This morning, Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve, testified before the House Committee on Financial Services at a hearing entitled “Federal Reserve Perspectives on Financial Regulatory Reform Proposals.”

Bernanke began his testimony by outlining his “five key elements” for reform:

  1. Effective consolidated supervision over systemically important financial firms;
  2. Establishing an oversight council composed of agencies involved in financial supervision and regulation;
  3. Creating a “special resolution process” allowing the government to wind down failing systemically important financial institutions;
  4. Creating “consistent and robust oversight and prudential standards” for systemically important payment, clearing, and settlement arrangements; and
  5. Enhancing consumer protections from “unfair and deceptive” financial practices.

In his call for consolidated supervision over systemically important financial firms, Bernanke pointed to the need for “capital, liquidity, and risk management requirements” that reflect the firms’ importance within the system. “Enhanced requirements are needed not only to protect the stability of individual institutions and the financial system as a whole, but also to reduce the incentives for financial firms to become very large in order to be perceived as too big to fail.” He called for the Federal Reserve to serve as the consolidated supervisor, pointing to the Federal Reserve’s expertise in “supervising large, diversified, and interconnected banking organizations.”

Bernanke preferred a council of regulators to perform systemic risk oversight, arguing that the “broader task of monitoring and addressing systemic risks … may exceed the capacity of any individual supervisor.” He proposed that such an oversight council consist of representatives from all agencies and departments that participate in overseeing the financial sector. In response to a question about who should lead the oversight council, Bernanke suggested the Treasury Department. “The Treasury has the broadest responsibility for the economy in general, has the broadest responsibility for any fiscal implications and financial implications … and would probably be better placed to mediate any differences among agencies that might arise.” Bernanke also suggested that the mandate of each of the relevant agencies be expanded to include identifying and responding to potential risks. When asked if hedge funds would be deemed systemically important, Bernanke said that he did not think “any hedge fund or private equity fund would become a systemically critical firm individually,” but he cautioned that an oversight council should “pay attention to the industry as a whole.”

Chairman Bernanke questioned the ability of the bankruptcy code to protect the public interest in the resolution of failing nonbank financial firms. “After the Lehman Brothers and AIG experiences, there is little doubt that we need a third option between the choices of bankruptcy and bailout for such firms.” He supported a system “analogous to the regime currently used by the Federal Deposit Insurance Corporation for banks.” He also supported a “mechanism for allowing these firms, when being taken over by the government, to impose significant losses on not only shareholders, but also creditors.”

Bernanke renewed his call for a more comprehensive view of payment, clearing, and settlement arrangements, calling the existing system “fragmented.” “In light of the increasing integration of global financial markets, it is important that systemically critical … arrangements be viewed from a systemwide perspective.” He called for “additional authorities” to implement this vision.

The Chairman also called for enhanced consumer protections, noting that “flawed” and “inappropriate financial instruments” harm both individual households and the financial sector as a whole. He also addressed the discrepancy surrounding “examination and enforcement of consumer protection laws among banks and nonbank affiliates of bank holding companies” and “firms not affiliated with banks.” Bernanke requested that Congress address the issue to ensure “fair competition in the market for consumer financial products.” Notably, Bernanke did not discuss the creation of a Consumer Financial Protection Agency, an undertaking strongly supported by Committee Chairman Barney Frank (D-MA).