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A Conversation with Jeffrey M. Lacker

Speaker: Jeffrey M. Lacker, President, Federal Reserve Bank of Richmond
Presider: Christine Harper, Chief Financial Correspondent, Bloomberg News
May 9, 2013
Council on Foreign Relations

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CHRISTINE HARPER: For those of you who don't know me, my name is Christine Harper. I'm the chief financial correspondent of Bloomberg News here in New York, writing about financial institutions and banks. So I'm pleased to be here today.

This meeting today is part of the Council on Foreign Relations Peter McColough Series on International Economics. And we are delighted to have Dr. Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond, to speak to us this morning.

So just a brief introduction before he gets up. Dr. Lacker has been president of the Richmond Fed since August of 2004, and he's served as a voting member of the Federal Open Market Committee in 2006, 2009 and last year. In addition to his work at the Richmond Fed, which he joined in 1989, Dr. Lacker has taught economics at Purdue University's Krannert School of Management, the College of William and Mary, and he has worked as visiting scholar at the Swiss National Bank.

Dr. Lacker has been a critic of the Federal Reserve's program of quantitative easing, warning just last week about the risks associated with the exit process. Today he's going to share with us his thoughts on ways that regulators can end the perception that some financial institutions are still too big to fail.

So please welcome Dr. Lacker. (Applause.)

JEFFREY LACKER: Thank you very much, Christine. It's delightful to be back in New York. I grew up just over the river, Ridgewood, New Jersey, and -- son's here, had dinner with my son last night and was treated to just an exceptional flight in over Lower Manhattan last night. So pleasure to be here. See some people I know in the crowd.

So what I -- as Christine said, what I want to talk about is this problem of "too big to fail." This is something that got -- garnered a lot of attention, of course, after the crisis. There were a wide range of reform proposals for dealing with this problem that emerged right after the crisis. Many of them were considered in the debate that led up to the Dodd-Frank financial reform legislation. Some found their way into the act, but that hasn't put an end to the debate. In fact, an array of proposals have garnered attention just recently, in the last couple of months, ranging from breaking up the largest banks to dramatically increasing capital requirements on those banks.

So despite this, there's widespread agreement we need to end "too big to fail" -- from my point of view, represents just a fundamentally flawed relationship between the financial sector and the government in our country and a lot of other Western democracies, and I think it's just vital that we do something about it.

What I'm going to describe today is what I view as quite essential to ending "too big to fail." And it's gotten less attention in the public discussion of "too big to fail" than I think it deserves. But before I begin, I have to emphasize, in case Christine -- introduction didn't make it clear, that I speak for myself and not necessarily the Federal Reserve System.

Broadly stated, let's be clear about what "too big to fail" means. It's two interlocking, mutually reinforcing conditions. First, creditors of some large financial institutions feel protected by an implicit government guarantee of support should the institution become financially troubled. And second, policymakers often feel compelled to provide that support to those financial firms to insulate creditors from losses.

So I think it's important to see how these are mutually reinforcing. Instances of intervention obviously reinforce creditors' expectations of support, and they encourage those creditors to -- encourage those firms to rely on financing via fairly liquid funding sources. Reliance on liquid funding sources by those firms makes them more fragile, makes them more vulnerable and makes their appeal for support more likely.

Now, the fact that creditors expect support in a crisis is in turn what forces policymakers to intervene, because disappointing those expectations by withholding support threatens to provoke a sudden and very turbulent adjustment of expectations on the part of those creditors and other creditors about support for other similarly situated firms.

So to be concrete here, in Bear Stearns, the major fear was that if support wasn't provided that creditors would pull away not only from Bear but for other -- from other financial firms. So it was the expectation, the confidence in government support, that the government support actually was forced to be forthcoming to support. So those perceived guarantees encourage fragility. The fragility encourages risk. The risk encourages -- induces intervention, and it's just a cycle that encourages further problems.

And the end result is seriously distorted incentives and taxpayer-funded subsidies and rescues that I think a lot of Americans view as deeply unfair. And I think it's a fair assessment.

So to end "too big to fail," we need to bring about two mutually reinforcing conditions. The first is that creditors do not expect government support in the event of financial distress, and the second is that policymakers allow financial firms to fail without government support. Those would be mutually reinforcing. The fact that we don't support financial institutions would encourage creditors not to expect it. And the fact that if -- the fact that creditors don't expect it would reduce the likelihood of policymakers being put in a box and forced to intervene just because people expect them to intervene. If we can achieve that situation and make it credible to market participants, we can improve private sector incentives. We can improve their incentives to avoid fragile financing relationships and arrangements, limit their risk-taking and reduce the pressure for government intervention.

Now, allowing a financial firm to fail without government support does not mean that the operations and activities of the failing firm grind to an abrupt halt. Outside the financial sector, most firms, even relatively large ones, that fail fail by filing for bankruptcy. This initiates a court-supervised procedure to either restructure obligations or continue operations and liquidate distribute -- or to liquidate and distribute assets. If it proves more valuable to the creditors to continue the firms operations as a going concern than to liquidate, bankruptcy provides a court-supervised mechanism for having that go forward. Indeed, several large financial -- I'm sorry, several large airline companies have gone through bankruptcy reorganization while continuing regular flight operations. I think our goal should be for the bankruptcy of a large financial firm to be as much of a nonevent as the bankruptcy of a large airlines.

