WASHINGTON Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson told Congress Thursday that new regulatory powers are needed to insulate the national economy from damage if a big Wall Street firm collapses.
Their recommendations were part of a broader debate before the House Financial Services Committee about the best ways to revamp the country's antiquated regulatory system. The idea is to brace the system to better respond to modern-day crises like the housing and credit debacles that have badly bruised the economy.
Both Bernanke and Paulson endorsed creating new procedures by which the government can guide an orderly liquidation of a failing investment bank in an effort to minimize any fallout that might be inflicted on the broader financial system and the overall economy. Such procedures, which are in place for commercial banks, might have made the dissolution of investment firm Bear Stearns more orderly.
"In light of the Bear Stearns episode, Congress may wish to consider whether new tools are needed for ensuring an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy, together with a more formal process for deciding when to use those tools," Bernanke said.
Paulson, who recently laid out such a proposal, said: "It is clear that some institutions, if they fail, can have a systemic impact." However, financial players need to be disciplined in managing risk and not expect the government to fly to their rescue, he added. "For market discipline to effectively constrain risk, financial institutions must be allowed to fail," he said.
The Fed's financial backing of JPMorgan Chase's takeover of the troubled Bear Stearns has drawn criticism from Democrats, who call it a government bailout that could put billions of taxpayer dollars at risk. Both Democrats and Republicans lawmakers said changes need to be made to protect taxpayers in the future should another big firm get into trouble.
Rep. Spencer Bachus, R-Ala., said a "shock absorber" is needed to make sure that "taxpayers are not holding the bag. ... This is a tall order."
The Treasury chief also sought Thursday to calm investor jitters about the financial health of mortgage giants, Fannie Mae and Freddie Mac. They are "working through this challenging period," Paulson told Congress. "Their regulator has made clear that they are adequately capitalized."
Shares of Fannie and Freddie tumbled on Monday after a Lehman Brothers report said that an accounting change could force the companies to raise billions in new capital. That sent a tremor through financial markets.
Bernanke in recent days has called for stronger oversight of big Wall Street firms, which are regulated by the Securities and Exchange Commission. Those firms have been given unprecedented albeit temporary access to tap the Fed for emergency loans, a privilege that has been granted for years to commercial banks, which are more tightly regulated.
With credit problems persisting, the Fed may extend the lending privilege to investment banks into next year, Bernanke has said.
The Fed chief called on Congress to consider giving the central bank explicit authority to oversee systems that process payments and other financial transactions by investment firms as well as banks.
And, he recommended that Congress give a regulator the authority to set standards for capital, liquidity holdings and risk management practices for the holding companies of the major investment banks. Currently, the Securities and Exchange Commission's oversight of these holding companies is based on a voluntary agreement between the SEC and those firms.
"The financial turmoil that began last summer has impeded the ability of the financial system to perform its normal functions and adversely affected the broader economy," Bernanke said. "This experience indicates a clear need for careful attention to financial regulation and stability by the Congress and other policymakers."
The Fed, which regulates banks, and the SEC, which oversees investment firms, announced an information-sharing agreement on Monday aimed at better detecting potential risks to the financial system. With the Fed lending money to Wall Street firms, it needs to have a firm grasp of their financial shape.
Paulson has put forward an ambitious overhaul that would turn the Fed into a super cop in charge of financial market stability. But the plan would remove the Fed from day-to-day banking supervision, which Bernanke opposes. The financial regulatory structure dates back to the Civil War.
No action is expected this year on such a regulatory overhaul and the debate is likely to spill over to the next president and the next Congress.
However, the sudden demise of the once mighty Bear Stearns, which was forced to the edge of bankruptcy after a run on the investment bank, underscored how quickly fortunes can change and raised new questions about the effectiveness of the regulatory system.