Reuters

Regulators must be “significantly tougher” on large and complex financial firms to limit wider risks, but big firms are still needed to keep the global economy humming, Federal Reserve Chairman Ben Bernanke said on Saturday.

Bernanke told an Independent Community Bankers of America conference that the problem of some firms being perceived as “too big to fail” is among the “most insidious” barriers to competition in financial markets.

“As the crisis has shown, one of the greatest threats to the diversity and efficiency of our financial system is the pernicious problem of financial institutions that are deemed ‘too big to fail,’” he said.

“It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms,” he added.

Reform proposals that would limit the scope and activities of financial institutions “are worth careful consideration,” the Fed chief said. Supervisors should be empowered to limit large firms’ involvement in “inappropriately risky activities,” he said.

Bernanke, however, was clear that big financial firms still play a vital role, saying that a “technologically sophisticated and globalized economy” needs “large, complex, and internationally active financial firms.”

The challenge is to make sure their size does not insulate them from market discipline, he said.

Bernanke’s comments come less than a week after Senate Banking Committee Chairman Christopher Dodd unveiled a regulatory reform proposal that would put the U.S. central bank in charge of overseeing banks and important financial firms with assets greater than $50 billion.

The Fed already has authority over big banks, but lacks power over nonbank financial firms, such as insurer AIG, which was one of the firms at the center of the global financial crisis.

The Dodd bill would also give the Fed the power to break up big firms that could threaten the stability of the financial system if they get into trouble.

Bernanke laid out a three-pronged approach favored by the Fed on how to tackle the problem of firms that are so big and interconnected that markets believe the government would step in if they faltered.

The issue of moral hazard, or that expectations of government intervention encourages risky activities, became a subject of intense scrutiny as the global financial crisis escalated.

“First, we develop and implement significantly tougher rules and oversight that serve to reduce the risks that large, complex firms present to the financial system,” Bernanke said.

He noted that the Fed has been working with its counterparts overseas on requiring that so-called “systemically important” firms hold bigger capital and liquidity buffers.

Secondly, the Fed is working on efforts to make the financial system more resilient should a firm fail, Bernanke said. Thirdly, a new legal framework that enables the government to wind down large failing firms is needed, he said.

Bernanke said the idea of requiring systemically important firms to develop “living wills,” which would outline how they could be wound-down in an orderly way, “is worth exploring.”

The Fed chairman also continued his pushback against Dodd’s plan to hand over the Fed’s supervision of thousands of smaller banks to other regulators.

Bernanke said the Fed’s close connections with community bankers give the Fed a more forward-looking and detailed perspective on the economy that is often lost in economic data.

The grass-roots information also gives the Fed a broader understanding of risks facing the economy, such as the problems in commercial real estate lending, he said.

“A supervisory agency that focused only on the largest banking institutions, without knowledge of community banks, would get a limited and potentially distorted picture of what was happening in our banking system as a whole,” he said.