So a key provision of Dodd-Frank -- it's in Title I -- requires bank holding companies larger than 50 billion (dollars) in assets as well as certain nonbank financial companies to draw up detailed plans for their orderly resolution and bankruptcy without government assistance and to submit those plans to regulators. I think these resolution plans -- the popular name for them is "living wills" -- I think these represent the most promising path to ending "too big to fail," and they deserve our attention, support and resources. Indeed, I think that without this, without robust and credible resolution plans, I think other financial reform strategies are going to be incomplete and likely to fall short.

So most recent proposals to address the "too big to fail" problem would make structural changes to financial firms, imposing quantitative limits on their size, for example, or prohibiting certain risky capital market activity, so going back to Glass-Steagall and separating institutions based on their activities.

In my view, it makes perfect sense to constrain the scale and scope of financial firms in a way that ensures that they can be resolved in an orderly manner without government protection for creditors. But how would you know you've chosen the right size limits? Is size alone the issue? And if so, how small would you make them? If activities are the problems, which ones make them hard to resolve? And how would you know you haven't gone too far and sacrificed valuable efficiencies, scale economies that might derive from the current organizational structure of large financial firms?

The only approach I can envision to answering those questions is resolution planning. That is the hard work of mapping out, in detail, just what problems the unassisted bankruptcy of a large financial firm as it's currently structured might encounter. Such maps would provide an objective basis for judgments about how the structure or activities of firms need to be altered in order to give policymakers the confidence that they can choose unassisted bankruptcy in the event of distress, but without going so far as to eliminate unnecessarily efficiencies associated with scale and scope economies.

So the Dodd-Frank Act, as I said, requires bank holding companies larger than 50 billion (dollars) in assets to submit annually plans of this sort to the Federal Reserve and the FDIC. A final rule was issued in October 2011. A plan or living will is a description of a firm's strategy for rapid and orderly liquidation -- or resolution, rather -- under U.S. bankruptcy code in the event of financial distress. It consists of a detailed description of the firm's organizational structure, legal entities but also how business lines are organized, key management information systems, what their critical operations, what operations are critical to their -- to their ongoing operations, and a mapping of relationships between the kind of core business lines and the legal entities that are what are relevant in bankruptcy.

The heart of the plan is a -- is a specification of the actions a firm would take to facilitate orderly and rapid resolution and prevent adverse effects of failure, including their strategy for maintaining operations and for funding their material entities, the important things they have going on. So an important provision is that the plans may not rely on extraordinary support from the U.S. government.

The Federal Reserve and the FDIC can jointly determine that a plan is not credible and would not facilitate an orderly resolution under the bankruptcy code. In that case, the firm's required to submit a revised plan to address the deficiencies. The resubmission could include plans to change the business operations, the current business operations of the firm, to change the current corporate structure of the firm in order to eliminate those deficiencies.

If the Fed and the FDIC jointly determine that the revised plan does not remedy identified deficiencies, they can require higher capital, higher leverage -- you know, lower leverage ratio, higher liquidity requirements, or they restrict growth, they can restrict the activities, or they can restrict the operations of the firm. So we have the power to require changes in the structure and operations of a firm in order to make them resolvable in bankruptcy without government assistance.

Regulators last year required the first round of submissions for the largest U.S. firms and for foreign-based companies operating in the U.S. These plans reflect considerable effort. A lot of time and energy went into them. The process of developing these plans was very informative, both for firms and for regulators. It deepens -- in some cases deepened firms' understanding of their own legal entity structure, in many cases uncovering little legal subsidiaries they didn't know existed. It shone -- it shined a spotlight on the interconnectedness of their operations. And it exposed some of the vulnerabilities that would be relevant to a bankruptcy filing.

So the first round of submissions is not yet indicative, I think, of a mature, robust set of plans. And this living wills program is going to involve more hard work and more detailed analysis before we can declare that we have plans that we have confidence in for financial firms. But I don't see any other way to reliably identify exactly what changes are needed in the structure and operations of financial firms to end "too big to fail." I don't see any other way to achieve a situation in which policymakers consistently prefer unassisted bankruptcy to the incentive-corroding kind of intervention that we saw during the crisis and to thereby convince investors that unassisted bankruptcy is the norm in our country.

So I think it's essential -- just in closing, I really think it's essential that we end "too big to fail." It's a problem that's been metastasizing for several decades, since the early 1970s at least. The problem is the ambiguous commitments of implicit government backstops for huge chunks of the financial sector. Richmond Fed economists have estimated that in 1999, about 45 percent of the financial sector's liabilities were backed either explicitly or implicitly by government backstops, implied government backstops. And that's a conservative estimate based on actual actions, law, like deposit insurance, actual actions or statements of intent on the part of policymakers. In 2011, as a result of the precedent set during the crisis, that number expanded to 57 percent. So we're running a financial seven -- sector, 57 percent of which, by our estimates, benefits from implicit or explicit government guarantees, and I'd submit that's not an ideal situation. So to end it, we're going to have to do some hard work. And this is -- this is the work that I think is underway that shows the most promise to getting us where we need to go.

Thank you very much. (Applause.)

HARPER: (Off mic.)

LACKER: Should we go sit down now?

