Fed calls for overhaul of financial regulatory system

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 to the Council on Foreign Relations, Bernanke said the USA and other industrial nations bore special responsibility for the spreading global crisis due to their failure to address chronic trade imbalances and clamp down on speculation.

In the near term, the U.S. and other governments must focus on getting lending restarted, because recovery "depends critically on our ability to get the banking system and the financial system ... back to a situation where the markets are reasonably stable," Bernanke said. The U.S. recession will end later this year only if the financial system is repaired, he said.

Bernanke said U.S. unemployment of more than 10% is "within the realm of possibility."

Bernanke laid out four key elements for systemic reform. High on his list is addressing financial institutions considered too big to fail — which he called an "enormous" problem — including setting up a system to restructure troubled firms. Another is bolstering systems and rules governing trading and payment in financial markets, to ensure they hold up under stress.

Bernanke suggested reviewing current rules to ensure they don't have the unintended consequence of magnifying ups and downs.

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 may cut lending to meet capital rules, making things worse.

Bernanke raised the idea of a super-regulator to monitor systemic risks. He said he had an open mind on whether the Fed should assume the lead role, though it would need to be involved in any systemic management.

The Senate Banking Committee held a hearing Tuesday on financial regulation, with Chairman Chris Dodd, D-Conn., saying, "The era of 'don't ask, don't tell' on Wall Street is over."

But Dodd and other senators were not necessarily sold on the Fed as super-regulator.

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.

Contributing: The Associated Press