Oct. 23 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke called on Congress to ensure that the costs of closing down large financial institutions are borne by the industry instead of taxpayers.

The Fed chairman called for a “credible process” for imposing losses on the shareholders and creditors, saying “any resolution costs incurred by the government should be paid through an assessment on the financial industry.”

Bernanke’s remarks coincide with central bank efforts to step up supervision of banks and crack down on compensation practices that fuel excessive risk-taking. As Congress considers the biggest overhaul of financial regulation since the 1930s, Bernanke said it’s “critical” for lawmakers to close regulatory gaps and provide supervisors with the tools to manage risks throughout the financial system.

Bernanke said all large, inter-connected firms, whether they’re banks or not, should be subject to “consolidated supervision” that requires “tougher” capital, liquidity and risk management practices. He didn’t say the Fed should have the main responsibility for that supervision.

The Fed yesterday proposed new guidelines on pay practices at banks and said it will launch a review of the 28 largest firms to ensure compensation packages don’t create incentives for the kinds of risky investments blamed for the financial crisis.

Pay Cuts

The plan followed an Obama administration call for pay cuts of an average of 50 percent and caps on benefits for top executives at seven companies, including Citigroup Inc. and Bank of America Corp., that received billions of dollars in taxpayer- funded bailouts.

Bernanke didn’t comment on the economic outlook or the path of interest rates in his prepared remarks.

The yield on the two-year Treasury note was up five basis points to 0.98 percent at 1:59 p.m. in New York after Federal Reserve Bank of Philadelphia President Charles Plosser yesterday told Bloomberg Radio his “instinct is the time for raising rates will be before many of my colleagues” think it is.

The Federal Open Market Committee next meets in Washington Nov. 3-4. Officials said at their last meeting that the economy had “picked up,” while maintaining their pledge to keep the target interest rate exceptionally low for an “extended period.”

Revamping Inspections

U.S. central bankers are revamping bank inspections, comparing analysis of individual firms with macroeconomic models run by quantitative research teams.

The Fed expanded the scope of its supervision during the crisis by allowing Goldman Sachs Group Inc. and Morgan Stanley to become bank holding companies and by deciding to intensify scrutiny of non-bank subsidiaries within large financial organizations.

Supervisors are also reviewing the capital structure of banks, and Bernanke said he supported international efforts to make banks boost their equity in times of prosperity.

“Countercyclical standards would require firms to build larger capital buffers in good times and allow them to be drawn down -- but not below prudent levels -- during more-stressed periods,” Bernanke said.

The Fed chairman said regulators are also considering a capital tax or “surcharge” for the largest, most inter- connected firms whose failure would disrupt financial stability. Other options include requiring those firms to issue debt-like securities that convert to equity in times of stress.

Open to Debate

Bernanke, replying to a question by former U.K. central banker John Gieve, said he is open to the debate on whether regulators would restrict the size and scope of the biggest institutions.

“My own initial take on this is that we can address these issues in a way that doesn’t destroy the economic value of large, complex, multifunction firms,” Bernanke said.

The government could design “tough” resolution regimes and “living wills” that state beforehand how large firms would be unwound, and apply “appropriate” capital requirements for trading, he said.

Risk Management

“We should leave open the possibility that if a supervisor decides that a particular firm does not have the managerial risk-management capacity to deal with a particular type of business -- putting aside any capital requirements -- there should be the ability to say you can’t do this activity,” Bernanke said.

Bank of England Governor Mervyn King suggested on Oct. 20 it might be valuable to separate banking from riskier activities in financial institutions. King said it’s “hard to see why” such proposals are “impractical.”

In a separate speech at the same conference today, Fed Vice Chairman Donald Kohn said there is no consensus yet on how to avoid international spillovers from the resolution of large financial institutions. Among the “promising proposals” supervisors could consider are changes “to simplify the organizational structures of systemically important firms.”

Kohn said if the Fed is given the responsibility for financial stability, it also needs tools to do the job, such as broader authority over the U.S. payments system.

Federal Reserve Act

“I would be very concerned about putting a remit in the Federal Reserve Act if we weren’t given the tools and authority to carry it out,” Kohn said in response to a question.

Bernanke this month told lawmakers the Fed should be the regulator for systemically important non-bank companies, backing the Obama administration’s proposed regulatory changes.

The Fed’s supervision expertise make it “well suited” to regulate the biggest non-bank financial companies that weren’t bank holding companies under its umbrella, he said in Oct. 1 remarks to the House Financial Services Committee.

Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, and Richard Shelby, the panel’s senior Republican, both oppose the Obama administration’s plan to expand the Fed’s oversight to include systemically important financial firms. Dodd plans to propose combining the Fed and other banking regulators into one agency.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Scott Lanman in Chatham, Massachusetts, at slanman@bloomberg.net.

Last Updated: October 23, 2009 14:09 EDT