HARPER: OK. All right. Well, so I'm just going to ask one or two questions and then open it up because I know members will be eager to ask their own questions. So I guess to begin with, the biggest criticism I hear sometimes of this -- the living will process or the bankruptcy idea for large global financial institutions is that that sounds very good in theory. You create a plan. But at the time the crisis happens, things could have changed, circumstances; you don't know what you don't know. That was the fear with, I would say, Bear. There were a lot of uncertainties. Lehman exposed things that people didn't know, both regulators and the -- and the executives involved. How do you address that issue that when people say, nobody's going to take this plan off a shelf in the middle of a crisis and figure out how to do things; they're just going to do what has to be done?

LACKER: Well, you'd be hopelessly optimistic to foresee that you can eliminate all possible sources of uncertainty in a situation where a large financial firm is in trouble and you're thinking about taking them down. But what the living wills process is is an organized, methodical way of tracking down all those sources of uncertainty, and a lot of them are perfectly foreseeable.

So for example, you know, international subsidiaries is -- so you have a branch operation overseas. You know, is that regulator going to let you get your money back or not? Well, that's a source of uncertainty that affected how Lehman was resolved, for example. One approach to resolving that -- you can -- you can address that ahead of time, for example, with subsidiarization, having separate legal entities for different legal jurisdictions with their own capital, with their own liquidity and with agreements between affiliates so that you have some legal certainty about just what the plan is for what they can or cannot upstream back to the parent or across jurisdictions to another affiliate. That's just one example of the ways in which you can reduce uncertainty.

The most important thing, though, and what I think was the key driving uncertainty in the crisis, starting from Bear, was the uncertainty about what regulators would do, whether we would assist Bear or not. I think the assessment -- my sense, just from reading the historical documents and talking to what participants were involved in making the decisions, is that the large fear around Bear was that if -- that support from the Fed was expected and that if we didn't supply it, creditors would pull away not only from Bear but Morgan Stanley, Merrill Lynch and on up the food chain. So it was this fear that failing to support would cause everyone to revise their expectations about whether we were going to support anyone else.

We need to take that uncertainty off the table. That's purely an artifact of how policymakers treat things in a crisis.

HARPER: OK. And two of your colleagues at the Fed recently, Eric Rosengren at the Boston Federal Reserve and Daniel Tarullo, the Federal Reserve governor who deals with a lot of supervision issues, have raised the special concerns about broker-dealer units and the wholesale-funded markets as perhaps where a lot of the real risk lies in the financial institutions and in the markets in general and have proposed potentially higher capital requirements on broker-dealer subsidiaries or on activities that are -- that are market-funded, as opposed to funded with deposits, for instance. How do you see that as a potential solution to dealing with some of these, you know, I guess, contagion issues that exist in the financial system?

LACKER: I think broker-dealers are an issue of very special concern just because of, historically, the way they've funded themselves and because of some other sort of special aspects of their legal status. And I think they deserve special attention, especially given what we've just been through and the role they played in 2008. So I do favor increasing capital, and I've been in favor of the broad upswing in capital that we've seen. Whether we need more or not -- I think we're sorting through that as a regulatory community and, you know, as a financial community, and I certainly see great advantages in larger capital buffers.

But it's worth pointing out that, you know, we're unlikely to get to a situation where our capital buffers are so large that the probability of eating through them is driven to absolutely, positively zero, not epsilon zero, and if you -- after you eat through the capital, the fact that you had a lot of capital beforehand is cold comfort. So you need to have a plan for what happens when the capital's gone. Despite how valuable larger capital is and despite the role of capital in reducing the likelihood of getting there, you need a plan for what's going to happen if you get there.

HARPER: Well, one solution, of course, is the convertible --

LACKER: Convertible debt.

HARPER: -- debt, debt that converts into equity in those sort of circumstances. Is that an idea that you think is workable?

LACKER: So convertible debt is a -- you know, I think it's sort of a -- so it's a clever way of taking advantage of the tax subsidy for debt with an equity-like instrument. And there have been a lot of -- there's a lot -- I mean there's huge aspects of the financial system are based on trying to bridge that. You know, at the end of the day, yes, if that provides greater buffer, fine. But I don't think we should be focused -- part of the -- key feature of some proposals for implementing contingent convertible debt focus on the incentives at the holding company level.

And I think we need to think more broadly and flexibly about putting in place plans that are robust. So if you have losses in a mortgage subsidiary or in a broker-dealer in London, for example, why not set things up so that you don't force all the losses to flow up to the parent and be dealt with that way, where you just -- you know now, you can sell off that entity, have them file for bankruptcy and the rest of the firm survive.

HARPER: Well, we were talking a little bit before we came up here about Bank of America, you know, having taken on Countrywide. There has been a debate -- it's over now, I guess -- about whether they would at some point put Countrywide into bankruptcy because of the special problems they were experiencing from that unit, but they chose not to, although it seems legally that wouldn't have been necessarily that difficult for them. So can you talk about maybe some of the reputational issues that could face big companies if they try to do that to a subsidiary?

LACKER: There's no doubt it would be a hit, you know, in general. I mean, as a matter of policy, we can't comment on individual companies. Bank of America, as you know, is headquartered in my district, and so we have a direct supervisory role with the holding company.

