Federal Reserve

Lacker: Banks' bankruptcy plans will reduce risk

Jeffrey Lacker, president and chief executive officer of the Federal Reserve Bank of Richmond.
Andrew Harrer | Bloomberg | Getty Images

U.S. banks are likely to cut back on risky short-term funding if markets believe bankruptcy not bailouts await them, a top Federal Reserve official is set to tell lawmakers on Tuesday.

Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, is expected to tell Congress that the biggest U.S. banks have relied on raising short-term cash because they have expected the government to step in if their strategies failed.

"In the absence of that expectation, firms and their creditors would have strong incentives to reduce reliance on fragile short-term funding,'' Lacker said in a statement prepared for a House committee hearing.

(Read more: Fed's Tarullo details plans to counter bank runs)

Fed officials have identified short-term funding as a funding method that fueled the 2007-2009 financial crisis and a continuing threat to the financial system.

The 2010 Dodd-Frank law requires firms such as JPMorgan Chase, Goldman Sachs and Citigroup to draw up so-called "living wills,'' or blueprints for how they could go through bankruptcy without government support.

Dodd-Frank will improve capital standards: Yellen

If regulators find the plans insufficient, they can force banks to shrink or raise more capital. Failed banks that are deemed unable to go through bankruptcy would be seized by the Federal Deposit Insurance Corp. and resolved using new liquidation powers assigned to the agency by Dodd-Frank.

Lacker said he prefers requiring banks to beef up their living wills and plan for bankruptcy rather than count on FDIC liquidation in a crisis.

Maintaining a government role in resolutions reduces the incentive for too-big-to-fail banks to make structural changes, such as slashing risky funding, he said.

(Read more: Gross: Fed will keep rates low until at least 2016)

Fed Governor Daniel Tarullo has said firms that raise short-term cash from other banks should be forced to boost their capital ratios to offset the risk.

Lacker said he was open to prohibiting risky activities or cracking down on banks' size to make it easier for them to go through bankruptcy. But until banks write credible living wills, regulators will not be able to write those rules, he said.

"I am open to the notion that such restrictions may ultimately be necessary to achieve a more stable financial system, but I do not believe we have a strong basis yet for determining exactly what activity and size limits should be adopted,'' he said.

Forcing banks to fully prepare for bankruptcy also would allow the U.S. government to wind down other emergency lending programs, such as the Fed's power to lend in "unusual and exigent circumstances.''

—By Reuters.