Senators grill Fed’s Ben Bernanke over bank bailouts

At confirmation hearings for Fed Chairman Ben Bernanke Thursday, some senators decried bailouts of 'too big to fail' firms. Others said the economy would be in worse shape without the Fed’s actions.

At a Thursday hearing about his nomination for a second term as Federal Reserve Chairman, Ben Bernanke walked a careful line – defending his performance but also acknowledging mistakes and calling for regulatory reforms.

It appears likely that Mr. Bernanke's sales job will succeed and that he'll be confirmed to serve another four years starting 2010. Some senators said the economy would be in much worse shape without Bernanke's efforts over the past year.

Still, he faced heated questions from others. The contrasting views on the Bernanke Fed are like a Rorschach test on the financial crisis.

A focal point at the hearing was the challenge known as "too big to fail." The financial system nearly collapsed last fall when some of the world's biggest banks seemed to be at risk of a simultaneous meltdown, amid fears that a run on banks by investors was spreading. Bernanke and other policymakers decided that those firms were so important they could not be allowed to fail. But a long-known problem is that bailouts can breed "moral hazard," the risk that large banks will behave irresponsibly again, based on the expectation that bailouts will occur when needed.

Reinforced 'too big to fail'?

In response to a question Thursday, Bernanke said this is "perhaps the central issue in financial reform."

Yet Bernanke also supported last year's bailouts, which may represent a historic expansion of the "too big to fail" problem.

The nation's largest banks haven't become any smaller as a result of the crisis. Through mergers, in fact, some of the largest banks such as JPMorgan Chase and Bank of America are now even bigger. And the notion that they can get bailed out in a crisis has been reinforced.

Now, the Senate and House are considering legislation to revise the way banks are regulated. It's possible that the Fed will come out of the process with expanded power, despite what critics see as lax supervision of large banks before the crisis. It's unclear, moreover, whether the reforms will prevent bailouts the next time a credit boom goes bust.

"The only way to [solve 'too big to fail'] is to find a way to let those firms fail," Bernanke said.

He said legislation could achieve this end, by creating a resolution process for large institutions, much as the Federal Deposit Insurance Corp. now does with smaller banks that get into trouble.

Sometimes this FDIC process involves closing banks down in a controlled way or selling them to new owners after stripping out bad loans.

Bernanke said creditors and shareholders of large and complex firm could be forced to take losses under this new system, without disrupting the financial system.

However, some financial experts are skeptical that the legislation now under review will truly result in what Rep. Barney Frank (D) of Massachusetts has called "death panels" for large banks. They say the reform under consideration also leaves open the possibility that banks will expect bailouts again in the future.

Concern about bailouts

A range of lawmakers raised concerns about bailouts at the hearings.

"Many of the Fed's responses [to the crisis] greatly amplified the problem of moral hazard stemming from too big to fail treatment of large financial institutions," Sen. Richard Shelby (R) of Alabama said. "Taxpayers simply should not be subjected to possible losses from private risks."

Bernanke "could have broken up too-big-to-fail financial institutions that took Federal Reserve assistance, but he did not," Sen. Bernie Sanders, a Vermont independent, said in a statement of opposition to Bernanke released before the hearing.

Sen. Jim Bunning (R) of Kentucky accused the Fed of being willing to prop up banks for as long as they want, raising the risk that unhealthy banks will exist as “zombies,” or functioning banks that are not making many loans.

"You are the definition of a moral hazard," he said to Bernanke. "I will do everything I can to stop your nomination."

Most senators don’t appear to be in that camp. Sen. Christopher Dodd (D) of Connecticut was among those who expressed support for Bernanke during the hearing.

So which is the accurate view of the Bernanke Fed, the dark or light one? With the economy still digging out from the crisis, that debate will probably go on for a long time.

Asked to grade himself during the hearing, Bernanke allowed room for improvement. But he vigorously defended the efforts to avoid the disorderly bankruptcy of large firms such as insurer AIG.

Without that action, "we could very well be in a depression-like situation," he said, with a much higher unemployment rate.

See also:

Ben Bernanke and Fed in crosshairs of left and right

JPMorgan earnings show 'too big to fail' banks getting bigger

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