Market Will Break Up Big Banks, Not Fed: Bernanke

NEW YORK ( TheStreet) -- Calls to break up the big banks are on the rise, but Federal Reserve Chairman Ben Bernanke suggests just leaving it to market forces.

In Congressional testimony Thursday, Bernanke said that post-crisis regulations requiring large banks to hold higher capital and subject them to a greater supervision will "take away the advantage of size."

"Market forces themselves will make it attractive to downsize, rationalize and so on," said Bernanke.

Breaking up big banks remains in the forefront of regulatory debate nearly four years since the crisis, as investors and taxpayers worry about the fallout of the euro debt crisis on American banks in an interconnected world.

JPMorgan Chase's ( JPM) $2 billion trading loss has also lent fresh ammunition to those calling for banks to split up.

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The mechanics of doing so remain uncertain, however. Some have suggested bringing back Glass- Steagall Act, repealed under the Clinton Administration, which separated commercial banking operations from investment banking.

Other policymakers remain focused on size, pointing out that banks can expose taxpayers as much through faulty lending as they can through risky trades.

Still, there is no clear agreement on just how banks should be broken up.

"When people talk about breaking up banks, they are not specific," Bernanke noted. "Do they want them to be only slightly smaller, do they want to have a lot of community banks?"

The Chairman went on to add that the creation of the orderly liquidation authority under Dodd- Frank that gives the Federal Deposit Insurance Company the authority to wind down large insurance companies and securities firms along with banks when they fail was one step towards ending the notion of "too big to fail."

He also said that banks being asked to create "living wills" that spell out how they are to be wound up in the event of failure will also help provide more clarity on banks' complex structures. It could also be used to restructure banks.

"One approach would be to ask banks to simplify their structures to avoid these complex situations," Bernanke said.

Asked about JPMorgan's trading loss, the Chairman said that the regulator continued to investigate the issue. He said he agreed with Fed Governor Daniel Tarullo's recent comments that the Volcker rule might have helped flag JPMorgan's trades earlier.

>>JPMorgan Volcker Rule Debate is All Wrong: Analyst

"One requirement of the Volcker rule is that there be very extensive documentation provided in advance for complex hedging, as well as auditing and appropriate incentives for employees. If Volcker had been implemented, we would have known more," the Chairman said.

Bernanke acknowledged the difficulties in writing the Volcker rule, particularly in making distinctions between proprietary trading and market making and agreed that higher capital requirements were a more definitive answer to preventing banks from failing and dragging the system down with them.

"The reason for high capital requirements is because we are not going to be able to anticipate everything that is going to happen," said Bernanke.

Separately, Bernanke also addressed the issue of JPMorgan CEO Jamie Dimon's presence on board of the New York Fed, which has raised concerns about a conflict of interest in the wake of the bank's trading loss.

>>Jamie Dimon Should Resign From Fed Now: Readers Speak

Senator Bernie Sanders, an independent from Vermont, called it a case of the "Fox guarding the hen house" and said is looking at passing legislation that would remove bankers from the boards of regional reserve banks.

Bernanke noted that the government accountability report last year pointed out an "appearance of conflict" in the board's structure, but did not find any evidence of "actual" conflict of interest, as bankers on the board were not allowed to vote on supervisory matters.

Bernanke expressed a willingness to work with Congress on changing the structure.

"This is not something that the Fed created. It is in our statute. Congress set this up. But if congress wants to change it, we will work with you to find alternatives," the Chairman said.

On a more general note, the regulator said that American banks were well capitalized and that their exposures to Europe were manageable.

The Fed stood ready to provide liquidity to banks against collateral through its discount window in the event of deep financial stress, Bernanke said.

-- Written by Shanthi Bharatwaj in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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