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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.

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And investors may be less vigilant in selling the stock of banks that engage in risky behavior.

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Bernanke was blunt on this point.

"The Fed's decision to lend to primary dealers – although it was necessary to avoid serious financial disruptions – could tend to make market discipline less effective in the future," he warned.

His concerns echoed ones that Mr. Paulson raised in a London speech last week.

The Treasury secretary, in effect, said regulators need to be ready to allow a major investment bank to fail – and to arrange for a quick shutdown that minimizes the destabilizing effects on financial markets.

"We need to create a resolution process that ensures the financial system can withstand the failure of a large complex financial firm," he said. "To do this, we will need to give our regulators additional emergency authority to limit temporary disruptions."

All these issues will be the focus of a hearing Thursday, in which Bernanke and Paulson will testify before the House Financial Services Committee, chaired by Rep. Barney Frank (D) of Massachusetts.

Paulson has also proposed a blueprint for a broad overhaul of US financial regulation. Such sweeping changes typically take years to work their way into law. But last week, he called for Congress to act sooner on the narrow question of financial emergencies.

Such a law could come up next year.

"After the election" this fall, predicts Mr. Nigro, who is now at Bryant University in Smithfield, R.I.

Even fairly narrow legislation involves a careful balancing act.

"What the US financial system doesn't need is line-by-line regulation," says Vincent Reinhart, an economist affiliated with the conservative American Enterprise Institute. But new capital standards are needed for investment banks, he says.

"A lot follows from Fed lending," he says. "If you lend, ... you have to supervise and regulate. [The investment banks] have to have capital commensurate to their risk taking."

For now, it appears that banks are struggling but not collapsing outright. Firms like Merrill Lynch are facing the prospect of needing to raise more capital to cover losses on investments.

Last year, "sovereign wealth funds" controlled by foreign governments poured billions of dollars into US banks. But as financial share prices have kept falling, it's proving harder for banks to find ready investors.

Banks can get capital by selling assets to other companies. And in severe crises, governments become the "capitalizer of last resort" for the system.

With the economy now possibly in recession, some analysts warn that bank profits won't be rebounding anytime soon. Consumers are defaulting at higher rates on things like car loans as well as mortgages. In turn, the trouble at banks hurts the whole economy by making credit less available.

But so far the credit crisis has not resulted in either a wave of bank failures nor in a full-scale credit crunch for businesses.