June 17 (Bloomberg) -- The Obama administration plans to restrict the Federal Reserve’s emergency-lending powers while endowing it with authority overseeing systemic risk, ushering in what may become the Fed’s biggest overhaul in decades.

President Barack Obama’s proposal on financial regulation would force the central bank to get written approval from the Treasury before it extends emergency funding, according to the plan released in Washington today. Obama also calls for a study of the Fed’s governance structure, including how it regulates financial firms.

The move is part of an effort that would alter almost every facet of federal rules for the industry, aiming to prevent the regulatory lapses and risk build-up that led to the worst crisis since the Great Depression. Much of the plan will require approval in Congress, where jurisdictional battles and ideological clashes may delay and alter the legislation. Obama aims to sign a bill by the end of the year.

“We have to have somebody who is responsible for seeing the risks of the system as a whole and not just individual institutions,” Obama said yesterday in an interview with Bloomberg News, referring to making the Fed the systemic risk regulator. “The Fed is best positioned to do that.”

Christina Romer, head of the White House’s Council of Economic Advisers, said the restriction on the Fed’s emergency lending power is formalizing an arrangement that has existed throughout the current financial rescue.

Taxpayer Risk

“One of the things we know, when the Fed does take some of these unusual actions, they are perhaps taking on more risk, putting taxpayer dollars on the line and it’s appropriate that elected officials have a role in those decisions,” she said today in an interview with Bloomberg Television.

The so-called White Paper encompasses areas ranging from derivatives to executive pay to the mortgage-backed securities that helped fuel the housing boom and touch off the credit crisis. It also requests federal oversight for the first time for hedge and private equity funds.

A Consumer Financial Protection Agency would oversee products from mortgages to credit cards, taking some of the Fed’s current duties. It would have power to ban “unfair terms and practices,” punish companies for violations with fines and penalties and write rules to set higher standards for banks and non-bank companies, according to the White Paper.

Thrift Regulator

A new regulator would supervise federally chartered banks, eliminating the Office of Thrift Supervision and the thrift charter in the process, the document said.

The agency will assume the responsibilities of the OTS and Office of the Comptroller of the Currency and be known as the National Bank Supervisor.

“In some cases, we’re expanding modestly the Fed’s powers,” Obama said yesterday. “In other circumstances, we’re actually going to relieve them of some responsibilities, for example, on the consumer side.”

The central bank will be given a new role overseeing all financial firms deemed too big to fail, an effort that aims to eliminate gaps in oversight that contributed to the collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc. last year. The proposal would incorporate large non-banks, such as insurers or hedge funds, whose interconnections in the financial industry mean their failure would endanger the system.

“These firms should not be able to escape oversight of their risky activities by manipulating their legal structure,” the White Paper said. Through higher capital requirements and stronger regulatory scrutiny “our proposals would compel these firms to internalize the costs they could impose on society in the event of failure.”

Fed Structure Review

The Fed will undertake a new study of its structure under the administration’s plan. The Treasury and outside experts “should have substantial input into the review and the resulting report” on the Fed’s governance study, according to the paper. The Treasury can propose changes to the central bank’s structure “to improve its accountability and its capacity to achieve its statutory responsibilities.”

Obama said his overhaul is needed to restore confidence in U.S. markets. “We now need some sensible rules of the road so that people aren’t taking exorbitant risks,” he said.

The revamp comes on the heels of the credit crisis, the collapse of major Wall Street firms and the government’s $700 billion bailout for the banking, auto and insurance industries.

“While this crisis has had many causes, it is clear now that the government could have done more to prevent many of these problems from growing out of control and threatening the stability of the financial system,” the White Paper said.

Hedge Funds

Investment banks “operated with insufficient government oversight” while hedge funds exist “completely outside of the supervisory framework,” according to the paper.

The administration is seeking to require firms that pose the biggest risk to the financial system hold extra capital. It proposes those levels should be determined by Dec. 31. It asks for a committee, led by the Treasury, to do a “fundamental reassessment” of how banks are supervised by Oct. 1.

The administration called for a national insurance office within the Treasury to gather information about the industry and try to identify gaps in regulation that “could contribute to a future crisis,” according to the plan.

The office will also make recommendations to the Fed on whether it should regulate individual insurance companies as systemically important, subjecting them to capital and leverage requirements.

AIG Rescues

The proposal follows multiple government bailouts of American International Group Inc., once the world’s largest insurer before losses on derivative contracts put the company on the brink of collapse. It stops short of recommending federal regulation of insurance companies, which are overseen by states.

Additional insurance oversight may be considered if it would “further reduce systemic risk,” according to the paper.

The administration plans to offer recommendations on housing-finance companies Fannie Mae and Freddie Mac, which were effectively seized by the government last year, by the time the 2011 federal budget is released.

“We need to maintain the continued stability and strength” of the companies “during these difficult financial times,” the paper said.

The Obama proposal calls on the Securities and Exchange Commission to make brokerage firms that provide investment advice fiduciaries to their clients. Such a standard, which already applies to money managers, would require brokers to put their customers’ interests above the firm’s in securities transactions.

Obama would tie compensation for market participants who securitize loans to the performance of the assets over time, according to the document. The pay for brokers, underwriters and others who package mortgages into bonds “should be linked to the longer-term performance of the securitized assets, rather than only to the production, creation or inception of those products,” the paper said.

To contact the reporters on this story: Robert Schmidt in Washington at rschmidt5@bloomberg.net; Jesse Westbrook in Washington at jwestbrook1@bloomberg.net.

Last Updated: June 17, 2009 13:56 EDT