Yesterday, Jeffrey M. Lacker, President of the Federal Reserve Bank of Richmond, delivered a speech entitled “Choices in Financial Regulation,” before the Charlotte Risk Management Association. In his speech he evaluated the regulatory measures that have been adopted to address the ongoing financial crisis and questioned whether the scope of the government’s support should be scaled back in light of Congress’ recent consideration of proposals that may significantly restructure the landscape of financial regulation in the United States. Mr. Lacker is currently a voting member of the Federal Reserve Board’s Federal Open Market Committee, and has openly criticized the Federal Reserve's exercise of its emergency lending powers and the central bank’s significant expansion of its balance sheet as a result of certain polices set in place to respond to the crisis and the extent of government support generally for the financial services industry.

In his latest speech he reviewed what he characterized as unprecedented levels of credit and credit guarantees the government and central banks have provided in response to the crisis and cautioned that prolonged market reliance “on government guarantees of private-sector financial liabilities" as a main defense against financial market disruption must result in enhanced regulation of "private risk management to offset the adverse incentive effects of that safety net.” He also noted that “meaningful market discipline requires a credible government commitment to not shield private counterparties of large financial intermediaries from credit losses.”

Mr. Lacker cautioned that government guarantees of private debt “can have profound effects on debtors' and creditors' incentives to appropriately price and manage risk exposures.” He noted in this regard that “[t]he scale and scope of the financial safety net should be matched by the scale and scope of the regulatory and supervisory regime surrounding financial institutions,” while the central role of prudential regulation should be to “constrain and prevent the excessive risk-taking that would otherwise be induced by the incentive effects of safety net support.” Mr. Lacker stated that the recent unprecedented “expansion of government support for financial institutions and markets has enlarged the safety net to well beyond the scope of the previous regulatory regime” and further cautioned that “[i]f no corrective action is taken to close that gap, the next economic expansion will likely see more excessive risk-taking and end with more firms in financial distress.”

In restructuring the financial regulatory system, Mr. Lacker questioned to what extent the government should continue to expand “regulatory constraints to catch up with an expanded safety net” or “limit the safety net and rely [up]on market incentives”? While many market participants may conclude that the present financial crisis is a direct result of a failed market-based approach, he stated that “market incentives have been seriously distorted for some time by beliefs about the financial safety net” and that “the incentive effects of the financial safety net added to the vulnerability of financial institutions and contributed significantly to the housing boom and subsequent bust.” He stressed that in improving financial market performance policymakers must clarify safety net policies by seeking “to identify and articulate clear and credible limits to our willingness to shield private creditors from loss.” Mr. Lacker also stated that effective resolution reform should impose limitations on the discretionary use of public funds. For example, he noted that while the Federal Reserve has played a prominent role in this crisis, its lending and regulatory actions have surpassed “the boundaries that previously were believed to constrain it” under Section 13(3) of the Federal Reserve Act.

In his concluding remarks, Mr. Lacker stressed that regardless of what measures are implemented to improve prudential regulation, those efforts will be undercut if policymakers “do not also seek to rein in the incentives created by expectations of limitless safety net protection in financial markets.” He noted that “[o]nly by setting credible bounds on the safety net can we expect private-sector incentives to align at all with the public interest in sound risk management."