Paulson: Wall Street Needs Stronger Oversight by Fed

Treasury Secretary Henry Paulson urged quick action to give the Federal Reserve explicit authority to step in to protect the financial system if its stability is threatened.

The U.S. central bank in March opened its emergency lending facilities to investment banks for the first time since the Great Depression to stem what officials felt was a threat of a full-scale financial market meltdown.

United States Treasury Secretary Henry Paulson
Lefteris Pitarakis
United States Treasury Secretary Henry Paulson

U.S. policy-makers, including Paulson, are now striving to put in place a new regulatory framework clarifying the ground rules for such an emergency backstop.

"We should quickly consider how to most appropriately give the Fed the authority to access necessary information from highly complex financial institutions and the responsibility to intervene in order to protect the system, so they can carry out the role our nation has come to expect -- stabilizing the overall system when it is threatened,'' Paulson said at a luncheon event.

While the Fed has regular facilities to make emergency loans to the commercial banks it regulates, its extension of credit to investment banks outside its formal purview was seen as a watershed event.

In addition to opening up a credit facility for so-called primary dealers, the U.S. central bank also helped broker a takeover of Bear Stearns by JPMorgan Chase and guaranteed a $29 billion loan to facilitate the deal.

The Fed's role in the Bear Stearns rescue was highly controversial.

It was credited with helping ward off a market meltdown, but it also heightened worry that investment banks would be less careful in taking risks because they would count on a bailout.

In an opinion piece in The Wall Street Journal on Thursday, U.S. Securities and Exchange Commission Chairman Christopher Cox said decisions need to be made about whether and how long to maintain the emergency Fed lending program, which is scheduled to expire in September.

By law, the Fed only lend to nondepository firms in ``unusual and exigent circumstances.'' ``In the long run, it will be up to Congress to make the fundamental policy choice of whether taxpayer-funded liquidity facilities should be made available to investment banks on a permanent basis,'' Cox said.

Paulson said it was vital that the Fed have authority to get any information it needs quickly from investment banks and that it was also important a view did not develop that the Fed would ride to the rescue of any troubled firm.

``We must limit the perception that some institutions are either too big or too interconnected to fail,'' Paulson said.

''If we are to do that credibly, we must address the reality that some are.'' New York Federal Reserve Bank President Timothy Geithner, who played a lead role in the Bear Stearns rescue, said June 9 the turmoil showed Wall Street's ability to innovate had outstripped its understanding of risk, and that reforms were needed.

``The most fundamental reform that is necessary is for all institutions that play a central role in money and funding markets -- including the major globally active banks and investment banks -- to operate under a unified framework that provides a stronger form of consolidated supervision, with appropriate requirements for capital and liquidity,'' he said.

Fed Vice Chairman Donald Kohn referred in May to the risk of heightened ``moral hazard'' resulting from the Bear Stearns rescue, and suggested that any investment bank that gets help from the Fed should expect extra regulatory scrutiny.

Treasury issued a ``blueprint'' in March for a proposed new regulatory system, and Paulson said Thursday that the Bear Stearns episode and the turmoil surrounding it ``placed in stark relief the outdated nature'' of the current regime.

``Whether it was (hedge fund) Long Term Capital Management in 1998 or Bear Stearns this year, our nation has come to expect the Federal Reserve to step in to avert events that pose unacceptable systemic risk,'' Paulson said.

``But ...the Fed has neither the clear statutory authority nor the mandate to anticipate and deal with risks across our entire financial system,'' he said.

Among other suggestions, Paulson called for tougher regulation of operating practices in over-the-counter derivatives markets and for a clarification of how to wind down a failing nondepository institution like an investment bank.