Bernanke urges stronger 'holistic' financial regulation

WASHINGTON -- Federal Reserve Chairman Ben Benanke laid out a far-reaching proposal Tuesday to strengthen government oversight of banks, mutual funds and huge financial firms to prevent a repeat of the current worldwide crisis, which he termed the "worst financial crisis since the 1930s."

In a speech, and question-and-answer session, at the Council on Foreign Relations, Bernanke once again said the economy could begin a slow recovery later this year, but only if government manages to repair troubled financial markets.

Bernanke said the recession suprised the Fed by "being more severe than anticipated," serving to underscore the powerful effect of the meltdown at banks and other financial firms.

Reovery "depends critically on our ability to get the banking system and the financial system ... back to a situation where the markets are reasonably stable and they can perform their vital function," Bernanke said. "If we can do that, (there's) a good chance the recession will end later this year, and next year will be a year of growth."

In an answer to a question about the Treasury Deparment's plan to stress test banks to ensure they have healthy capital to weather a deep downturn, Bernanke said an unemployment rate averaging more than 10% for a period of time "is well within the realm of possibility" though not part of consensus forecasts at this point.

Bernanke's prepared remarks laid out his strategy for a "holistic" overhaul of financial market regulation. The White House and leading lawmakers are also preparing to begin work on a comprehensive remake of financial rules. The issue will be a top item on the agenda of a meeting in London this week of top global finance officials. That gathering will help set the stage for a meeting of leaders from the world's 20 major economic powers in April.

Bernanke laid out four key elements to guide any regulatory overhaul.

First on his list is the problem of financial institutions considered too big, or interconnected, to fail — including setting up a system to unwind troubled firms.

Another is bolstering systems and rules that govern trading and payment in financial markets, to ensure they perform well under stress.

Bernanke suggested reviewing current regulations to ensure they don't have the unintended consquence of magnifying ups and downs in the financial system and the economy.

The Fed chair gave, as one example, regulations requiring banks to hold a certain amount of capital. Because it's tough to raise capital in a downturn, banks often find the best way to meet capital rules is to cut back on lending, thereby making a bad situation worse.

Bernanke also said policymakers should consider creating a sort of superregulator to monitor broad, systemic risks. He added that he has an open mind on whether the Fed should assume the lead role, though it would need to be involved in any systemic management.

In response to a question, Bernanke said the economy would "be in much better shape today" if his proposed regulatory changes had been in place several years ago. He added, however, that there would likely have still been a period of stress or some boom and bust, because so much money had flowed into the United States that it created "a period of excessive risk taking and a boom mentality."

In his speech, Bernanke said the United States and its trading partners "did not do enough" to reduce trade distortions or ensure proper regulatory oversight, contributing to the current crisis.

While Bernanke said tougher regulation can't prevent future market busts, it could help to make crises "less frequent and less virulent."

Bernanke put increased attention to what he called the "potential fragility of the money market mutual fund sector." The Fed was forced to step in and backstop money market funds after a prominent firm last fall was unable to maintain a value of $1 per share, causing fearful investors to quickly withdraw more than $250 billion from prime money market mutual funds.

Bernanke suggested tighter restrictions on money market mutual fund investment strategies, potentially requiring shorter maturities and increased liquidity. Another approach might be to develop a limited system of insurance for funds that seek to maintain a stable net asset value, he said.

The Fed and the Treasury Department during the past year have been forced to rescue major financial companies that are so interwoven with other players and the global financial system that their collapse would put the entire economy in danger. The bailouts of insurance giant American International Group (AIG), Citigroup (C), Bank of America (BAC), and mortgage finance companies Fannie Mae and Freddie Mac have put billions of taxpayers' dollars at risk and angered the American public.

Bernanke defended the government's use to date of the $750 billion financial rescue law, saying that infusing capital into U.S. banks had averted a worldwide financial collapse. He predicted that banks receiving taxpayer money would start to step up lending.

The Treasury Department's decision to use the money to give banks capital, and bail out some flailing firms, rather than buying up troubled assets as initially proposed, has been wildly unpopular on Capitol Hill.