By Mark Felsenthal
WASHINGTON (Reuters) - Top U.S. central bankers on Wednesday fought back against a plan to strip the Fed of its oversight of smaller banks, saying the knowledge it gains from that role is vital to monetary policy.
Federal Reserve Chairman Ben Bernanke urged lawmakers to reconsider an element of a Senate regulatory overhaul bill that would shift supervision of thousands of banks to other regulators.
"The insights provided by our role in supervising a range of banks, including community banks, significantly increase our effectiveness in making monetary policy and fostering financial stability," he told the House of Representatives Financial Services Committee.
Former Fed Chairman Paul Volcker joined Bernanke in defending the Fed's role in supervising smaller firms.
"The Fed's regional roots would be weaker and a useful source of information lost," he said. Volcker is now an economic advisor to the Obama White House.
Lawmakers have heaped criticism on the institution for oversight lapses that contributed to the worst financial crisis in generations. Congressional proposals to overhaul financial supervision could redistribute regulatory powers among different regulatory agencies.
Senate Banking Committee Chairman Christopher Dodd, who has called the Fed's regulatory performance in the run-up to the crisis an "abysmal failure," proposed in November stripping the central bank of its bank oversight powers.
Revised legislation he unveiled on Monday would allow the Fed to oversee banks and important financial firms with assets greater than $50 billion.
However, the measure would pull the Fed out of supervision of more than 5,000 smaller bank holding companies and state-chartered banks, handing those responsibilities to the Federal Deposit Insurance Corp and the Office of the Comptroller of the Currency.
Bernanke argued that small banks provide the Fed with an important window into financial conditions throughout the nation's economy.
"We are quite concerned by proposals to make the Fed a regulator only of the biggest banks, making us essentially the 'too big to fail' regulator," he said in response to questions from lawmakers. "We want to have a connection to Main Street as well as to Wall Street."
The 11 regional Federal Reserve Banks outside Washington and New York would likely see their responsibilities shrink if the Fed system no longer oversees smaller banks.
Public resentment at the government's bailout of large financial institutions and anger over a deep recession have helped make regulatory reform a top priority for the Obama administration and lawmakers in a mid-term election year.
At Tuesday's hearing, a woman held up a sign reading "Break Up the Banks" when Bernanke began his testimony. She left the room when asked to do so by lawmakers.
Passage of financial reform legislation is uncertain in the Senate, where many Republicans remain opposed to the measure Dodd has unveiled.
The House has passed a bill that would leave the Fed in charge of supervising smaller banks.
"The legislation passed by the House last December would preserve the supervisory authority that the Federal Reserve needs to carry out its central banking functions effectively," Bernanke said.
The House measure contains a provision which the Fed strongly objects to that would allow Congress to review the Fed's monetary policy decisions -- a provision that is not in Dodd's proposed bill.
Financial Services Committee Chairman Barney Frank said he expects lawmakers to meet to meld the House and Senate bills in April or early May.