There's no doubt that a failure of a major operating subsidiary is a black eye for an institution, something they'd like to avoid. But I think they -- you want to avoid a situation where in the crisis, in that situation, you know, they're tempted to take further risk in order to avoid taking the pain early and take actions that make the pain worse later, just to try and preserve their reputational capital.

HARPER: OK. I'm about to open it up to questions, so I hope you're thinking of them. I'm going to ask one last question.

Derivatives. With these big companies, those are obviously a particular area of risk. Just to go back to Bank of America, since it's a company you know well, in the deposit-taking part of Bank of America, there's some $42 trillion of notional value of derivatives. That's about 69 percent of the holding company's total derivatives value, according to the OCC. So a lot of the derivatives risk at these big universal banks is being put into the depository piece of it.

Does that, in your mind, create problems when you would try to go through a bankruptcy process? I mean, derivatives are often treated in a special way during a bankruptcy.

LACKER: So derivatives are exempt from the automatic stay. The automatic stay is the feature of a bankruptcy code that basically has all creditors stand still until a court-supervised process can determine who gets what. And derivatives, due to some changes in the law made in the '80s and '90s, are exempt from that, so they get to settle out, they get to net, they get to get their money back. RP lending, reverse lending, is also in the same -- repurchase agreement lending --is also in the same category.

So they have an explicit treatment in bankruptcy that reduces the extent to which those contractual arrangements are disrupted by filing, and there's provisions in Dodd-Frank that govern how the FDIC treats them. In fact, there's sort of a -- there's, like, a 24-hour standstill. There is actually a stay. They're sort of subject to the stay for 24 hours under Dodd-Frank. Derivatives -- and these are qualified financial contracts, the general class of things that are exempt from the stay -- are a real question mark, I think, analytically, for whether that treatment in bankruptcy makes sense or not. You know, I'd like to see some further thinking and research on this. Obviously, I think it's pretty clear that the exemption from the automatic stay has encouraged a lot of financing to occur via this mechanism. Whether that makes firms more or less fragile or not I think is an open question.

HARPER: Mmm hmm. And generally speaking, are you comfortable with the move of derivatives risk into depositories, or --

LACKER: Well, so the -- we have an explicit safety net for deposit-taking banks and for insured deposits.

HARPER: Which is wise.

LACKER: And I'd -- you know, I'd like to see that protected. To get that 57 percent number down, we're going to have to reduce implicit guarantees that are perceived for holding companies and the like and uninsured creditors of banks. But to narrow the risk-taking and ensure depositories would be a good thing. And I think we ought to orient or supervise (regulatory ?) activities appropriately.

HARPER: OK. Great. All right. So I know you all have questions. So please identify yourself, and keep your questions short. Let's start over on this side of the room. Wait for the microphone.

QUESTIONER: Niso Abuaf, Pace University. Isn't the need to have some type of government backstop, large or small, a logical extension of a fractional reserve banking system?

LACKER: No, I don't think so. I think that -- I think we can -- I don't think a government needs to provide it. I think private insurance arrangements could work in general. This is sort of a -- you know, just a theoretical level. I think that deposit insurance in the United States arose because of the -- you know, the desire to protect some creditors. So it's -- in essence, you should think of, you know, government backstops as distributional -- redistributional policies, you know, analogous to, you know, income support or unemployment insurance or the like, just a desire to protect creditors from the risks they would bear. And anytime you do that, you've got incentive effects. I think that, you know, banks -- you know, without the deposit insurance, without the government backstops, capital ratios were on the order of 30, 40 percent a century ago, and bank failures, you know, occurred, it was a -- but it was a workable arrangement. So that's my opinion.

HARPER: OK. In the middle right here. Please.

QUESTIONER: I'm Lucy Komisar. I'm a journalist. My question is, would the banks' resolution plans have to tell in detail how and for what they are using subsidiaries and off-balance sheet entities and tax havens, whose activities still now have been largely secret from regulators?

LACKER: So to the -- they'd be relevant to the extent that they can be resolved in bankruptcy. So we'd want to know, for the material entities, what operations they have in what jurisdictions, and, you know, to the extent that that reveals they might not otherwise have told us, that would happen. I'm not sure that gets at exactly what you're asking about, but --

QUESTIONER: Well, I was asking, for instance, Enron, you know, lot of secret stuff that people didn't know about -- (off mic) -- off-balance sheet and -- (off mic) -- in places like Grand Cayman -- (off mic) -- dozens and dozens, and they would rather the government and regulators not know about that. Are the banks going to be in that same position?

LACKER: We have visibility into everything a holding company does in the United States, so I'm confident that's not an issue for this -- in the banking sector -- I'd say in the banking sector.

HARPER: OK. Let's take a question from Jim Grant (sp).

QUESTIONER: Jim Grant (sp).

LACKER: Hi, Jim (sp).

QUESTIONER: President Lacker, you know, for much of the country's history, the stockholders of a bank were at risk for the solvency (of institution ?). They got capital call, double liability, it was called. And for most of the history of this country, broker dealers were partnerships in which the general partners were personally at risk for the debts of the firm. Have you not thought about restoring some personal liability on the parts of the managers and owners of these institutions with the theory the capitalists ought to bear the downside as well as the upside?

