Lacker vs. Bernanke: Too Big to Go Away


3-5-14-Jacks-Blog.pngThe Federal Reserve Board waits five years to release the minutes of its official deliberations, and I imagine that ardent Fed watchers and monetary policy wonks have been waiting eagerly for the 2008 vintage transcripts, which cover a period of time when the financial crisis was coming to a full boil and the bank’s policymakers – including former Fed Chairman Ben Bernanke – were scrambling to keep things under control.

Last week the Fed released 1,865 pages of transcripts that included eight formal and six emergency policy meetings in 2008. The bank made a lot of controversial decisions that year. It arranged a marriage between the investment bank Bear Stearns and JPMorgan Chase & Co. when the former was judged to be close to failure, then stood by and did nothing while an even larger investment bank – Lehman Brothers – slid into bankruptcy, leading to a near meltdown in the global financial market.

The central bank also put together a bailout for the troubled insurer American International Group even though it wasn’t entirely clear that it had the legal authority to do so, and worked with the Treasury Department to lay the groundwork for the Troubled Asset Relief Program, which would pump hundreds of billions of dollars into the U.S. banking system.

For all its mystic and mystery, reading through the official transcripts (I did a quick scan of the August 5, 2008 transcript) is like reading an extended report on the state of the U.S. economy because, well… that’s essentially what these Fed meetings are. Fed staffers offer their perspectives on the economy, as do presidents of the district banks and the chairman. It all sounds as exciting as listening to the livestock commodities report on my local NPR station, although the Federal Reserve’s new chair – Janet Yellen, who in 2008 was president of the Federal Reserve Bank of San Francisco – did try to lighten the mood at one meeting when she said that “An accounting joke concerning the balance sheets of many financial institutions is now making the rounds. On the left-hand side, nothing is right; on the right-hand side, nothing is left.”

Still, the transcripts do point to tension between liberal policymakers like Bernanke, who wanted to pump as much money into the economy as possible through a series of drastic interest rate cuts, and monetary hawks like Richmond Fed President Jeffrey Lacker who worried that easy money would light the bonfire of inflation. There was also a clear disagreement between Bernanke and Lacker over the chairman’s support for bailouts. Lacker was intellectually opposed to the federal government’s decades-old practice of rescuing large banks when they got into trouble during an economic downturn – known as Too Big to Fail – and he voiced his opposition during meetings in 2008.

In fact, their disagreement was significant enough that Bernanke felt it necessary to say (for the record, remember) during the August 5 meeting that “President Lacker and I have, I hope respect – I respect him, and I hope he respects me.” Lacker later responded to Bernanke that “For my part, our exchanges have in the past been predicated on nothing but the utmost respect. I expect that to continue. If I have done anything or said anything to contribute to any other impression, I regret it, and I apologize.”

Okay, so neither man was talking smack exactly. They are economists, after all. I wrote a profile of Lacker in 2004 when he became president of the Richmond Fed and found him to be polite, serious and just a little reserved. In public Bernanke comes off as exactly what he was before he became Fed chairman in 2006, a tenured economics professor at Princeton University. If these guys were to fight an old fashioned duel, they would probably swat at each other with rolled up printouts of the latest economic data.

But their disagreement over the 2008 bailouts continues, that much is clear. In January, during remarks at the Brookings Institution shortly before he left the Fed, Bernanke voiced support for the bank’s actions in 2008, as he has previously. He started out by comparing the political pressure the Fed faces today with the pressure it faced in the 1930s. “If you think about the 1930s we had exactly the same kind of reaction,” he said. “In fact it was more intense. And of course [President] Roosevelt, what he argued was that the strong actions he was taking were about saving capitalism essentially.”

“The Fed was created to address financial panics and its independence and its ability to act quickly is a key feature of that the Fed is about. And if we had not done that and if the financial system had imploded and the economy had plunged into even a deeper depression, I think the populist reaction would have been pretty bad as well. So we were kind of stuck one way or the other.

“So we did the right thing, I hope – we tried to do the right thing. And there certainly has been push back,” he concluded.

And one of those skeptics who continue to push back is Lacker, who argued his position on bailouts in a February 11 speech at the Stanford University’s Institute for Economic Policy Research. After laying out all of his reasons for why the federal government shouldn’t be in the business of funding bailouts, and reviewing the steps that have been taken since the financial crisis to end Too Big to Fail – including various provisions in the Dodd-Frank Act, Lacker went one step further. Essentially, he said, the financial markets and bankers themselves will never believe that Too Big to Fail has been unalterably rescinded so long as the Fed retains its discretionary authority to intervene during a crisis.

