Speaking before the Financial Crisis Inquiry Commission this morning in Washington, Federal Reserve chairman Ben Bernanke said if steps could have been taken three years ago to stop the bubble in the economy, which eventually lead to today’s recession, it would not have been a prudent decision to do so. “Even if monetary policy was not a principal cause of the housing bubble, some have argued that the Fed could have stopped the bubble at an earlier stage by more-aggressive interest rate increases,” he said. “For several reasons, this was not a practical policy option.” The bipartisan commission is investigating the root of the causes of the financial crisis and is expected to report its findings to Congress in December. In 2003 and onward, Bernanke said there was no clear consensus about whether the increases in house prices were worrisome. If the Federal Reserve raised interest rates in that time period, the economy would have felt several negative effects to other assets and sectors. “In this case, to significantly affect monthly payments and other measures of housing affordability, the FOMC likely would have had to increase interest rates quite sharply, at a time when the recovery was viewed as “jobless” and deflation was perceived as a threat,” the Fed chairman said. Bernanke said that strong supervision and regulation should be the first line of defense against potential threats to financial stability. The Federal Reserve’s supervisory capital assessment program (SCAP), or stress tests, showed many financial firm’s systems are not capable of providing timely, accurate information about bank exposures to counterparties. Too Big Too Fail “If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved,” Bernanke said. His speech indicated a theory that, in a tightened regulatory regime, it would be impossible for any firm to get so large that its failure would have catastrophic results on the economy. In practice, he said, initiatives under Basel reform to capital requirements will reduce any propensity for excessive risk taking. The regulator must also be resolved to take over and shut down the operations of any financial firm that fails to comply with Basel oversight “in a fashion that avoids disorderly liquidation while imposing losses on creditors and shareholders.” Under this regulatory umbrella, firms will naturally have less-complex corporate structures, with reduced vulnerable interconnections among other firms, making resolution simpler. Not Just Subprime “Although subprime mortgage losses were the most prominent trigger of the crisis, they were by no means the only one,” Bernanke said. Another huge contributor to the credit crises occurred in June 2007, he said. Syndicated lending between large corporate borrowers had previously moved from banks to special purpose vehicles that were funded themselves via collateralized loan obligations (CLOs). In June, that lending stopped as banks horded their credit to reduce risk. “As in the case of subprime mortgages, the perceived potential losses on leveraged loans in the late summer of 2007 were significant, although not large enough by themselves to threaten global financial stability,” he said. “But they damaged the confidence of short-term investors and, consequently, the functioning of money markets and the broader financial system. ” Write to Jacob Gaffney.