LACKER: That's a really fascinating question, Jim (sp). So, you know, I mean, it's just this striking feature of the suite of sort of financial capitalism over the last couple of centuries, the way contractual rate arrangements have evolved. I don't think that we got rid of double -- you know, the double liability of bank shareholders for -- so the fact that we got rid of that, the fact that that went away presumably reflected some benefit cost shifting, trade-offs shifting.

Now, the -- so the obvious thing with double liability is that you care who the other shareholders are. And with liability sort of truncated, you put in your money, and that's all the liability you have. There's an improvement in tradability. You don't -- you don't care how much wealth somebody who owns a share has. And that, to me, seems like it's likely to have -- you know, a fairly significant effect on the liquidity markets and the way the liquidity of the shares works. So we've -- I think we've made a trade-off. I think we've gotten some benefits from getting rid of double liability, and we've incurred some costs.

And whether it was adverse or not is a great question. I mean, maybe what we're seeing and what we've seen over the last, you know, half-century is -- has been the consequence of those changes, eroding it -- gradually eroding incentives, you know, that you had gradually loosening capital controls, gradually loosening regulatory controls, gradual financial deregulation, and so what came home to roost was just that incentives weren't as well-aligned as they were in the past, you know, a century ago, and that's really at the -- kind of the heart of this fundamental flaw I told you, you know, about the relationship between the financial sector and the government. So those -- that's a really deep question, and I don't know it's all answered.

HARPER: Is it something the Fed has looked into? I mean, is that a topic of conversation, or is that --

LACKER: So financial historians, I know, look into this, so -- (laughter) --

HARPER: All right, right here in the front, please.

QUESTIONER: I'm Harrison Golden (sp). Dr. Lacker, broadly speaking, very broadly speaking, there were two thrusts to "too big to fail." One of them relates to the implicit guarantee that the institutions will be preserved, but the other relates to their contagion, to the enormous impact that they have internationally on the financial system, and to the effect of their failure, their dissolution, their reorganization, the threat that they will not continue to function on the world financial system. So focusing exclusively on trying to create a system in which people don't expect that the government is going to come to the aid of these institutions doesn't address the imperative that led to the intervention in the case of AIG and other institutions, which was a reflection of the concern of the impact that its failure would have worldwide. Could you address that issue, please?

LACKER: That's a really good question, well posed. So in thinking about the risks that, you know, a central bank ought to be concerned about and that -- and that might give rise to a rationale for backstop intervention, what you identify, the sort of domino effects of one institution failing, that causing problems that impedes the operation of another institution, which has further effects, was very prominent in discussions in the '80s, '90s and onward. I think this crisis has shown that that's just not as germane as we thought.

So the -- it's been widely cited that Lehman's bankruptcy per se -- and I want to say a word about contagion in a minute and just sort of think -- sort of parse out different aspects of contagion. But the direct effect of Lehman's bankruptcy was quite -- seems quite manageable. I mean, there was one firm that went down, and arguably, there was some misrepresentation. There had been some, you know, legal problems -- legal -- some litigation about that. There was this one firm -- this one fund that went down that was arguably misrepresenting its position. So no one -- no one else failed directly as a result of Lehman.

Now, AIG -- I mentioned before, essentially distributional motivations, that the financial system -- you know, you could argue the financial system would have worked just as well after AIG one way or another, if you just look at the nuts and bolts of things.

Now, there's an extra element I've been holding aside here I want to talk about: contagion. Now, contagion was, you know, widely discussed in the '90s in the context of the Asian crisis. And here you see the same dynamic, that what the IMF did, what official institutions did in one country led investors to revise their expectations up or down about what they would do in the next country. And that seems to be the most important aspect of contagion. And I think that's the kind of contagion that policymakers had in mind with Bear, that if they didn't intervene with Bear, the contagion is that it would contaminate what other -- what creditors would view the central bank is likely to do with other firms. And I think that kind of contagion -- that's just a byproduct of ambiguity on policymakers' parts. So a brief snippet of a deep subject.

HARPER: Let me -- I just want to challenge your statement that the bankruptcy of Lehman didn't necessarily have impacts beyond the primary reserve fund, because I was covering Morgan Stanley and Goldman Sachs at the time, and I can tell you that it did seem to have an impact on the way people saw those firms, and indeed, the Fed decided to let them convert to banks, and TARP was rolled out. And so it did seem like there was a serious contagion risk there with two other firms at risk and special arrangements were made to make sure that they weren't damaged.

LACKER: Well, I think that just sort of makes my point, Christine, that -- because the -- you know, what was going on there was assuring people that we would backstop them, right? I mean, they sought holding company protection because I think it became clear that, you know, there's a dividing line between investment banks and holding companies.

So keep in mind that going into the Lehman weekend, we had handled Bear, IndyMac, Fannie and Freddie, four institution we've handled three different ways. After Lehman, that's five institutions four different ways. After AIG, it's six institutions five different ways. And when I say five different ways, five different decisions about who in the capital structure you support and who you don't support, how the support is structured, and at that point I think it was -- you know, it would have been very difficult for policymakers to articulate, you know, a clear set of rules of the game, you know, other than, we're going to backstop everything. I also think it's clear that, you know, coming out of Lehman, you know, the message of Lehman was that we were willing to support -- we may be willing to support holding companies but not investment banks, and I think that led to the desire of those two firms to convert.

