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Who's really too big to fail?

Let some troubled financial firms fail, U.S. regulators tell Congress. Fannie Mae and Freddie Mac are exceptions.

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He said that in the case of Bear Stearns, the Fed had a complex mix of reasons to step in with a loan and arranged merger with the bank JPMorgan Chase. Bear's size played a role, Bernanke said, but the move also was underpinned by broader market tensions at the time and by poor functioning of certain financial markets to which the company was connected.

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He said the goal of legislation – and of preserving market discipline – is to make sure the need for such a rescue does not arise again.

Preserving market discipline while preventing market meltdown is an age-old balancing act for financial regulators. Now these regulatory challenges are being faced in connection with a world where investment banks play a larger role in the flow of credit, because loans are increasingly packaged into securities rather than held by traditional banks.

"In light of the Bear Stearns episode, the 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," Bernanke said in his testimony. And he called for "a more formal process for deciding when to use those tools."

It's possible that Congress will decide to give the Fed a formal role in supervising large investment banks – including setting standards for the amount of capital they must hold in reserve to offset the investment risks they take.

At the hearing, Paulson said that the industry has taken on more leverage, or risk, than was healthy.

If a large investment bank failed, the role of rescue or liquidation might fall to the US Treasury. The department's Federal Deposit Insurance Corp. now plays that role for much of the commercial banking industry.

Paulson said the need for such legislation is urgent, but he acknowledged that it will take lawmakers some time to work through the details of reforming financial regulation. That means a law might come next year, not sooner.

Rep. Barney Frank (D) of Massachusetts, who chairs the House Financial Services Committee, said that current regulatory powers should be adequate until then, as indicated by the Bear Stearns rescue. He said it's more important to get the legislation right than to do it quickly.

"It's very difficult" to find the right balance between free markets and government oversight, says Henry Hu, a corporate law expert at the University of Texas in Austin. The investment banks are important enough that a failure poses risks to the world financial system, he says. Yet tighter regulation could have drawbacks, such as if the industry lost in dynamism what it gains in stability.