Jeff Lacker is ready to trade the rough and tumble of monetary policymaking for the angst of financial services reform.
"I do intend to focus on bank regulatory and financial issues," the president of the Federal Reserve Bank of Richmond says in an interview in his office, high above the James River. "It really is the question of our time."
That Lacker's answers differ from those held by a majority of his Federal Reserve colleagues will surprise few. He's solidified a reputation for independence by opposing the Fed's initial rate cuts back in 2007 and casting the lone "no" vote at each of the FOMC's eight meetings last year.
Lacker, 57, isn't afraid to speak his mind. In fact, he views it as his duty. And on banking policy, he's convinced the Dodd-Frank Act of 2010 handed way too much power to federal regulators.
"I worry about people taking away from the crisis the lesson that what's key is to respond with maximal force and to provide regulators with maximal discretion across the widest possible terrain," Lacker says. "Enhancing the scope for intervention and enhancing the tools just spreads the poison that boxes us in, in a crisis."
That neatly sums up the divide among policymakers that has emerged since the 2008 crisis. One camp — the one that's firmly in charge — believes the path to financial stability is paved with rules, oversight and enforcement while the other is desperately searching for ways to rebuild market discipline.
These policymakers, including FDIC Vice Chairman Tom Hoenig and Dallas Fed President Richard Fisher, are trying to shift the debate to focus on shrinking financial giants or limiting access to the federal safety net.
But Lacker, who joined the Richmond Fed in 1989 and became its president in 2004, takes another angle. He wants the government to reverse years, even decades, of rescuing any large financial company that gets into trouble. He wants to tie the government's hands so regulators have no funds to finance these bailouts. Only then, he argues, will market participants believe bailouts are over and begin to discipline financial companies themselves.
"The linchpin seems to be the credibility about what we say about who we will rescue," Lacker explains. "We deliberately fuzzed that up in the '80s and '90s with constructive ambiguity. We wanted to maintain the fiction that we would not intervene, but at the same time we tried to preserve the flexibility, the discretion to intervene.
"Well, markets see through that."
Lacker also laments that too many policymakers view any volatility in financial markets as too much.
"There is this acute incentive to avoid being blamed for turmoil that is perceived as avoidable," Lacker says of government officials. "This is the other danger going forward. One thing I fear is just that the preoccupation with financial stability has become an indiscriminate urge to limit volatility."
The best way to convince markets that the era of bailouts has ended is to let a big financial company fail, he says.
"Credibility is going to require us to take actions that will be painful to some, painful to financial markets," including "guiding a large financial institution through the bankruptcy process, unaided with government taxpayer funds."
Asked if the government could simply stand by when markets freeze up, Lacker questions the question.
"Freeze up is a loaded term. There is a lot of implicit theorizing going on when people use metaphors like pipes and ice when they talk about markets," he says. "People on the sell side in a crisis often throw around the phrase that things are frozen or clogged or jammed or dysfunctional, and it's really just people not getting the prices they want.
"As a government official I think we ought to be really shy about coming to the judgment that some market isn't doing what it ought to do, that we know better than market participants what a piece of financial paper ought to be worth."
Lacker traces the recent financial crisis to August 2007, when the Fed cut the discount rate and encouraged banks to borrow. When few did, the Fed cajoled four giants to borrow more than $2 billion in a weird attempt to make it look like going to the discount window was no big deal.
By spring 2008, the government was orchestrating Bear Stearns' sale to JPMorgan Chase, reinforcing to creditors that Washington would never let a big-name financial firm go down.
"Central to the story is what creditors expect us to do in the event of distress," Lacker says. By not letting Bear Stearns fail, "we diffused and diminished the incentive other firms had to raise capital, hunker down on liquidity and put themselves in a condition where they could have weathered the turmoil that came in the fall."
What came that fall was the nationalization of Fannie Mae and Freddie Mac followed by the shotgun marriage of Merrill Lynch to Bank of America.
But then when Lehman Brothers hit the wall, policymakers drew a line and let it fail. That set off a panic among confused market participants. The chaos forced the government to step in days later and save AIG. It then helped JPMorgan swallow Washington Mutual and Wells Fargo absorb Wachovia.
"We handled six or seven [financial institutions] in a short amount of time in very different ways without clearly articulating a broad principle behind it," Lacker says.
Dodd-Frank was an attempt to clear up some of the uncertainty. The reform law's first title calls for every systemically important financial company to detail a road map for resolution, while its second title gives the Federal Deposit Insurance Corp. more authority to take over and unwind these firms.
Lacker views the law's higher capital, liquidity and corporate governance standards as an "unalloyed good thing," but says the law still leaves the door open to bailouts. Initial funds to finance the takeover of a giant may come from the Treasury Department; that money must be paid back by other financial firms later on.
"Dodd-Frank embodies competing philosophies, competing narratives regarding the safety net," Lacker says. "Title I and Title II are very different in terms of how they are grounded.
"Title II is predicated on the notion that the market can't supply sufficient liquidity to a large financial institution that is going through resolution and bankruptcy. The government has to do it. The mechanism it provides for doing that short-circuits the incentives of creditors of holding companies the same way our bailouts have done. So it really continues the type of safety net we have with discretionary intervention to buffer, to insulate, short-term creditors from some of the inconveniencies of a failed institution's losses."
Put a bit more simply, Lacker is saying that creditors have less incentive to police a company because its losses are absorbed by others.
"Orderly liquidation authority preserves … the ability to intervene in a discretionary way after the fact," Lacker says. "When you go into an instance of financial distress without having clarified expectations, then you are facing this excruciating dilemma: you either enhance moral hazard by fulfilling expectations and rescuing creditors, or you disappoint expectations and you force a rapid and abrupt adjustment of expectations."
Lacker says it would be better to adjust expectations "over time through clear statements well in advance of any distress that your intention is not to use Title II. Your intention is to use Title I."
He adds, "It would be even better not to have Title II available to regulators."
Lacker has much higher hopes for Title I. "Title I is built on the opposite philosophy, which is to plan for an orderly bankruptcy resolution. I am persuaded that is a feasible endeavor. We can devise those plans, we can restructure the firms where necessary to make those plans credible."
The conflict between the titles compounds uncertainty in the markets, he says.
"As long as we've got both and regulators aren't saying which path they would take, you are going to have this expectation for large bank holding companies that the short-term creditors are going to get some rescue through the orderly liquidation authority mechanism."
Unlike Hoenig and Fisher, Lacker is not arguing for a breakup of the largest banks. "I'm an agnostic on that," he says. "If you want to break up the banks, fine. But how do you know how far and when to stop?"
He doesn't support reinstating the walls between commercial and investment banking either.
"Those schemes fail to limit the safety net without achieving a measure of commitment not to rescue creditors of large firms whether they are on one side of the Glass-Steagall wall or the other," he says. "It treats a symptom but it doesn't really address the fundamental problem, which is that commitment, the inability or unwillingness to commit to limiting rescues."
That's the fundamental reform Lacker keeps coming back to: breaking what he calls the "rescue-regulate-bypass" cycle where government officials rescue firms, then regulate them and then stand by while businesses find ways around the oversight.
Lacker began beating this drum before Dodd-Frank was even enacted, saying in March 2010.
"Regulatory improvements alone, as essential as they are, won't be enough. This cycle of crisis, rescue and bypass is destined to recur, and with ever more force, unless we alter what market participants believe will happen when a financial firm becomes distressed."
In the interview, he boiled it down even more.
"Government support is not the answer to financial problems."