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Time for new financial system safeguards?

Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson indicate need for new regulation of banking industry.

By Staff writer of The Christian Science Monitor / July 10, 2008

The banking industry is showing new signs of strain, which is adding urgency to calls by federal authorities for greater oversight powers.

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Just a couple of months ago, executives at Wall Street banks were voicing what sounded like sighs of relief that the worst of the financial storm might be over.

That may still be the case, but the latest signs are that strong risks remain. Share prices keep heading downward as financial firms scramble to raise enough cash to tide them through tough times.

Against that backdrop, the nation's top bank regulators – Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson – are urging new measures to safeguard a financial system that's more dependent than ever on investment banks that are outside the traditional authority of these regulators.

Their words probably won't result in new legislation this year, but the implication is clear: An era of expanded regulation is on the way.

The question isn't so much whether this will happen as how to do it in a way that strikes the right balance. The financial system needs to be safeguarded without either stifling corporate innovation or encouraging recklessness by corporations who believe they'll be bailed out in a pinch.

"Regulators and policymakers need to catch up with the financial innovation that has occurred over the past 10 years," says Peter Nigro, an economist who has served in the Treasury's Office of the Comptroller of the Currency. "We're behind the curve and I think we have to jump back in front."

These issues came to the forefront in March, when the Federal Reserve stepped in to do something new: arrange a hasty buyout of an investment bank, Bear Stearns, in order to prevent the chaos that would have ensued had the securities firm declared bankruptcy. The bank JPMorgan Chase was the buyer.

That crisis also prompted the Fed to open its lending window, for the first time, to securities dealers such as Bear. Essentially, the fallout from bad home loans was rippling beyond the traditional banks, which have been able to get short-term loans from the Fed.

This week, Mr. Bernanke made clear that these extraordinary steps have permanently altered the regulatory landscape, even as they raise difficult questions.

He said in a Tuesday speech that the Fed may keep extending credit to investment banks, as needed, into next year.

And with access to Fed help comes the responsibility of the Fed to be more engaged as a regulator. Already, Fed examiners are on the scene at investment banks, just as they have long been in commercial banks.

"Congress should consider requiring consolidated supervision of those firms, providing the regulator the authority to set standards for capital, liquidity holdings, and risk management," Bernanke said.

Although several federal agencies currently have a role as bank regulators, the consolidated "regulator" in this case will likely be the Fed itself, many experts say.

A great risk in all this is what's called "moral hazard," the likelihood that banks will actually behave in risky ways the more they believe that regulators are taking responsibility for their ultimate safety and survival.