bloomberg reports that the Federal Reserve Bank of Richmond's Jeffrey Lacker said that the financial system was weakened in 2007 by the rescue policy pursued.

The Richmond Fed president has been one of the biggest critics of an expanded safety net which he says reduces market discipline and creates more risk by raising expectations of bailouts. 

The Fed used multiple tools to aid financial institutions during the crisis, including opening a funding facility for corporate commercial paper and offering direct support for the Bear Stearns Cos. and American International Group Inc....

Please recall that the policies pursued reflected the US Treasury and the Fed's decades old policy of financial failure containment that was adopted and formalized under Robert Rubin, Alan Greenspan and Larry Summers.

The policy of financial failure containment expressed itself in 2008/2009 through the adoption of the Japanese Model for handling a bank solvency led financial crisis.  This model protected bank book capital levels and banker bonuses at all costs.

The question in 2007 was whether the Treasury and the Fed would be willing to sacrifice the US economy and the social contract to implement the Japanese Model.

By not raising capital and therefore weakening the financial system, bankers increased the likelihood that the Treasury and the Fed would be willing to adopt the Japanese Model.

“It seems quite plausible to me that the signal sent by the Fed’s lending actions in August 2007 dampened the willingness of troubled institutions, such as Bear Stearns and Lehman Brothers, to seek safer solutions to the strains they were facing -- whether by raising capital, selling assets or reducing reliance on short-term funding,” Lacker said... 

Lacker said perceptions of government support had built over decades which may have underpinned the dependence of investment banks such as Bear Stearns on low-cost short-term funding such as repurchase agreements. 

“When Bear lost funding in mid-March, the critical fear was that without government support, investors would pull away from other investment banks as well,” Lacker said. 

“Backstop lending was thus necessitated by expectations of backstop lending.” 

Your humble blogger disagrees with Mr. Lacker about why the market expected the Fed to provide backstop lending.  I think the market expected the Fed to act as a lender of last resort and lend freely against good collateral at high rates of interest.

The fact that the Fed did not lend at high rates of interest sent a message to the banks that confirmed the Fed's willingness to adopt the Japanese Model and that bank book capital levels and banker bonuses would be protected at all costs.