April 16 (Bloomberg) -- As a result of the Bear Stearns Cos. debacle, Federal Reserve examiners now are operating inside the nation's biggest investment banks, and by all accounts the banks are happy to have them looking over their shoulders.

In a world of tight liquidity and shaken confidence, the Fed presence gives valuable reassurance to counterparties that the investment banks, at least the ones that are primary dealers in government securities, are creditworthy.

Of course, the reason the examiners are there is that these firms, like deposit-taking banks eligible for Fed discount window loans, can now borrow directly from the central bank.

But the Primary Dealer Credit Facility set up March 16 was created under a provision of the Federal Reserve Act applicable only in an emergency. Eventually, the crisis will pass, and when it's over, ``we will have to take this window back,'' Fed Chairman Ben S. Bernanke told a Senate Banking Committee hearing on April 3.

Congress ought not to let that happen.

It's going to be quite some time before credit conditions are normalized, which means there is time for Congress to consider what the Fed chairman called the ``very weighty issues'' involved.

Nevertheless, the Bear Stearns episode made a number of things clear.

Last Resort

First, the major investment banks have become much too important in the financial system not to have access to the Fed in its role as a lender of last resort.

Second, the Securities and Exchange Commission, the investment banks' primary regulator, simply doesn't have the expertise to oversee the banks' financial activities and their safety and soundness.

At the same April 3 hearing, Timothy Geithner, president of the New York Federal Reserve Bank, said that at the SEC's invitation, the Fed has people at the investment banks ``looking carefully at their funding and how they're managing their funding, how they're going to position themselves to be stronger to withstand'' the pressures from financial turmoil.

And the Fed is leaning on them ``to make sure that institutions take steps to strengthen their capital positions, so they're better positioned to manage through this crisis,'' he said.

This intensive scrutiny is a form of ad hoc though necessary regulation, and it's fortunate there was something on the books that allowed the Fed to act.

Former Fed Chairman Paul A. Volcker, in an April 8 speech, said the actions extended ``to the very edge of its lawful and implied powers, transcending certain long-embedded central banking principles and practices.''

Authority Needed

Many commentators saw that comment as a criticism of Bernanke. It wasn't. Volcker at no point suggested the Fed's involvement in the Bear Stearns purchase by JPMorgan Chase & Co. or lending to investment banks was a mistake.

Instead, Volcker said that lending to the investment banks means that ``a direct responsibility for oversight and regulation follows. I do not see how that responsibility can be turned on only at times of turmoil -- in effect when the horse has left the barn.''

Exactly, and that's why Congress has to act promptly.

Lacking that oversight responsibility, the New York Fed 16 years ago dropped its surveillance of primary dealers that had been focused mostly on whether they met required capital standards. The dealer surveillance plan included regular on-site inspections to check compliance.

No Panacea

The surveillance led the public to believe the Fed was regulating the dealers, which it didn't have the authority to do. Rather than seek such authority, in January 1992 the New York Fed announced it was stopping the visits.

It's a pity the Fed didn't have such authority in recent years as the role of investment banks as credit providers and dealers in esoteric financial instruments burgeoned. For instance, Bear Stearns had many thousands of counterparties in deals involving over-the-counter derivatives when it got into trouble.

Giving the Fed authority to oversee investment banks is no panacea. It already has such power over bank holding companies and that did little to rein in the widespread use of SIVs -- structured investment vehicles -- and conduits that were set up to handle highly leveraged, off-balance-sheet activities that have produced tens of billions in losses for commercial banks.

Still, the Fed is better suited for the job than the SEC. Congress should make sure the central bank has the necessary powers over investment banks before the current emergency is over.

(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: April 16, 2008 00:01 EDT