WASHINGTON, Feb 26 (Reuters) - Below are highlights from the question and answer session of a Senate Banking Committee hearing on Tuesday with Federal Reserve Chairman Ben Bernanke testifying on monetary policy and the U.S. economy. BERNANKE ON TOO-BIG-TO-FAIL BANKS, EXPECTATIONS FOR BAILOUT: "The subsidy is coming because of market expectations that the government would bail out these firms if they fail. Those expectations are incorrect." "That's the expectations of markets but that doesn't mean that we have to do it." "Over time you'll see increasing market expectations that these institutions can fail. I would make another prediction - and predictions are always dangerous - that the benefits of being large are going to decline over time." BERNANKE ON EQUITY BUBBLE AND MONETARY POLICY: "I don't see much evidence of an equity bubble...Equity holders are still being somewhat risk averse in their behavior. But again, we have a two-part plan. First is to monitor these different asset markets. The second is to try to understand what would be the implications if we are wrong. What would happen, who would be hurt, what would happen to financial institutions, would there be broad knock-on effects if in fact some particular asset turned out to be in a bubble. So we are trying to do both of those things." "We do not rule out that if these problems become sufficiently worrisome, that they would be taken into account in our monetary policy." BERNANKE ON 'TOO BIG TO JAIL': "No individual or institution should be exempt from paying for crimes that they have committed. We also agree (too big to fail) is something that needs to be addressed. Getting rid of too big to fail is an important objective and we are working in that direction." BERNANKE ON 'MUTUALLy BENEFICIAL' STIMULUS: "We don't view monetary policy aimed at domestic goals as being a currency war. It's not like putting tariffs on your imports so that you can beggar-thy-neighbor to the benefit of your domestic industry. That's not what we're doing. If all the major economies that need support provide stimulus and extra aggregate demand, that's mutually beneficial. Because for example China depends on the strength of Europe and the U.S. as their export market." "This is a positive sum game, not a zero sum game, that we have here." BERNANKE ON WEAK FOURTH-QUARTER GDP: "I think the fourth quarter was really a combination of transitory factors. I don't think it really signaled any real change in the pace of growth of the economy." "On the other hand, the pace of growth of the economy remains around 2 percent, which is positive, but it's not as strong as we would like." BERNANKE ON CREDIT MARKETS AND LOW RATES: "Credit markets are more open today, banks are lending more today. And so in some sense, the low interest rates can pass through more easily today than they could have a couple of years ago." BERNANKE ON UNWINDING BALANCE SHEET: "We don't anticipate having to do that (liquiditate a big portion of the Fed's holdings)." "We could exit without ever selling, by letting it run off and we could tighten policy by raising (the) interest rates that we pay on reserves. That would be one strategy, for example. At any case, we have said we will sell slowly with lots of notice and we will, of course, be offering our forward guidance about rates so that there will not be a shift in rate expectations on the part of the market." "There is no risk-free approach to this situation. The risk of not doing anything is severe as well. So, we are trying to balance these things as best we can." BERNANKE ON BEING A 'DOVE' "You called me a dove. Well maybe in some respects I am, but on the other hand my inflation record is the best of any Federal Reserve chairman in the post-war period. Or at least one of the best, about 2 percent average inflation." BERNANKE ON PAYING INTEREST ON EXCESS RESERVES DURING EXIT: "We'll be paying market rates. We'll be paying exactly what they could be getting in the repo market, in the commercial paper market, anywhere else. There's no subsidy involved." BERNANKE ON ITALIAN DEBT: "The market is reacting first and foremost to uncertainty. It doesn't know which way the Italian government will go and how those policies will effected. I'm not an expert in Italian politics, but I don't think that any of the candidates have outright rejected either staying in the euro or maintaining the policies that are being required of Italy in order to continue to be in the euro zone But again there is a lot of uncertainty there, and see what happens. Italy is unusual in that its currency deficits are not very large but it has a very large outstanding debt, and so there's a lot of Italian debt held around the world." "Our assessments going back of, say, our banking exposure to Italian and Spanish debt is that it's moderate, that it would be meaningful, but that it would not in itself - a writedown for example, which again I am not forecasting in any way - would not inflict serious damage on our financial institutions." BERNANKE ON CURRENCY WARS: "We are not engaged in a currency war, we are not targeting our currency. The G7 put out a statement which is very clear that it's entirely appropriate for countries to use monetary policy to address their domestic objectives, in our case employment and price stability. Our position is that our expansionary monetary policies, which are being replicated in other industrial countries, are increasing demand globally and helping not only our businesses, but also businesses in other countries that export to us. So its not a beggar thy neighbor policy." BERNANKE ON BASEL 3: "We are planning to have a final rule out on Basel 3, I can't give you the exact date, but somewhere in the middle of this year. We aim to be getting the implementation of Basel 3 during 2013...As far as we can tell through our stress tests and other measures, virtually all of our banks are already well on track to meet the Basle 3 requirements. So it's not a question of banks not being adequately capitalized. They already either at, or about to reach, the Basel 3 capital levels." BERNANKE ON SEQUESTRATION IMPACT: "The six-tenths on GDP growth in 2013 is a CBO number, and we get very similar results to that. I think that's a reasonable estimate." "In terms of the impact, the sequestration takes place over time, furloughs take place over time, spending cuts take place over time, so I wouldn't expect to see a big impact immediately. I think it would probably build over a period of months." BERNANKE ON FISCAL, MONETARY POLICIES AT 'CROSS PURPOSES': "Monetary policy is no panacea, it's not a cure all... We can all disagree on how powerful these measures are, and I do think they are effective, but I don't think they can offset the one-and-a-half percentage points of fiscal restraint that we're seeing this year." "In terms of the near-term recovery, there is a sense in which monetary and fiscal policy are working at cross purposes... To some extent, the fiscal policy decisions being made are mismatched with the timing of the problem. The problem is a longer-term problem, and should be addressed over a longer time frame in a way that, to the extent possible ... it does no harm to the ongoing recovery." BERNANKE ON EFFECT OF PROLONGED EUROPEAN RECESSION ON U.S.: "The risks that we've been facing for the last couple of years have been primarily financial given uncertainties about the stability of certain countries' sovereign debt. Given the risks on this behavior, we've been seeing the financial markets (lose) as news comes in about financial developments. The European central bank has taken a number of important steps, including most recently the outright monetary transactions which have help to bring down the sovereign debt yields." BERNANKE ON JAPAN'S ECONOMIC POLICY: "I think they should try to get rid of deflation. I support their attempts to get rid of deflation." BERNANKE ON DEFLATION RISK: "With inflation at or below our 2-percent target, our policies have also had the effect of greatly reducing any risk of deflation, which at the moment doesn't seem like much of a concern, but at certain times, as inflation gets close to the zero critical level, that risk increases and keeping inflation from going too low -- I realize sometimes it's hard to explain to people why inflation that's too low is a problem -- but if it's too low, you run the risk of a Japanese-style situation, where prolonged deflation is a barrier to economic growth and stability."