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Lacker said restricting the boundaries of the safety net, which he estimated now covers 62% of the financial industry, may mean allowing some firm regarded as “too big to fail” to go under. He acknowledged that doing so would cause “short-term disruptions,” but said the long-term benefits would be “quite large.”
Far from limiting the scope of the safety net or matching government protection with increased regulation, Lacker suggested the financial reform legislation passed in the wake of the financial crisis may have extended the problem.
Lacker said Fannie Mae and Freddie Mac, who he used as prime examples of government-subsidized risk taking that led to the crisis, need to be “wound down,” though not by shutting them down immediately.
He admitted that is probably not politically feasible, but he said the nation needs to “rethink” the government role in promoting home ownership.
Lacker, not a voting member of the Fed’s policymaking Federal Open Market Committee this year, did not talk about the economy or monetary policy in remarks prepared for delivery to a
Lacker’s topic was “innovation in the new financial regulatory environment,” and his thesis was that innovation is heavily influenced by the incentives embodied in government regulation and the “safety net” — the combination of explicit or implicit government guarantees, insurance and access to emergency liquidity.
“This safety net often influences the direction of financial innovation,” he said. “Firms that benefit from a government backstop are willing to forgo costly measures to protect themselves against runs or liquidity pressures that would elicit government protection.”
“The precedents set in the recent financial crisis extended government support more broadly than before, and thus have dramatically expanded the implicit safety net — to nearly two-thirds of the financial sector,” he said.
“Ideally, the extent of implied government support would be matched by the scope of prudential regulation to contain the moral hazard that would otherwise encourage excessive risk taking,” he continued. “That was not the case leading up to this crisis, and it is not clear that recent reforms have succeeded at closing the gap or limiting the safety net.”
“As a result, I believe there is a substantial risk that much future financial innovation will be directed at by-passing regulations and exploiting the safety net, rather than improving people’s wellbeing,” he added.
In the past, Lacker said the Fed and other regulators pursued a policy of “constructive ambiguity” as to whether financial firms would receive government aid in a crisis, but far from discouraging firms from taking undue risks, he said this practice “did exactly the opposite.”
He said “the ultimate result of constructive ambiguity was that the implicit safety net grew to include much of the so-called ‘shadow banking’ system,” including such things as money market funds and the “repo” market, which were major players in the unfolding of the crisis.
“If we learn one thing about the financial crisis, it should be that we must establish a credible commitment regarding which assets will benefit from the government safety net and which do not; otherwise the boundaries of the safety net will continually expand,” Lacker said.
“Establishing such credibility is going to be a challenge,” he went on. “It may require policymakers to let an institution fail even if creditors believe that it is implicitly guaranteed.”
“Doing so, to be sure, could cause some short-run disruptions to the financial sector as investor expectations revise their expectations about future intervention,” he said. “But in the long run, establishing credibility about which firms are going to receive protection and which are not will be key to avoiding the type of financial instability that we observed in 2008.”
While repo financing is very useful, it “exposes the borrower to tremendous risks if lenders refuse to roll-over their repo positions and the borrower has a hard time selling their assets,” he said. “This was the essence of the situation facing
“Without government support, the fear was that repo lenders also would pull back from other large investment banks out of a belief that they, too, were now less likely to receive government support,” he said. “Intervention stabilized markets by implying a commitment to intervene to prevent other investment banks from defaulting.”
“As with money funds, the repo market represents a financial innovation that escaped the regulatory burden imposed on traditional bank deposits,” he added. “It is important to recognize, however, that the implicit safety net tilts the playing field toward such inherently fragile arrangements.”
Lacker also took aim at the government-sponsored housing enterprises Fannie Mae and Freddie Mac, which he said “fueled the demand for securities backed by risky subprime mortgages.”
“These institutions were widely viewed by market participants as likely to benefit from government support in the event of financial distress,” he said. “The implied backstop led them, and their creditors, to underweight the risk of a broad nationwide downturn in housing markets, since that would be most likely to elicit official support to protect creditors.”
“Their biased risk preferences had the effect of distorting the incentives of a broad range of other participants in the mortgage distribution chain, from credit rating agencies to securitizers to originators to loan brokers,” he continued. “The resulting oversupply of subprime mortgage lending increased the demand for housing, which drove up home prices in regions like
“The resulting price surge made subprime lending look profitably for a time, because troubled borrowers could refinance using the rising equity in their own home,” he went on. “When demand expansion reached natural limits, price appreciation slowed and then ceased, raising the cost of home ownership and increasing defaults among overextended borrowers.”
Lacker said Thursday Fannie and Freddie guaranteed “so many loans that became troubled” because they were “widely perceived, correctly as it turned out, as being inside the safety net. As a result, they had much less incentive to provide sufficient scrutiny when evaluating many of the loans they guaranteed or securities they purchased.”
“Others have argued that affordable housing mandates also encouraged Fannie and Freddie to acquire large amounts of securities backed by poorly-underwritten mortgage loans,” he said. “Those mandates, I would argue, were a by-product of their perceived status as government supported.”
Lacker noted that “a consensus has emerged that Fannie and Freddie need to be wound down in some fashion.”
“One way to do this would be to shut them down immediately,” he said. “While this has some appeal, I don’t think it is politically feasible, or economically desirable. Such an approach would require overly rapid adjustments in housing finance arrangements, as the housing market is still coping with the aftermath of the bust.”
But he said it is “vital” that Fannie and Freddie be “wound down” in some way because “through their various activities, all backed by implicit government support, Fannie and Freddie introduced distortions into the housing market and put the taxpayer on the hook for billions of dollars.”
“More fundamentally, though, we ought to rethink whether the government should be in the business of subsidizing homeownership at all,” he said.
Speaking more generally, Lacker said the provision of a safety net must be matched by prudential regulation.
“When there are gaps between the two, financial institutions have incentives to by-pass regulation and structure their funding in ways that exploit safety net protection,” he said.
“This diagnosis implies that the first reform priority should be establishing clear and credible boundaries around the federal financial safety net in a way that conforms the extent of the safety net to the extent of prudential regulation,” he said. “My broad sense is that we would be better off if we were to significantly scale back the boundaries of the government-managed portion of the financial sector to include fewer institutions and their respective liabilities.”
Lacker reiterated that “establishing credible safety net boundaries will likely require that policymakers permit the failure of an institution that was previously believed to be too big to fail.”
“This could involve serious short-term disruptions — in fact, it may be that the more costly the disruption the greater the enhancement to safety net credibility,” he conceded. “But the long-term benefits would be quite large.”