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Fed's Lacker : Relationship Between Banks, Regulators Still Flawed

03/29/2012 | 07:11pm US/Eastern
   By Michael R. Crittenden 

The interplay between U.S. banks and government regulators remains "fundamentally flawed" despite efforts to toughen up oversight, the president of the Federal Reserve Bank of Richmond said Thursday, warning that simply relying on more rules will not forestall the next crisis.

Richmond Fed President Jeffrey Lacker, speaking before a group of lawyers in Charlotte, warned that the landmark Dodd-Frank Law overhauling financial sector oversight, as well as other changes made in the wake of the 2008 financial crisis, are not enough to prevent a future collapse.

"We should be under no illusions that the steps taken so far will provide durable and reliable protection against future instability," Lacker said in his remarks.

A voting member of the Federal Open Market Committee and a monetary hawk, Lacker avoided discussion of monetary policy or the economy generally in his remarks. Instead, he made the case that offering incentives to induce greater market discipline might be the best salve for what ails U.S. financial markets.

"Instead of placing all of our eggs in the basket of tighter regulation, we should place significantly greater reliance on the powerful decentralized forces of market discipline to constrain the risk-taking of large financial institutions," he said.

The Dodd-Frank law "leaves many important things undone," Lacker suggested, including not fully eliminating moral hazard and the specter of firms being considered "too big to fail." While he praised the law's requirement that large firms create so-called living wills to map out the steps needed to wind them down, Lacker said officials need to instill in market participants the belief that creditors of financial firms will not be backstopped by the government in times of financial stress.

Letting a large financial firm fail might be the answer, Lacker said.

"Commitment to market discipline might not be fully credible until the first instance in which authorities allow a large financial firm to fail without public assistance," Lacker said, suggesting an overhaul of the bankruptcy code with an eye to dealing with large, complex financial firms might be in order.

Additionally, he suggested lawmakers put greater restrictions on the Fed's ability to respond with special liquidity programs and extraordinary aid in times of crisis. Eliminating entirely the central bank's ability to lend to firms, which was restricted by the Dodd-Frank law, would help address the perception that the government is ready to step in during times of stress.

The key, Lacker added, is to rely on financial-market forces to police undue risks.

The more the centralized judgment of a small handful of officials, however well-informed or well-meaning, replaces the decentralized judgments of a multitude of financial market participants, the less resilient our system will become," he said. "We should strive for a financial system that is robust to large shocks and to the unavoidable errors of judgment made by individuals or single organizations."

-By Michael R. Crittenden, Dow Jones Newswires; 202-862-9273; michael.crittenden@dowjones.com

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