Lacker’s solution: Repeal the Fed’s emergency lending powers so that it can’t rescue another failing bank ever. The very thing which Bernanke values so highly – The Fed’s independence and its ability to act quickly – is the very thing that Lacker would take away. Bernanke would probably say that the situation in 2008 was so dire that the Fed simply had to intervene. Lacker would probably counter that the Fed’s intervention in 2008 merely convinced the skeptics that when the next crisis occurs, the Fed will once again resort to bailouts. Their differences seem irreconcilable to me.

We know how history turned out in this affair. The Fed gradually defused the crisis and the U.S. economy fell into the Great Recession rather than another depression. Still, it is interesting to ponder this question: If the situation had been reversed and Lacker was Fed chair during the crisis instead of Bernanke, how would have things turned out then? A Fed chair has to be very confident about his or her beliefs when staring into an economic abyss because that’s when academic arguments become very real.

This article originally appeared on The Bank Spot and was reprinted with permission.

Should Big Banks Be Broken Up?


Many blame the largest banks for our most recent banking crisis, which leads to the question. Should “too big to fail” become “too big to exist?”

While the top five banks have assets worth more than 50 percent of the nation’s gross domestic product, it is clear that the safety and soundness of these institutions is essential for a healthy economy. Several high-profile figures have suggested that the big banks should be dismantled to ensure the health of the U.S. economy, including Federal Deposit Insurance Corp. board member Thomas Hoenig and Citigroup’s former chairman Sandy Weill. So Bank Director decided to poll bank attorneys to find out what they think.

Do you think the five largest banks in the United States should be broken up to lessen their systemic risk to the economy?

Guynn_Randall.jpgI don’t think anyone has made a persuasive case that breaking up the banks will reduce systemic risk. Breaking them up could actually increase systemic risk. For example, take a bank with $1 trillion in assets. Suppose it were broken up into 10 banks of $100 billion each. If the 10 smaller banks continue to engage in the same activities—e.g., taking deposits and making loans—all 10 would be just as likely to fail simultaneously and cause just as much systemic risk. Moreover, if they are less efficient risk managers, they may be more likely to fail. We will also lose the benefits of having banks with balance sheets and global footprints that match those of their customers.

—Randall Guynn, Davis Polk

Robert-Monroe.jpgYes, unless the U.S. wants to move towards the European model of banking containing a very small number of banks.  We have seen in the current banking crisis the near economic collapse of our financial systems and our economy resulting from the near failure of two to three of our largest banks.  We need to spread the risk to our economy to a larger base of banks rather than fewer

—Bob Monroe, Stinson Morrison Hecker LLP

G-Rozansky.jpgEconomic crises (e.g., United States 2007-2009 and East Asia in the ‘90s) have generally originated from common exposures to risks (such as a fall in housing prices or a currency depreciation), rather than from the failure of a large bank bringing down others. Moreover, initiatives underway, including those to improve internal risk management processes and impose greater market discipline on large institutions, show promise as a means to reduce systemic risks. In light of the foregoing—and considering the unknown consequences of a forced break-up on the functioning of the financial system, the valuable services only being provided by the largest institutions, and the broad legal authority U.S. regulators already have to force a downsizing on a case-by-case basis—sound policy considerations underpin a more modest approach to “too big to fail.”

—Gregg Rozansky, Shearman & Sterling LLP

Horn_Charles.jpgNo.  Simply breaking up a bank based on size alone is a blunderbuss approach to systemic regulation, which may not achieve its intended results and may do unnecessary harm to the banks involved. Systemic regulation should be based on a reasoned analysis of actual systemic risk presented by individual financial institutions based on their individual structures, activities and risk profiles. Similarly, the decision to break up a large financial institution should be based only on the same type of analysis, and only if the financial institution poses a plain risk to the financial system, and there are not reasonable assurances that the institution can be adequately managed or regulated. Financial regulators, however, should have the authority to require risk-reduction downsizing or divestments of business lines and activities under appropriate circumstances, subject to clear standards and adequate due process protections.

—Charles Horn, Morrison Foerster