Erratic government responses to failures of large financial firms like AIG and Lehman Brothers have contributed to market uncertainty, Philadelphia Federal Reserve President Charles Plosser said on Friday.
With this in mind, the central bank should develop a clearer procedure for determining what institutions are so big that their downfall threatens the entire financial system, and how to wind them down in an orderly manner in times of crisis.
"Failures are an inevitable consequence of a dynamic financial system," Plosser said at a conference sponsored by New York University's Stern School of Business.
"The financial problems at Bear Stearns, AIG, and Lehman Brothers elicited different responses from government, which contributed to uncertainty. Arguably, this uncertainty in itself became a source of systemic risk."
The Fed's bailouts of these institutions, along with a string of other unprecedented measures, have helped double the amount of credit the Fed pours into the financial system.
The U.S. economy has come under severe strain in the past year, and mounting job losses have now taken the jobless rate to 8.1 percent.
The banking sector, at the heart of the turmoil, took risky decisions in part, Plosser suggested, because some institutions believed the government would ultimately come to the rescue if they went under.
"The belief that regulators will bail out creditors of financial firms creates moral hazard that leads to poor risk-taking decisions and undermines the incentives for creditors to monitor these firms," said Plosser.
"Moreover, it creates incentives for financial firms to become too large and too complex to fail in order to exploit the implicit government guarantees."
Plosser did not favor actively trying to make systemically important firms smaller, arguing that the industry was simply too large to tame.
"Imposing size limits on financial firms would sacrifice efficiencies of scale," he said.
Instead, it was important to find ways to undertake bankruptcies of non-bank institutions that would not disrupt the entire system by sending a ripple effect through the chain of lenders.
Plosser noted that the Federal Deposit Insurance Corp. or FDIC, already has such mechanism for commercial banks.
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