Two Federal Reserve district bank presidents said the 2010 Dodd-Frank Act hasn’t eliminated creditor expectations for federal bailouts of financial firms, perpetuating the idea that large banks are “too big to fail.”

Richmond Fed President Jeffrey Lacker said in testimony prepared for a hearing Wednesday by the House Financial Services Committee that the ability of the Federal Deposit Insurance Corp. to pay creditors at its discretion creates an incentive for bondholders and lenders to pay “insufficient attention to risk and invest in fragile funding arrangements.”

Dallas Fed President Richard Fisher said in testimony prepared for the same hearing that an implicit government guarantee for the biggest U.S. banks is an “injustice” that prompts them to take excessive risks and that they should be allowed to fail.

Regulators and legislators are still trying to ensure the largest banks won’t derail the economy or need taxpayer-funded bailouts almost three years after the July 2010 enactment of the Dodd-Frank Act. Their challenge grew as big banks expanded with the rescue of failing firms during the financial crisis.

New York-based JPMorgan Chase & Co. bought Bear Stearns Cos., Charlotte-based Bank of America Corp. purchased Merrill Lynch & Co. and Wachovia Corp. was purchased by San Francisco- based Wells Fargo & Co.

The four largest U.S. banks—JPMorgan, Bank of America, Wells Fargo and New York-based Citigroup Inc.—held total assets exceeding $7.9 trillion at the end of the first quarter this year, equal to almost half of U.S. nominal gross domestic product. U.S. bank regulators including the Fed are trying to use higher capital, liquidity and risk management standards to curb risks from the size and complexity of big banks.

Tighten Standards

Some members of Congress are considering legislation that would further tighten capital standards. Senators Sherrod Brown, a Democrat from Ohio, and David Vitter, a Republican from Louisiana, introduced legislation in April that proposes a 15 percent capital requirement for the largest banks to remove the perception they would get a taxpayer-funded bailout in a crisis.

The Richmond Fed has studied how the federal safety net shapes incentives in the financial system for more than 20 years. Lacker advocates bankruptcy as a primary tool for dealing with failing large banks, and wants explicit limits on the federal safety net.

“Given widespread expectations of support for financially distressed institutions in orderly liquidations, regulators will likely feel forced to provide support simply to avoid the turbulence of disappointing expectations,” Lacker said. “We appear to have replicated the two mutually reinforcing expectations that define ‘too big to fail.'”

Smooth Dismantlement

The Richmond Fed president has said regulators need to ensure banks are organized in ways that would allow for smooth dismantlement. Resolution plans, or so called living wills, are the key tool for that process, he said.

“Some recent proposals to address the ‘too big to fail’ problem would make structural changes to financial firms― imposing quantitative limits on their size or prohibiting certain risky activities,” Lacker said in his testimony. “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.”

The proportion of total U.S. financial firms’ liabilities covered by the federal financial safety net has increased by 27 percent during the past 12 years, according to Richmond Fed estimates.

Safety Net

The safety net covered $25 trillion in liabilities at the end of 2011, or 57.1 percent of the entire financial sector. Almost two-thirds of that support is implicit and ambiguous, the Richmond Fed said in research published this year.

Sheila Bair, FDIC chairman during the financial crisis, said in remarks prepared for testimony to the committee that the Dodd-Frank Act has reduced the chances of a taxpayer bailout.

“Implicit and explicit too-big-to-fail policies were in effect under the legal structure that existed before Dodd- Frank,” said Bair, now a senior adviser to the Washington-based Pew Charitable Trusts. “Dodd-Frank has abolished them.”

During the financial crisis, the Fed used emergency powers to expand the safety net beyond banks to provide loans to U.S. corporations, money market mutual funds and government bond dealers.

The Dallas Fed proposed earlier this year that the safety net be limited to commercial banking activities inside financial holding companies, and not their non-bank subsidiaries.

The largest financial firms should be restructured so each of their units “is subject to a speedy bankruptcy process,” and creditors should be notified their investments won’t be guaranteed by the government, Fisher said in his prepared testimony.

Fisher reiterated his view that the government should break up the biggest institutions to safeguard the financial system. He is one of the central bank’s most vocal critics of the “too- big-to-fail” advantage he says large firms have over smaller rivals.

With assistance from Jesse Hamilton in Washington. Editors: James L Tyson, Mark Rohner