So it's that -- it's that ambiguity about what policymakers are going to support and doesn't that becomes just poison in a crisis, and it forces your hands. It forces you to support more and more.

And then -- and then -- so this is something I had some direct experience with. Then a couple weeks later, we get to WaMu, and their holding company creditors bear a loss. The next day Wachovia creditors are asking them to buy back debt. And that forced our hands with -- that forced the issue with Wachovia, and a decision was made to support the holding company, and using a sort of so-called systemic risk exemption. So there, you know, we were just sort of forced to go farther just because of the ambiguity and creditors threatening to flee because they had expected support, but now it looked like they might not get it -- fateful.

HARPER: OK. Any more questions? Right here.

QUESTIONER: Empol Lazard (ph). Can we just revisit the capital question? You mentioned -- I think you can never eliminate the risk of a -- of a bankruptcy unless you had zero leverage. How much discussion is there in the Fed about whether Basel III has gone far enough in terms of increasing capital requirements based on size and complexity? And how would you actually reach a quantitatively substantive decision on how much more capital might be required to feel better about the condition of U.S. institutions?

LACKER: You know, I can be flippant and save a lot of conversation and -- very carefully -- (laughter) -- you know, it's -- (laughter) -- a real answer. So, you know, it's still -- it's still something we're sorting through. I mean, we're in this journey to reconstruct, you know, a financial regulatory world, and adjusting capital was sort of high on the -- on the list. And you know, Basel III, whether it's sufficient or not, is, you know, I think, an open question in my mind and in some other people's minds. And so I think we're just having to sort through those issues. There's playing field issues. There's measurability issues. There's, you know, issues about handling, you know, netting derivatives when you measure risk-weighted assets, for example, that I think are very germane and very -- and very real issues. And I hope we'll work towards -- you know, work towards getting those sorted out in the next couple years.

I will say that I think the (capital ?) stress tests have just been, you know, an amazing innovation. I mean, you talk to senior bank executives and you talk to CEOs, and they'll say, yes, this has been good for our company to go through capital stress tests. I mean, I won't say all of them say that, but -- (laughter) --

HARPER: Some of them definitely don't say that.

LACKER: Yeah. But I think it's been broadly one of the most positive things we've done.

HARPER: OK. Now I'm going to go to the back, since I've been calling on the front a lot.

QUESTIONER: Gerald Cohen, Ziff Brothers. It is often the case that liquidity problems can morph into solvency problems. And as the lender of last resort, as the Federal Reserve is the lender of last resort or has acted historically as the lender of last resort, how does the Fed not exacerbate the problem by adding to the implicit guarantee of being the lender of last resort to an insolvent institution?

LACKER: So I'm glad you asked about them -- I'm glad you used that phase "lender of last resort" and referred to our history.

One reason is that -- 2013 is our centennial, so I get to insert here a shameless plug for the centennial of the Fed Reserve system, founded in 1913. When we were founded, the model was the Bank of England and other European banks. For banks at that time, in the 1800s, what happened in financial panics is that people wanted to withdraw their money from banks. And what did that mean? It means converting a deposit into gold coins or paper currency, gold or silver coins or paper currency.

And in the United States, under the National Bank Act, the era from 1863 to 1913, the mechanism, the -- sort of the physical and bureaucratic mechanism for expanding the supply of paper notes was cumbersome, inflexible. It just didn't work well at all. And so you saw interest rates would go up in the fall, when you had to move crops to market. They'd go up at Christmas time because people needed more currency. It just didn't work well.

And in a panic, it became a real problem because the clearinghouse -- the clearinghouses in the large cities would sort of band together, lock down their system and not allow withdrawals outside of the clearinghouse. You couldn't get your deposit. You could transfer a deposit from one clearinghouse bank to another, but you couldn't get your money out. And they would often not honor withdrawal requests from country banks that had deposits at city banks. So the whole aim was an elastic supply of currency. That's in our preamble.

And the lender of last resort function was the mechanism for increasing the supply of currency. It wasn't about helping individual institutions that were in trouble. It was about increasing the supply of currency when the demand for currency went up, increasing liquidity so that interest rates didn't spike when people wanted more liquidity.

That's morphed over the years, and it's become a -- you know, the function, the discount window, gives us this ability to channel public resources to individual firms on terms they wouldn't be able to get in the market. So it's -- we've been -- we sort of -- the purpose has sort of morphed. And the meaning of lender of last resort has morphed, especially over the last 30 or 40 years, in a way that's at variance with the purpose of the Fed Reserve -- envisioned by the founders of the Fed Reserve, I believe.

HARPER: OK. As -- oh, right there. Can we get a mic right here.

QUESTIONER: Hi. David Malpass with Encima. I understand your point about the value of a resolution plan. Separately, Dodd-Frank gives authority, new authority for early intervention apart from the bankruptcy code. That creates its own set of uncertainties or -- how do you address that? Do you think it's a good idea to have that new intervention authority, or should the bankruptcy code be used?

LACKER: Are you referred to the Title II orderly liquidation authority?

QUESTIONER: Yes.

