Fed presidents in conflict over 'too-big-to-fail'

Regional Fed presidents and regulators today clashed over the efficacy of the Dodd-Frank Act and how to eliminate government support for large and complex financial institutions, in a hearing before the House of Representatives Committee on Financial Services.

One of the key provisions in the Act is the creation of the Orderly Liquidation Authority (OLA), which allows the Federal Deposit Insurance Corporation (FDIC) to act as a receiver and conduct the liquidation and wind-up of a financial institution.

The presidents of the Federal Reserve banks of Richmond and Dallas, Jeffrey Lacker and Richard Fisher, both argued that the OLA failed to remove the implicit government support for large and systemically important financial institutions.

Dodd-Frank gives the FDIC the discretion to determine how much to pay creditors of failed institutions as they wind them up. Lacker said discretion "traps policy-makers in a crisis", as it creates the expectation that it will be used in the favour of creditors, which in turn makes policy-makers "feel compelled" to do so. Consequently, they end up providing more funds than they would want to.

Fisher went further, insisting the OLA would create "nationalised financial institutions" by providing financing to the "artificially-kept-alive" subsidiaries of failed companies for five years or more.

"To us, this looks, sounds, and tastes like a taxpayer bailout, just hidden behind different language. If it waddles like a duck and quacks like a duck, it's a duck," he said.

Thomas Hoenig, a director of the Federal Deposit Insurance Corporation (FDIC), agreed that Dodd-Frank – and the OLA – does nothing to change the safety net subsidy and "continues to encourage" institutions to take one excessive risk.

Sheila Bair – the FDIC chair between 2006 and 2011 – "strongly disagreed" with the other panellists, insisting Dodd-Frank has "abolished" both the implicit and explicit subsidies.

Under the arrangements of the OLA, Bair said, shareholders and creditors "would absorb losses associated with failure" while allowing some of the claims to be converted to equity to recapitalise the new enterprise created in the place of the failed institution.

Lacker said he put more stock in the "living wills" – the resolution plans financial institutions must create detailing how they will be resolved without government assistance should they fail.

"Resolution planning will require a great deal of hard work. But I see no other way to ensure that policy-makers have confidence in unassisted bankruptcy and that investors are convinced unassisted bankruptcy is the norm," he said.

Fisher was less convinced. The Dallas Fed president said the plans were "likely to prove futile" in helping to "navigate a real-time systemic failure". He argued the ability of large institutions to move assets and liabilities across subsidiaries and off balance sheet rendered the plans ineffective.

By way of an alternative, Fisher reiterated his support for "rolling back" the federal safety net altogether to the point where it only covers traditional commercial bank deposit and lending intermediation, and payment system functions.

"Knowing where the federal government guarantees begin and end would properly realign incentives and reinvigorate a degree of creditor discipline that has been dormant at large, complex financial institutions for far too long," he said.

Hoenig also lent his support to the idea of the safety net being "narrowed and confined" to commercial banking activities, "as intended when it was implemented with the Federal Reserve Act and the Banking Act of 1933".