The Federal Reserve is identifying risks in the financial system that could someday erupt into a new financial crisis, but regulators must be careful not to unintentionally hamper lending as they set up new oversight, according to Chairman Ben Bernanke.   “We want the system to be as strong and resilient as possible,” and more intense oversight and changes such as requiring banks to hold more capital will help, said Bernanke at the Federal Reserve Bank of Chicago’s Bank Structure & Competition conference.  “If we can’t arrest risks, we want to make sure the financial system is defending itself,” he said.  The Dodd Frank Act establishes governmental structures to analyze risk aimed at preventing another financial failure as harsh as the one that almost brought down the world’s economy in the fall of 2008.

Through the Financial Stability Oversight Council and within the Fed, regulators are still analyzing what can cause “systemic risk,” – identified as risk that can cause widespread financial failure, Bernanke said.  Similar actions are underway in other nations; Bernanke said that regulators worldwide are communicating with each other while implementing their own systems.  If the new structures had been in place previously, Bernanke said, the 2008 financial crisis likely would not have happened. The old system of regulation spread authority across too many entities, was poorly coordinated, and problems “fell through the cracks.”  As the Federal Reserve develops a structure for analyzing risk, Bernanke said the focus must go beyond “fighting the last war.”  Future financial threats may differ from those of the past, which is why the banking industry currently is facing new oversight.  When some banks announced plans to pay shareholders dividends, regulators applied “stress tests” to their finances to determine if the institutions would be sound even if the economy weakened.  According to Bernanke, the government’s new stress testing system has provided accurate assessments of bank finances.

Even so, the regulations – the first new ones in 70 years — will be written to encourage bank compliance.  “No one’s interests are served by the imposition of ineffective or burdensome rules that lead to excessive increases in costs or unnecessary restrictions in the supply of credit,” Bernanke said.  “Regulators must aim to avoid stifling reasonable risk-taking and innovation in financial markets, as these factors play an important role in fostering broader productivity gains, economic growth, and job creation.”

Bernanke and Fed officials are trying to balance the need to diminish the risk of another financial crisis with the aim of stimulating the economy after the worst recession since the Great Depression. The Dodd-Frank Act gives the Fed the job of overseeing the biggest financial companies.  “While a great deal has been accomplished since the act was passed less than a year ago, much work remains to better understand sources of systemic risk, to develop improved monitoring tools, and to evaluate and implement policy instruments to reduce macro-prudential risks,” Bernanke said.

Lawmakers who solidly opposed the financial overhaul legislation, say Dodd-Frank goes too far and might make it more difficult for American banks to compete globally.  Some are working to cut funding for agencies established by the law and limit the scope of new rules.  According to the General Accounting Office, the law will cost nearly $1 billion to implement in 2011.

Additionally, Bernanke cited the sovereign-debt concerns in Europe as an example where the analysis led to the May 2010 decision by the Federal Open Market Committee to authorize “dollar liquidity swap lines with other central banks in a pre-emptive move to avert a further deterioration in liquidity conditions.”

To listen to our podcast on financial reform with Anthony Downs of The Brookings Institution, click here.