Fed's Lacker says must let ailing big firms fail

By Pedro Nicolaci da Costa

ROANOKE, Virginia (Reuters) - Large financial firms should be allowed to fail or they will continue to take excess risks that lead to crises, Richmond Federal Reserve President Jeffrey Lacker said on Thursday.

Lacker said a very proactive response to the financial crisis, while stabilizing the situation in the short-term, has simply expanded the government's implicit safety net to nearly two-thirds of the financial system.

That raises the chances that such companies will continue to have unfair advantages and not adequately prepare for possible losses on their investments because they expect the government to step in when troubles arise.

"It is not clear that recent reforms have succeeded at closing the gap or limiting the safety net," Lacker told students at an event sponsored by Ferrum College.

Fed Chairman Ben Bernanke and other top regulators have argued that the Dodd-Frank financial reform law have largely solved the problem of banks that are considered too big to fail by giving the authorities the ability to wind down those firms.

A council of regulators that includes the Fed, the Securities and Exchange Commission and others is soon expected to designate a number of firms as explicitly too large to be allowed to go fail -- and impose tougher regulatory requirements on them.

But Lacker, along with regional Fed presidents Thomas Hoenig of Kansas and Richard Fisher of Dallas, did not suggest the financial regulation overhaul had done the trick.

Instead, it actually may have reinforced the impression in the markets that certain Wall Street firms will always get special treatment.

"The precedents set by intervention during this most recent crisis led to a significant increase in the scope of the safety net," Lacker said.

He said that to reestablish a credible threat of failure for megabanks and other large financial firms would require actually allowing one to go down, even when investors expect it to be bailed out.

"Doing so, to be sure, could cause some short-term disruptions to the financial sector," he said. But in the long-run, such steps will be "key to avoiding the type of financial instability we observed in 2008."

On the issue of housing finance reform, Lacker said the government will eventually have to wind down Fannie Mae and Freddie Mac, though it could not likely do so in the near-term.

He added that the government should rethink whether it should be in the business of subsidizing home ownership at all.