LONDON - Regulators must get into a position to allow financial services firms to fail without compromising the broader financial system, a senior US Treasury official said on Tuesday.
Anthony Ryan, US treasury assistant secretary for financial markets, said told a conference in London that regulators and private sector participants must strengthen market mechanisms such as post-trade practices, centralized clearing, risk management and transparency.
"As we resolve the challenges of today, federal regulators must balance the need for market stability with concerns about the likelihood of increased moral hazard," Ryan told the Euromoney Global Borrowers Investors Forum. "While firm failures are painful, as a policy matter, we must be in a place where firms are allowed to fail."
He said the question of whether an institution could be "too big to fail" has evolved into a question about whether institutions may be "too interconnected to fail."
"Collectively, we must all seek to reduce the likelihood of such a failure through more robust market discipline, enhanced market infrastructure, reduced interdependence, improved transparency, and more robust awareness and management of risk," he said.
Ryan's remarks come just days after US Treasury Secretary Henry Paulson called for giving the Federal Reserve explicit authority to step in to protect financial stability, even it means offering funding to investment banks.
The case for a new backstop comes as the Fed considers what to when its emergency credit life-line for Wall Street investment banks expires in September. The emergency facility was created around the same time that Bear Stearns & Co collapsed in March.
Paulson said last week that a permanent lender-of-last-resort role for the Fed may be needed, but it should be limited to avoid a perception that Wall Street banks could count on a federal bailout if they got into trouble.
"Having diverse instruments and interconnected market participants is not a problem," Ryan said. "What we must have are mechanisms and facilities that allow a market participant to fail without compromising the broader system."
Ryan said as markets recover from turmoil, US regulators were working on changes to reform the origination, distribution and rating of credit, to improve financial institutions' risk management practices and bolster financial market infrastructure.
But it was important for the private sector, including investors, to hold up their end of the bargain and improve market discipline, due diligence and awareness of risk, he said.