US financial model can be fixed, Bernanke says

“We do not have the luxury of waiting for markets to stabilize before we think about the future,” he said. “Indeed, many of the necessary changes that have been identified - including increasing transparency, improving risk management, and attaining better coordination among regulators - could provide important support to the process of normalizing our financial markets,” he said.

Bernanke spoke as finance ministers and central bank heads of the Group of Seven rich nations gathered for a Friday meeting in Washington, where they are expected to endorse steps to respond to a global crisis that was spurred by rising US mortgage defaults.

Bernanke, the head of the US central bank, acknowledged in response to questions that the economic crisis may be the most severe the United States has faced since the second World War.

At the same time, he said the current slowdown is nothing like the Great Depression of the 1930s, in part because the Fed has been far more proactive in its response.

Bernanke, whose academic studies focused on the Depression, said during that era the central bank allowed banks to fail, prices to fall and the money supply to contract, which contributed to the protracted slump.

“We now know the lessons from that,” he said. “We are certainly going to make sure that the financial system remains in good functioning order.”

Since the credit crunch emerged last year, the Fed has reacted both by cutting interest rates and offering ready sources of liquidity for financial institutions finding it progressively harder to obtain funding.

The Fed has slashed borrowing costs by 3 percentage points since September to 2.25% and has expanded its credit offerings to banks.

It has also dusted off powers not used since the Depression to provide liquidity to Wall Street firms outside the central bank's normal clientele.

But the Fed chairman said the US economy remains in a bind because as financial institutions respond to the crisis by shoring up their balance sheets and boosting capital, they are withdrawing from their regular function of extending credit, which dampens economic activity.

“The interests of the financial system, the individual firms, are in some sense opposed to the interests of the broader economy,” Bernanke said.

Failures in the so-called originate-to-distribute model of credit extension were the root of the current crisis, Bernanke said. In that model, one entity makes a loan to a borrower, assessing that individual's creditworthiness and ability to repay. The loan is then sold to an institution, which bundles it with other loans to create a security, which in turn is sold to investors.

But the originate-to-distribute system “broke down at a number of key points, including at the stages of underwriting, credit rating and investor due diligence,” he said. Financial institutions that had bought those securities did not have adequate risk management or liquidity plans in place.

“These problems notwithstanding, the originate-to-distribute model has proven effective in the past and with adequate repairs could be so again in the future,” Bernanke said.

The Fed chairman made no comment on the outlook for the US economy or interest rates. Bernanke told Congress last week that a recession is possible as the United States weathers a deep correction in the once-booming housing market and a credit crunch paralyzing credit markets. (Reuters)