LACKER: Yes. I didn't -- I didn't discuss this in my remarks. Dodd-Frank does a lot of things, and it's based on various different philosophies. Title II of Dodd-Frank gives the Federal Deposit Insurance Corporation orderly liquidation authority. They're able to take financial firms into receivership at the holding company level or any other level they want, and they're charged with liquidating them. Now, that could mean selling off the business, or -- but they're charged with resolving (them ?).

Now, as part of that, they have the authority to create an orderly liquidation fund. They're entitled to go to the Treasury. The Treasury will issue debt. They will get this money from the Treasury that they can lend to the bankrupt firm, the firm we've taken into receivership. That firm can use that money to let creditors out the door. And -- now, the law requires that creditors get no more than they would get in bankruptcy, but that's, you know, kind of a speculative thing in the middle of an event like this. And, you know, if they take their money out and then they close or dissolve, it's not at all obvious you're ever going to be able to get that back in an effective way.

Essentially, this recreates -- this creates that rescue authority. And I think the FDIC's clearly indicted their willingness to use this orderly liquidation fund authority. And I think it creates the expectation -- has the danger of creating and perpetuating this expectation of support for holding-company creditors that I think is potentially corrosive and inimicable -- inimicable to -- (laughter) -- bad for financial stability.

And what I'd like to see, what I personally would favor is, over time, after a couple of years when we've gotten the living wills process to the state where we can sort of declare that, yes, robustly, broadly, we've got these plans in place, at that point we wind down Title 2 and we can scale back on -- we can sort of tie our hands as regulators and say, look, we're serious; in order to reduce any ambiguity about our willingness -- our likelihood to intervene, we're going to remove our ability, our legal ability to intervene. So we're going to restrict Federal Reserve lending, restrict FDIC bailout authority so that we can't do it in a crisis.

HARPER: Right here.

QUESTIONER: Andrew Gundlach, Arnhold and S. Bleichroeder. Jeff, how do you apply a living will, "too big to fail," to the U.S. subsidiaries of foreign banks? I think it was Jim Grant who pointed out that -- in a recent letter of Grant's Interest Rate Observer of his -- that Deutsche Bank, you know, is less capitalized -- less well capitalized than Lehman, of course their U.S. subsidiary, and also the stress tests -- you know, the Cyprus banks all passed their stress tests a year ago. So how do you use all that to achieve what you're trying to achieve with the foreign central banks?

LACKER: Yes, the foreign banking organizations with operations in the United States pose some special issues here. I think for the ones for whom all of their U.S. operations are in a separately capitalized subsidiary or intermediate holding company, I think it's straightforward We just require that. And I think, you know, ideally other, you know, jurisdictions are going to follow suit and adopt a similar approach about, you know, resolution plans for their parent company. But even if they don't, we can limit the risk in the United States of us feeling compelled to support a foreign -- you know, foreign banks, you know, if we require their operations to be in a separately capitalized subsidiary in the United States.

Now, the gap we have now is branches, and foreign banking organizations can branch here, in which case it's not a separate legal entity. And that's a -- that's a -- handling those cases is something that has to be resolved. And, you know, if it seems politically, you know, doubtful that we'd support a foreign banking organization, I'd point out that the Term Auction Facility, which was our first special credit facility in December of 2007, the bulk of the funds went to foreign banks, foreign banking organizations.

QUESTIONER: Arthur Rubin with Nomura. It seems like there's two general themes that are going back and forth in the debate over regulation. There's the more transparent management of outcomes and problems that you're advocating, and along with that, raising capital. But on the other hand, it seems there's also a tendency to micromanage, to overregulate Volcker Act type of operations to say you can't do this, you can't do this, you can't do this.

Your preference is pretty clear, but from where you sit, where do you think we wind up at the end of this debate? Is there a real risk that the micromanagement, overregulation, tends to dominate the management-of-outcomes approach?

LACKER: So when you talk about micromanagement, the way I describe it is ex-ante and ex-post; so before the fact, after the fact. So a lot of attention in Dodd-Frank to constraining risk-taking ahead of time in order to prevent us getting in that circumstance. And, you know, the insight I think that's important to bear in mind is just that the actions of creditors and the incentives that various actors -- creditors, bank management -- have depends a lot of what happens in the event you get into the -- even if it's a -- even it it's lower probability, as you get closer, as losses accumulate and maybe the prospect of going under actually starts looking plausible, those incentives are very -- you know, very heavily affected by how you -- you know, what they view is likely to happen in those instances. And I think we have to pay a lot of attention to that. I view them as complementary. Yes, there is a danger of sort of overreacting, of lashing out at risk wherever it seems to be in the financial system. I think, you know, over time we'll sort that out and make corrections as need be.

HARPER: Way in the back?

QUESTIONER: Thank you. Sengeetha Ramaswamy (sp). So my question for you, Dr. Lacker, is the current stance of very easy monetary policy; how do you think that's going to lead to further distortions in our financial sector and, more broadly, our economy?

LACKER: It's a hard question. So the -- by design, low interest rates are supposed to encourage people to move out of low interest rate assets into other assets like riskier assets. And so the extent to which that's a distortion or not kind of depends on your perspective.

From a point of view of a policymaker whose trying to encourage growth, they're trying to encourage people to take risk, and so they're trying to -- now, whether we've gone too far or not, I -- you know, I really think the real question is whether there's more stimulus than we need or not. I mean, in -- you know, whether it shows up in financial -- you know, whether you call those distortions or not, at the end of the day, it's either you have too much or too little. From a central banker's point of view, I think the -- you know, the bottom line has to come down to purchasing power of money. And, you know, are we -- are we going to cause too much inflation?

