Aug. 28 (Bloomberg) -- The year-old crisis triggered by the subprime mortgage debacle has uncovered so many weaknesses in the U.S. financial system that it's going to be like cleaning the Augean stables to fix them.

Using both brawn and cleverness, Hercules managed that task in a single day. It's more likely to take years to repair all the weaknesses in the U.S. system, if indeed it turns out to be politically feasible.

A large number of interrelated steps are needed to reduce systemic risk -- that is, the types of failures of institutions or procedures that might cause the entire system to crash. Such a calamity was narrowly avoided in March when the Federal Reserve took some extraordinary actions to prevent the abrupt failure of Bear Stearns Cos.

In a nutshell, those steps will involve limiting risks undertaken by financial institutions. Much of what's needed is likely to meet strong resistance because those limits might prevent a return to the high level of profitability that prevailed before so many people and institutions overreached and created the mess we are in today.

``The full implications of coming constraints on leverage, risk taking, and returns for financial institutions have yet to be understood'' by investors, economist Richard Berner of Morgan Stanley told clients on Aug. 25.

Nevertheless, the costs of the unbridled risk taking and lack of close supervision of parts of the financial system are too great to be continued.

Avoiding Regulation

In the past, financial companies and their lobbying groups, which are major sources of contributions to politicians, have for the most part been able to ward off the kind of tight regulation now in the offing. Even with all that's gone wrong, they might be able to do it again.

In an Aug. 22 speech, Federal Reserve Chairman Ben S. Bernanke laid out some of the issues that will be part of ``the coming national debate on the future of the financial system and financial regulation.''

The scope of what that debate is going to involve is daunting.

The Bear Stearns case highlighted the fact there is no ``clear statutory framework'' for dealing with the failure of an institution that might pose a substantial systemic risk, Bernanke said. Obviously a normal, protracted bankruptcy process doesn't work.

The Fed facilitated the acquisition of Bear Stearns by JPMorgan Chase & Co. using the unprecedented step of taking $29 billion of Bear Stearns's assets onto its own balance sheet. Since that potentially put taxpayer money at risk, Bernanke suggested legislation be passed giving the Treasury Department the responsibility and the resources to act in such a case.

New Tools

To make sure other investment banks don't get caught in a liquidity squeeze as Bear Stearns did, the Fed created a new facility to allow primary dealers -- those firms that trade directly with the Fed as it aims to meet its overnight lending rate target -- to borrow money from the central bank. It relied on a Depression-era law authorizing lending to firms outside the banking industry under ``unusual and exigent circumstances'' -- a condition met by the subprime crisis.

But Bernanke and other Fed officials believe Congress needs to amend the Federal Reserve Act to explicitly authorize such lending. The officials also say that if the Fed is going to lend to investment banks, it must have legal authority to regulate and supervise them, just as it or other federal regulators do banks and thrift institutions.

Right now the Fed has examiners at the investment banks under a memorandum of understanding with the Securities and Exchange Commission, which has the authority to supervise some of their activities. The SEC, though, has never really regulated the amount of risk they incur or the degree of leverage in their investments.

No Choice

With the proper authority, the Fed would do that -- and, in the process, limit the industry's profitability. It would have no choice because as the U.S. financial system has evolved, some of these institutions have become ``too big to fail,'' a policy that puts taxpayer money on the line to prevent a bank's collapse. As with Bear Stearns, a failure would pose a risk to the entire financial system and to the U.S. economy.

Effective government oversight would seek to ensure that securities firms ``maintain adequate buffers of capital and liquidity and develop comprehensive approaches to risk and liquidity management,'' Bernanke said in his speech.

Management Failure

As is now obvious, top executives of some large investment banks failed miserably in managing risks and liquidity and had too little capital given the level of risk they accepted.

The Fed chairman touched on several other issues that might involve additional legislative action, including a need to reexamine capital regulations, provisioning for possible losses and rules that may lead institutions to collectively over-expand credit.

The current crisis has revealed a host of problems in the country's financial structure, the management of financial institutions and their regulation and supervision. The Fed is trying to mitigate the crisis and look ahead in a comprehensive way to make the system less vulnerable in the future.

The president and Congress should do their part to make that happen beginning early next year.

(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net

Last Updated: August 28, 2008 00:01 EDT