By Tom Polansek
CHICAGO (Reuters) - Federal Reserve Chairman Ben Bernanke said on Friday that the shadow banking system still posed a threat to financial stability, and funding markets might still not be able to cope with a major default.
In a wide-ranging speech explaining the Fed's role in monitoring the health of the banking system, Bernanke also laid out how the central bank was looking at asset markets closely for signs of excessive risk taking.
"While the shadow banking sector is smaller today than before the crisis...regulators and the private sector need to address remaining vulnerabilities," Bernanke said at a banking conference sponsored by the Chicago Federal Reserve Bank.
The 2007-09 credit meltdown, and the collapse of investment bank Lehman Brothers, brought to light a group of firms and funding vehicles known together as shadow banks that were poorly regulated but harbored large risk.
The highest grouping of U.S. financial regulators, the powerful Financial Stability Oversight Council, which is chaired by Treasury Secretary Jack Lew, last month also warned that runs on shadow banks were still possible.
Asked about the issue of too-big-to-fail banks, Bernanke said regulators should tell banks to hold more equity if they decide that current rules do not do enough, rather than impose an arbitrary limit on size.
"Because that makes them safer, but also because it reduces or eliminates their funding advantage and gives them an incentive to reduce or simplify their firms," Bernanke said.
Calls to cut the size of big banks, which are perceived to rely on taxpayer bailouts no matter how risky their business conduct, are on the rise in Washington, but Bernanke said current global capital rules needed to be put in place first.
Fed Governor Daniel Tarullo, the central bank's main spokesman for supervision, last week said that the leverage ratio, a cap on how much banks can borrow that is part of the global Basel III capital accord, might need to be tougher.
Tarullo also said that big banks could be told to raise more hybrid debt, which converts into equity in case of financial stress, and that they could get a capital bonus if they funded their business with less-risky instruments.
He has also proposed a rule that would force foreign banks operating in the United States to hold more capital here, a measure that has invoked the wrath of the European Union and led to a flurry of critical letters from banks.
The Fed chairman said more work was needed to ensure the repo market - the wholesale market banks use for their everyday funding needs - could deal with the potential consequences of a default by a large borrower or a broker-dealer.
A run on money market funds also remained a possibility, Bernanke said.
He did not address the outlook for monetary policy or the economy, but he did say that the Fed was monitoring a wide range of asset markets for signs investors were "reaching for yield" in a way that might pose risks to the financial system, given that interest rates were so low.
(Writing by Douwe Miedema Additional reporting by Jason Lange and Tim Ahmann; Editing by Andrea Ricci)