WASHINGTON — Big Wall Street investment firms should be subject to greater regulatory oversight because any severe problems they might encounter can raise dangers to the entire financial system, the Federal Reserve's No. 2 official said Thursday.
"We must worry about excessive leverage and susceptibility to runs not only at banks but also at securities firms," Donald Kohn, vice chairman of the central bank, said in remarks to a credit forum in Charlotte, N.C.
After the crash of Bear Stearns, the nation's fifth-largest investment bank, fears grew that others might be in jeopardy given major stresses in credit and financial markets.
Scrambling to avert a market meltdown, the Fed — in the broadest use of its lending authority since the 1930s — agreed last month to temporarily let investment firms obtain emergency financing from the Fed, a privilege that previously had been granted only to commercial banks.
By doing this, the Fed became a lender of last resort to investment firms. The program, which started on March 17, has generated a debate about whether investment firms should be subject to the type of supervision applied to commercial banks. It also has spurred debate over whether the emergency lending program for investment banks should be made permanent.
"Whatever type of backstop is put in place, in my view greater regulatory attention will need to be devoted to the liquidity risk-management policies and practices of major investment banks," Kohn said. "In particular, these firms will need to have robust contingency plans for situations in which their access to short-term secured funding also becomes impaired."
Treasury Secretary Henry Paulson last month said investment firms should face stepped-up regulation if they use the Fed's emergency lending facility. However, he said it was too soon to determine whether the program should be made permanent.
Investment houses have key roles in the financial system. If one fails or is having difficulty, it could put the whole financial system in jeopardy. That's because they have complex relationships with many players in the system, including hedge funds, commercial banks and others.
Turmoil in financial markets, which erupted last August, has threatened to plunge the United States into a deep recession.