May 11, 2009 / 1:49 AM / in 10 years

Fed's Lacker: Government safety net encouraged financial risk

WASHINGTON/BEIJING (Reuters) - A Federal Reserve policy maker called on Monday for U.S. government protection of the financial industry to be rolled back because it had encouraged excessive risk taking at the heart of the current crisis.

The sign for a foreclosed house for sale sits at the property in Denver, March 4, 2009. REUTERS/Rick Wilking

“The financial safety net, especially those parts that were more implicit and perceived than explicit and written into the laws, played a significant role in the accumulation of risks that ultimately led to the turmoil we are still experiencing,” said Richmond Federal Reserve President Jeffrey Lacker.

“While deployment of the financial safety net is often viewed as an essential response to the financial crisis, I believe we need to give serious thought to the extent to which the safety net was actually a significant cause of the crisis,” he said in remarks prepared for delivery to a banking conference in Beijing.

A text of his speech was made available to media in Washington ahead of delivery.

The U.S. government last year rescued investment bank Bear Stearns and insurer American International Group (AIG.N), insisting big banks take taxpayer infusions of capital and assured investors that no systemically important firm would be allowed to fail.

Last week, it completed an exhaustive stress test of its largest 19 banks to restore public confidence in their health.

It told 10 of them to raise fresh capital to ensure they could ride out an even more severe recession than currently expected, and said that if they failed to find the money from private sources, it would invest taxpayer money to make up the shortfall, and take a corresponding public stake.

Lacker, a voting member of the Fed’s policy-setting committee this year, said the reaction of financial markets to the test results suggested they regarded them as a reliable indicator of the relative health of the U.S. banks.

“The confidence it has given that institutions will in short order escape the need for government support has done more to facilitate the process of private equity recapitalization than the other programs,” Lacker said in response to questions at the forum.

He was referring to TARP, or the Troubled Asset Relief Program, a $700 billion U.S. government fund set up to support banks.

Lacker has been an outspoken critic of the government bailouts to shore up U.S. banks and the implicit backing of firms that are deemed ‘too-big-to-fail.’

“The existence of our financial safety net actually can amplify financial instability,” he said in his speech.

“A discretionary safety net in particular, creates incentives for “too-big-to-fail” institutions to pay little attention to and underprice some of the biggest risks we face,” he said.

Such overt optimism led to massive bets on the U.S. housing market as home prices soared, then to savage losses, including on assets that banks moved off their balance sheets via securitization.

Banks provided back-stop liquidity to these so-called special purpose vehicles, which Lacker said took deliberate advantage of the public safety net.

“Banks’ provision of backstop liquidity services is a way they can profit from their comparative advantage in accessing government funds in times of financial market stress,” he said.

The Fed has said on numerous occasions during the crisis that it needs new powers to wind down systemically important financial firms as a remedy for the ‘too-big-to-fail” problem.

Lacker said such powers would be welcome, but urged that the use of public money to bail out creditors is closely controlled.

“I would prefer a mechanism that puts credible constraints on discretionary extensions of the safety net,” he said.

Additional reporting by Simon Rabinovitch in Beijing

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