Richmond Fed’s Lacker says central bank should resist crisis lending

Richmond Federal Reserve Bank President Jeffrey Lacker argues in a new essay that the Fed should break its cycle of lending to financial institutions in a crisis to curb risky behavior in the future and prevent more bailouts.

In the wake of the 2008 financial crisis, some observers have argued that “financial stability” should become a core mission of the Fed. But Lacker and co-author Renee Haltom say the Fed should stick to the central bank’s core mission of managing short-term interest rates to maintain low and stable inflation.

“A broad and ill-defined financial stability mandate for the Fed would contribute to the cycle of crisis and intervention,” the authors write in an essay accompanying the Richmond Fed’s 2013 annual report, released Wednesday.

The Richmond Fed’s territory covers the Carolinas, and its examiners regulate Charlotte-based Bank of America.

During the crisis, the Fed provided financing as part of bailouts for failing financial firms Bear Stearns and AIG and helped other creditors by using emergency lending to bolster asset prices, write Lacker and Haltom, the editorial content manager in the Richmond Fed’s research department. But a “well-functioning financial system must allow firms to fail, even if they are large and interconnected,” they contend.

Since becoming Richmond Fed president in 2004, Lacker has gained attention for his dissenting views. He has frequently criticized banking industry bailouts and voted against the Fed’s buying of mortgage-backed bonds as a way to stimulate the economy, citing concerns about the Fed’s ballooning balance sheet.

Top banking regulators, however, have defended their efforts to stabilize the financial system in 2008 and 2009, arguing it prevented a much bigger meltdown and further economic catastrophe.

In his new book “Stress Test: Reflections on Financial Crises,” Tim Geithner, the former Treasury secretary and New York Fed president, contrasted his aggressive efforts with Lacker’s resistance to bank rescues and his focus on containing inflation.

“I found the more hawkish obsessions with moral hazard and inflation during a credit crunch bizarre and frustrating,” Geithner wrote. “Recession seemed a more plausible threat than inflation.”

In their essay, Lacker and Haltom argue that “Living Wills” – plans submitted by large banks under the Dodd-Frank financial reform act that show how a bank can be taken apart in bankruptcy – are a promising way to scale back expectations that financial institutions will be rescued in an emergency.

“The real lesson of the Fed’s first 100 years is that the best contribution the Fed can make to financial stability is to pursue its monetary stability mandate faithfully and abstain from credit market interventions that promote moral hazard,” the authors write. The Fed celebrated its 100th anniversary on Dec. 13.