By Brai Odion-Esene

WASHINGTON (MNI) - Dallas Federal Reserve President Richard Fisher launched an attack Thursday against a handful of too-big-to fail "Blobs" that he accused of "gumming" the system during the financial crisis and impeding the overall effectiveness of traditional monetary policy intended to deal with the turmoil.

Dismissing assertions by the government that it will no longer intervene to save systemically important institutions, Fisher argued that the onus is on policymakers to devise a system that discourages any desire to grow to too-big-to-fail status again.

In a speech that was peppered with customary historical and literal references, Fisher railed against a financial sector whose "misperceptions of risk and misplaced incentives led to misguided actions."

"It was not enough that one or two large institutions erroneously thought that real estate prices would rise forever -- nearly all of the biggest banks did. It was not enough that one or two large institutions thought they could contract with third parties they presumed would immunize them against failure -- nearly all did," he said.

Bank regulators were also not spared by the brunt of Fisher's ire, not even the Federal Reserve:

"And it was not enough that one or two regulators turned a blind eye to the systemic risk posed by this behavior -- nearly all did, including the Federal Reserve," he said.

Fisher was withering in his criticism of current bank capital regulation, saying its procyclical nature exacerbated the freeze in the lending markets. "Bank capital regulation provides some microeconomic incentives, but destabilizing macroeconomic outcomes, when a large number of very large banks are simultaneously in trouble," he said.

Still, the Fed came good in the end, Fisher argued, taking steps to fight a panic that froze the credit markets and -- without Fed and other central bank intervention -- would have brought the world economy within a "hair's breadth" of depression.

Fisher then switched to the need to deal with "the most malignant" of the perpetrators of the financial crisis -- financial institutions thought to be too big to fail.

It is high time, he said, "as we refashion, modernize and provide needed improvements to the regulatory system."

So what should be done with too-big-to fail institutions? While some are willing to live with them and others want to get rid of them, Fisher stated his acceptance that as "painful as it might be, destruction of errant or inefficient economic agents must occur for progress to take place in a capitalist society -- that without failure there can be no good."

"Therefore, in the words of Milton, I would say that regulation should be designed to enable financial institutions to be 'sufficient to have stood, though free to fall.'"

Even from the perspective of monetary policy, "I view of paramount interest an overhaul of a system that has come to coddle such 'too-big-to-fail' perceptions and capital-market sources of systemic risk," Fisher said.

Before the financial crisis, he argued, monetary policy's increased effectiveness helped usher in a quarter century of unprecedented macroeconomic stability with infrequent and mild recessions and low inflation, adding, "This was perhaps the closest we have come to economic paradise."

Now, however, "the very existence of the blob of banks considered as too big to fail blocks, or seriously undermines, the mechanisms through which monetary policy influences the economy," he said.

He accused too-big-to fail institutions, referred to in his remarks as the "Blob," of not only gumming the works to spark the crisis, but then blocking the channels monetary policy uses to influence the real economy when the crisis hit.

Otherwise, the aggressive policy adopted by the Fed "should have returned our economy to the trajectory of stability and growth more quickly," Fisher said.

Instead, he continued, obstructions in the monetary policy channels worsened a recession that has proven to be longer and, by many measures, more painful than any post-World War II slump. With its conventional policy tools blocked, the Fed had to resort to unprecedented measures, opening new channels to bypass the blocked ones and restore the economy's credit flows.

Such unorthodox measures, he warned, carry great and unprecedented risk. He said, "They give rise to questions about the Federal Reserve's commitment to its traditional mandate, to suspicions that we are undertaking fiscal-like initiatives and to concerns that these initiatives might compromise our independence by putting us on the road to political perdition."

In addition, "they bloat our balance sheet, requiring us to now craft and articulate an exit strategy that might take us even further from our traditional practices," Fisher said, adding the that the sooner the Fed is able to return to traditional policymaking the better.

To craft a smart solution to this vexing problem of banks considered too big to fail, he suggested, requires dealing with the way people and businesses really are.

"To me this means finding ways not to live with 'em and getting on with developing the least disruptive way to have them divest those parts of the 'franchise,' such as proprietary trading, that place the deposit and lending function at risk and otherwise present conflicts of interest," he said.

Fisher put forward other proposals that even he acknowledged would hardly endear him to the large institutions that are commonly viewed as too big to fail. He insisted, however, that it is a "fantastical notion" to ignore the dynamic that leads business and financial organizations to want to grow to become the biggest and the most profitable.

Just as it is also a "fantastical" notion to assume that smart bankers will not take advantage of government guarantees to customers or creditors of one part of their business to incur risk and higher returns in another part, as long as they are allowed to do so.

Not only that, Fisher continued, clearly warming to his theme, but it is also a fantastical notion to expect that having once pulled poorly run, systemically threatened firms out of the fire, the U.S. government won't do it again, no matter how many times and how loudly it says it won't.

This is why the supervisory structure must ensure that these institutions do not have the opportunity, or the incentive, to grow to too-big-to-fail status again, Fisher said, and that activities that present risks to taxpayers must be contained using tools like capital requirements and living wills.

"We would also be well-served to roll back various pieces of the government's safety net, forcing creditors of risky, nonbank behavior to bear the full cost of their actions," he added.

These higher requirements, he concluded, could act as a tax or disincentive to bigness and, if structured properly, could provide a useful brake on the "dynamic that leads to reckless growth and unmanageable complexity."

** Market News International Washington Bureau: 202-371-2121 **