Ex-Fed chair: investment banks need stricter rules

Such a step is a "natural corollary" to the assistance the Federal Reserve has extended recently to Wall Street investment banks such as Bear Stearns, Volcker told Congress' Joint Economic Committee. The Fed's financial backing previously was only available to commercial banks.

Volcker's comments came a day after Federal Reserve Chairman Ben Bernanke said the credit crisis appears to be easing, in part due to the central bank's actions.

Sen. Charles Schumer, D-N.Y., however, said that an overhaul of the financial regulatory system is still needed, even if "things do not seem as bad as they were a month or so ago."

"We must figure out how to regulate the currently unregulated parts of financial markets," he said, citing credit default swaps, "a multi-trillion dollar industry almost completely outside the purview of regulators," as an example.

Broader regulation is justified, Volcker said, by extreme episodes of market turmoil that aren't properly anticipated by new, complex financial models.

A lesson of the current credit turmoil is that "mathematic modeling ... cannot easily take account of the human element of markets," he said.

The Securities and Exchange Commission monitors the financial stability of investment banks but has limited authority over them. On Capitol Hill, the agency has been characterized as nearsighted and criticized for not anticipating the near-meltdown of Bear Stearns.

Commercial banks are subject to a heavier regulatory regime than investment banks, said Alex Pollock, a fellow at the American Enterprise Institute, and are overseen by the Federal Deposit Insurance Corp., the Federal Reserve, and state regulatory agencies, among others. Regulators more closely examine the asset quality of commercial banks, he said.

Treasury Secretary Henry Paulson last month released a blueprint that would combine several overlapping regulators into three agencies and give the Federal Reserve more authority to monitor the stability of the broader financial system. Members of Congress have said that legislative action may have to wait until next year, however, and a new administration due to the complexity of the issue.

SEC Chairman Christopher Cox has said the SEC may require big investment banks to maintain larger cash cushions in times of market disruption.

Volcker, meanwhile, endorsed giving the Fed greater authority but warned against an excess of power that might threaten the agency's political independence.

That independence "is integral to (its) central responsibility ... for the conduct of monetary policy," he said.

At the height of the credit crunch in early March, the Federal Reserve provided a $29 billion loan to support JPMorgan Chase & Co.'s purchase of Bear Stearns, which had been the fifth-largest investment bank until its near-collapse.

Bernanke also decided that month to extend emergency loans to investment banks, the broadest use of the central bank's lending authority since the 1930s.

"When things are going well, no one wants to be regulated," Volcker said. "When things are going bad, everyone says to the regulator, Where were you?"