Time for new financial system safeguards?

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

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

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.

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

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.

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