U.S. needs financial regulatory overhaul: officials

WASHINGTON (Reuters) - Policy-makers said on Thursday they were doing everything possible to restore calm to financial markets, but stressed to lawmakers that a longer-term regulatory overhaul was vital to avert future crises.

Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson told Congress they agreed the Fed needs a stronger hand in supervising investment banks to help shield the broader economy from problems like the ones that forced the emergency rescue of investment bank Bear Stearns.

"The Bear Stearns episode and market turmoil more generally have placed in stark relief the outdated nature of our financial regulatory system, and has convinced me that we must move much more quickly to update our regulatory structure and improve both market oversight and market discipline," Paulson told Congress.

"We should consider how to most appropriately give the Federal Reserve the authority to access necessary information from complex financial institutions ... and the tools to intervene to mitigate systemic risk in advance of a crisis," he said.

Bernanke, in testimony before the same House Financial Services hearing, said authorities were doing everything possible within their existing authority to settle markets roiled by a credit crunch.

NEED TOUGHER SCRUTINY

But he said stricter oversight was needed to supervise large investment banks and primary dealers that trade securities directly with the Fed, in light of the disruptions that have battered the U.S. economy.

"Cooperation between the Fed and the SEC (Securities and Exchange Commission) is taking place within the existing statutory framework with the objective of addressing the near-term situation," Bernanke said in comments that echoed a speech he gave on Tuesday.

"In the longer term, however, legislation may be needed to provide a more robust framework for the prudential supervision of investment banks and other large securities dealers," he said.

Bernanke added that regulatory standards for capital and risk should reflect the differences between investment banks and commercial banks.

Both policy-makers agreed that, with presidential elections on the horizon, it was unlikely that regulatory reforms could be pushed through this year. But they vowed to continue looking for solutions to restore market stability.

CAN HANDLE CRISIS

The officials said they could not rule out a further financial crisis, but could deal with one with existing tools. Paulson said regulators should get emergency authority to step in to limit temporary disruptions to financial markets.

But the bar for using such power should be high, he said.

"Any potential commitment of government support should be an extraordinary event that requires the engagement of the Treasury Department and contains sufficient criteria to prevent costs to the taxpayer to the greatest extent possible," he added.

Bernanke said the Fed's decision to extend short-term credit to investment banks and primary dealers through its discount lending window facility has eased risks of another run on an institution of the type that brought down Bear Stearns.

"At some point we would have to phase it out when we felt that the system had sufficiently recovered," he said.

Paulson also said that Fannie Mae and Freddie Mac -- the nation's top providers of housing finance, which have faced tough scrutiny amid the subprime mortgage lending crisis -- play a vital role and should continue to do so.

The stock prices of the two government-sponsored mortgage finance enterprises have been pummeled because of speculation they face financial difficulties, and could even be in need of a government bailout.

"Their regulator has made clear that they are adequately capitalized," Paulson said.

Separately, the presumptive Republican nominee for president, Sen. John McCain, said the government could not allow Fannie Mae and Freddie Mac to fail in a crisis.

Paulson, in discussing regulatory reforms and the need to overhaul the financial regulatory system, argued that it was vital to maintain market discipline as a guiding force.

"Regulation alone cannot eliminate all future bouts of instability," Paulson said. He added that market participants should not count on getting lending from the Fed or any other government support easily.

"For market discipline to effectively constrain risk, financial institutions must be allowed to fail," Paulson said.

(Additional reporting by Emily Kaiser, Patrick Rucker, Doug Palmer, Joanne Morrison, and Karey Wutkowski; Editing by Jan Paschal)