So when I look back, for example, at this, you know, fierce debate about whether interest rates were too low in 2003 and (200)4, you know, I look at housing, I look at what was inflation after that. And if you look, it was 3 percent from 2004 to 2007, four straight years averaging about -- averaged about 3 percent over those four years. On that score, I think we could be criticized. Now, you can argue that these were just bad shocks and that it was just bad luck and that we -- you know, it wasn't our fault. But I think if you're going to argue interest rates were too low, you should look at inflation, not, you know, whether some particular sector expanded too rapidly.

HARPER: Right there in the middle.

QUESTIONER: Thank you. My name is Mercedes Fitchett with the Department of Defense. I wanted to focus on the human aspect of the crises. Within the U.S. military, we do red team exercises and simulations and all that. To what extent have you all undertaken similar exercises that replicate the experiences of 2007 and 2008 to get a better understanding of how the regulators should work together with each other, setting expectations and so on?

LACKER: It's a really good question. I don't know of any such sort of war-gaming type of efforts.

HARPER: The stress tests are perhaps the closest.

LACKER: So yeah, the stress tests. I mean -- but, you know, that's stressing -- that's, like, we're, you know, making them do it and not us.

So that's an interesting question. I mean, it was, you know, a wrenching experience. And it wouldn't surprise me if a lot of people are sort of averse to recreating that experience. (Laughter.) So maybe in a couple years we'll get around to it. But good suggestion. I'll take that back and ask about.

HARPER: Hany (ph).

QUESTIONER: Hany Sunder (ph), the Financial Times. I would like to go back to the question of capital. You know, from my point of view, I mean, we all want a safe financial system. But I'm spending more and more time thinking about the unintended consequences of trying to make this system safer by raising capital requirements, the effect of which is that a lot of small and medium enterprises can't get loans from the banks. And I see the so-called shadow banks or nonbanks; you know, actually, everything they do is taking advantage of all the constraints on the banks. And I wondered how concerned you are about that. Thank you.

LACKER: So let me separate it into two pieces. The first is small businesses and, you know, other borrowers having access to credit.

I think -- I think the access to credit is there, and I don't it's been a problem. And I don't see the range of capital requirement changes people are talking about as having a significant effect on the supply of credit. I -- you know, when I talk to our bankers in our -- in -- all over our region, of all sizes, you have large banks -- you know, Capital One, BB&T -- down to very small community banks, they are -- they're fighting tooth and nail for bankable credit, for credit-worthy borrowers. Credit-worthy borrowers, it's a -- you know, it's a borrowers' market out there. And they're getting -- and, you know, they're complaining about spreads being too thin, about terms being competed to too -- you know, that their competitors are being too lax. So I think the supply is out there for credit-worthy borrowers.

Now, yet -- there's a different sense of what credit-worthy means. And that makes sense. I mean, in 2005 anybody is going to be more credit-worthy than they are in 2009. You know, same balance sheet, same sales, same revenue -- identical firm, two different economic environments, you're going to be riskier. So there is some modulation of credit terms (that's occurring ?).

The broader question you ask I think is very important and something I'm very concerned about, and that's this cycle that we've been in of -- you know, there's support, there's a crackdown afterwards, there is stiffening regulations, and then there's bypass. And in that bypass, that's what creates this shadow banking operation.

So, for example, the -- coming into the crisis I think -- I think it's fair to characterize, you know, the regulation of bank holding companies as oriented around protecting insured depository institutions, the banks, from losses elsewhere in the holding company. I think that was our orientation. And I think that -- I think that orientation colored our approach to a lot of issues. So you could think of the holding -- nonbank holding company activities as kind of shadow banking. And that's where there were these, you know, CIVs and other off-balance sheet entities that arose.

And that risk ended up coming back and affecting the banks and bank holding companies. I don't think we appreciated going in the extent to which policymakers would feel compelled to intervene to support nonbank holding company obligations. And sort of by the end -- by the time we got to Wachovia, we were all in, we were supporting everything. And so I think we've reoriented our approach.

But you're right, there is -- some little mushroom of bypasses going to spring up and sprout and spread, and, you know, it's going to affect -- you know, the incentives are going to be there to get around some regulation. That's why -- that's another reason I prefer sort of getting the incentives right by working on what happens when you fail so that, you know, on both sides of the divide, they have the -- they have the incentive to manage themselves soundly. You know, the big danger with bypass is that they take risks, and if they think we're going to come rescue them wherever they take risk, well, we're just going to be chasing our tail, and we're going to support some of the shadow system; then we're going to regulate them, because we're supporting them; then they're going to go somewhere else, and it's -- and that's how that 45 percent number got to 57. You know, we were regulating the 45 percent, it sprouted somewhere else, we felt like we had to support it, and it kept going. And we'll get to -- we'll get to 95 if we don't stop.

HARPER: All right. Well, I think that might be a good place to end. We're at 9:00. Thank you very much. Let's thank Dr. Lacker for his time, and thanks for coming. (Applause.) Great.

LACKER (?): Great job.

HARPER: Thank you. That was really interesting.

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