Testifying at a House hearing, Bernanke waged a fresh battle against Senate efforts to scale back the Fed's role in overseeing the nation's banks.
The Fed boss argued that policymakers factor information they get from the Fed's role as bank regulator into their decisions on interest rates. And, Bernanke said its banking duties give the Fed insights into the health of the entire banking system.
"The insights provided by our role in supervising a range of banks, including community banks, significantly increases our effectiveness in making monetary policy and fostering financial stability," Bernanke told the House Financial Services Committee.
Bernanke's testimony comes as the Fed faces a significant shift in its supervisory duties.
In an effort to overhaul the nation's financial regulatory structure, Senate Banking Committee Chairman Christopher Dodd has offered legislation that wouldto supervise state-chartered banks and bank holding companies with assets of less than $50 billion.
That would leave the Fed with 35 of the biggest bank holding companies under its supervision.
Critics blame lax regulation at the Fed and at other agencies for contributing to the financial and economic crises. Bernanke once again acknowledged deficiencies, and said the Fed is taking steps to beef up oversight.
"Frankly, the Fed's performance ... has been inadequate," said Rep. Spencer Bachus of Alabama, the senior Republican on the House panel. "In spite of its oversight, many of the large, complex banking organizations excessively leveraged and engaged in off-balance sheet transactions that helped precipitate the financial crisis," he said.
The Fed currently oversees about 5,000 bank holding companies, about 850 smaller banks that are both state-chartered and are members of the Federal Reserve system and some foreign banks operating in the United States.
Dodd's bill, however, would also give the Fed new powers to oversee nonbank financial firms that are so large and interconnected that their failure could pose a risk to the economy.
Such firms could include insurance giant American International Group Inc., or General Electric Co.'s GE Capital business.
Bernanke said the Fed is "quite concerned" about losing oversight of small banks and essentially becoming the "too big to fail regulator" under the Dodd bill. "We want connections to Main Street as well as Wall Street," said Bernanke.
With its narrower authority, the Fed's system of 12 regional banks could face profound changes. The Kansas City Federal Reserve Bank and the St. Louis Federal Reserve Bank, for instance, would have no banks under their supervision.
The Obama administration has supported a broader supervisory role for the Fed. Legislation passed by the House overhauling the regulatory landscape doesn't trim the Fed's banking duties.
Former Fed Chairman Paul Volcker, who currently serves as economic adviser to Obama, also argued for the Fed to retain supervision over all the banks it now oversees and cited similar reasons as Bernanke.
"It would be a really grievous mistake," Volcker said of curtailing some of the Fed's banking oversight.
"Something important, if less obvious would also be lost if the present limited responsibilities for smaller member banks were to be ended. The Fed's regional roots would be weaker and a useful source of information lost," Volcker said.
Small banks also made the case to continue to be regulated by the Fed.
Jeffrey Gerhart, president of Bank of Newman Grove, said the Fed would "lose valuable information about local economies," which informs interest rate decisions, if the Fed no longer supervised small banks.
Dodd's bill would also place an independent consumer watchdog inside the Fed. The Consumer Financial Protection Bureau, however, would have its own director appointed by the president and would not fall under the authority of Bernanke.
The administration has called for a freestanding consumer agency, an approach that would strip the Fed of its consumer-protection responsibilities. The House version of a financial revamp resembles the administration's approach. Bernanke has argued that despite past weaknesses, the Fed should retain its consumer-protection duties. He didn't address the matter in his testimony prepared for Wednesday.
Anil Kashyap, professor of economics and finance at the University of Chicago Booth School of Business, said that consumer-protection oversight should be handled by some other agency, not the Fed.
But he backed Bernanke's pitch for the Fed to keep its banking oversight. "Stripping the Fed of its role in bank supervision would be a step in the wrong direction," Kashyap said.
Allan Meltzer, a professor at Carnegie-Mellon University, doubted any regulator can prevent all risks to the financial system. "Setting up an agency to prevent systemic risk without a precise, operational definition is just another way to pick the public's purse," he said.
He also worried that the Fed's extraordinary money pumped out during the financial crisis will eventually spur inflation. "I believe we are headed for higher inflation, not immediately, but later," he warned.