Bernanke: Big banks will not be allowed to fail, new regulator needed

Ben Bernanke dispelled all doubt about the Fed's policy on banks that are deemed too big too fail. The policy is simple as can be: big banks will not be allowed to fail.

"The Federal Reserve, other federal regulators, and the Treasury Department have stated that they they will take any necessary and appropriate steps to ensure that our banking institutions have the capital and liquidity necessary to function well in even a severe economic downturn," Chairman Ben Bernanke said in his speech before the Council on Foreign Relations. "Moreover, we have reiterated the U.S. government's determination to ensure that systemically important financial institutions continue to be able to meet their commitments."

New 'system risk monitor' up ahead?

Bernanke recommended a broad review of both financial regulations and the creation of a new institution to both monitor individual bank and systemic risk , with the power to intervene to make corrections to prevent another financial crisis form occurring.

Bernanke suggested that Congress create a systemic risk monitor -- "a governmental authority to monitor, assess, and, if necessary, address potential systemic risks within the financial system." The new institution would take a "macroprudential approach" specifically related to systemic risk. He hinted that the Fed could take on this monitor role, with specific authority and sufficient staff, but underscored that the new institution's location in the government framework was ultimately a legislative matter for Congress.

Earlier, Senate Banking Committee Chairman Christopher Dodd, D-Connecticut, told Bloomberg News a systemic risk monitor would represent too much responsibility for the Fed. "When you keep asking an agency to take on more and more, it becomes less and less likely that agency will succeed at any of it," Dodd said.

Recovery in 2010 if banks stabilized

On the recession, Bernanke said it "surprised us in being more severe," as it did other institutions. He added that the U.S. economy's recovery "depends on our ability to get the banking system back to its critical function [providing credit for commerce] . . . If so, the recession will end this year, and 2010 will be a period of growth." He added that 10 percent unemployment is within the realm of possibility during the recession.

Still, Bernanke reiterated his long-term confidence in the U.S. economy's ability to heal and grow again. "This economy will recover, there are too many underlying strengths, it's too dynamic, it will recover," Bernanke said.

The Fed chair also said inflation is tame. "We're not anticipating deflation, we do expect inflation to be quite low," Bernanke said, but added that the Fed would be at-the-ready to adjust monetary policy, should inflation resurface.

Favors mark-to-market

Bernanke also said he favors mark-to-market accounting for assets, with maximum transparency, not a suspension of it. However, Bernanke added that "when markets don't exist or are illiquid, we all recognize that the numbers that come out [on asset valuations] are not accurate" and that regulators must identify weak points in the mark-to-market regulation and make recommendations for changes, as warranted.

On additional fiscal stimulus, Bernanke deferred to Congress, while recognizing the positive role it plays in limiting a contraction and hastening the recovery.

Monetary Policy Analysis: For investors, the most important comments in Bernanke's speech Tuesday concerns his recommendation for a new institution -- a system risk monitor -- and his statement that large, interconnected 'too big to fail banks' will not be allowed to fail.

The system risk monitor concept has been propelled by the fog and haze of the financial crisis created by the myriad of off-balance sheet and related assets hidden by banks from regulators. Clearly, Bernanke is saying that regulators' inability to identify the health of these assets, where the risk existed, and the system's overall risk hampered the Fed's and regulators' ability to respond to the crisis. A new system risk monitor would have comprehensive knowledge of all risk by all players at all times -- somewhat the way an air traffic controller has knowledge of the location, altitude, and speed of flights approaching and leaving an airport.

On support for large, systemically-critical banks and institutions, the policy is consistent with earlier comments by the Fed: the U.S. may create new banks, may temporarily nationalize banks, may create a separate agency to moth-ball and resell toxic assets, but the financial system's overhaul will not involve the Fed cutting-and-running from existing banks, from the existing private banking infrastructure in place.

Having seen the negative impact on credit markets and money flows from the failure to stabilize Lehman Brothers, the Fed is apparently convinced that they will not let that mistake be repeated. Letting a big bank fail would cause far more harm than good -- and it could devastate an already weak and constrained financial system.

In a nutshell, Bernanke's speech strongly suggests that the Fed's stance is thus: intervene and stabilize first -- even at great cost to taxpayers -- to get maintain financial system function and get credit flowing again; review and revise regulations, including creating new institutions, later.
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