WASHINGTON — The Federal Reserve's ability to provide emergency lending to institutions in the event of a crisis must be eliminated, a top central bank official said Tuesday.

Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, said creditors are relying on such powers to save large financial institutions, perpetuating the existence of "too big to fail." He said Congress must take away the Fed's emergency powers, already curbed five years ago in the Dodd-Frank Act, in order to ensure the private market no longer expects bailouts.

"The long-term solution is … to restore market discipline so that financial firms and their creditors have an incentive to avoid fragile funding arrangements," Lacker said. "Credible commitment to orderly unassisted resolutions thus may require eliminating the government's ability to provide ad hoc rescues. This would mean repealing the Federal Reserve's remaining emergency lending powers and further restraining the Fed's ability to lend to failing institutions."

Lacker's call to rescind the Fed's emergency lending powers comes as Sen. Elizabeth Warren, D-Mass. and Louisiana Republican Sen. David Vitter co-authored legislation that would curb the Fed's emergency lending powers in a similar way to what Lacker described. Many observers, including former Fed Chairman Ben Bernanke, called the move too risky because it would leave the government helpless to prevent a collapse of the financial system if a large institution became distressed.

In the wake of the financial crisis, Dodd-Frank significantly cut back the Fed's previous emergency abilities, but allowed it and the FDIC to provide broad-based support to the industry in the event of a crisis. Some argue that will give the central bank leeway to provide more bailouts in the future.

Speaking at the Louisiana State University Graduate School of Banking in Baton Rouge, Lacker also outlined how a century's worth of regulatory efforts to distance banks and other financial firms from the negative effects of finance — runs, consolidation, deflation, etc. — have morphed into a de facto policy of government guarantee for the largest institutions.

That implicit backing, combined with the explicit backing of deposits by the Federal Deposit Insurance Corp., have led to a situation where an estimated $26 trillion in assets — 60% of the financial sector's liabilities — are in some way underwritten by the U.S. government, according to a Richmond Fed analysis called the "Bailout Barometer".

"Those decisions have distorted the incentives of financial market participants to monitor and control risk and arguably have made our financial system less stable," Lacker said. "Perceived guarantees thus encourage fragility, which induces interventions, which encourages further fragility."

Lacker said that regulators should place greater emphasis on getting banks to develop credible "living wills", or outlines by institutions of how they would be taken apart via the traditional bankruptcy process. The largest banks are required to have living wills by Dodd-Frank , and the FDIC and Fed must certify that the plans are "credible."

The FDIC last year deemed many of the bank living will submissions that it has received "not credible", but the Fed did not follow suit, drawing criticism from many Wall Street hawks, including Sen. Elizabeth Warren, D-Mass. The regulators are due to receive a tranche of new living will submissions in early July.

"Without resolution plans that are credible, I don't think the Fed or the Treasury or the FDIC would be able to credibly pledge to not rescue uninsured creditors," Lacker told American Banker in an interview ahead of the speech. "Once credible resolution plans are in place, then we'll be able to do so."

Lacker went on to say that once credible living wills are in place, the FDIC's additional powers granted under Dodd-Frank, to use orderly liquidation authority to seize and unwind a megabank, must also be wound down. If the FDIC maintains its OLA powers, private creditors will continue to expect a bailout, he said.

"[Orderly liquidation authority] is quite clearly a mechanism by which the uninsured creditors of uninsured subsidiaries of these large firms will be able to realize returns that they might not have realized otherwise," Lacker told American Banker.

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