The following are highlights from Federal Reserve Chairman Ben Bernanke's testimony on Thursday to the Financial Crisis Inquiry Commission on the problem of financial institutions that are too big too fail.

BERNANKE: LEHMAN MAY HAVE BEEN INSOLVENT

My general tone and attitude was is there anything we can do and I believe that that goal was shared by the other principles, by (NY Fed) President Geithner and (Treasury) Secretary Paulson and (SEC) Chairman Cox. And none of those folks have been known for timidity in previous episodes in terms of trying to find ways to prevent a worsening of the financial crisis and what I heard from them was just a sense of defeat, this is just way too big a hole. My own view is that it's very likely that the company was insolvent even, not just illiquid.

BERNANKE ON FINANCIAL INNOVATIONS

I think one of the lessons of the crisis is that innovation is not always a good thing.

The new financial stability oversight council, for example, ought to pay close attention to financial innovations, and regulators, as we look at risk managements and systemic consequences of these decisions, need to be assertive if there are developments that we find either counterproductive from the perspective of consumer protection or systemically risky.

BERNANKE: LENDING TO LEHMAN WOULD HAVE BROKEN LAW

The only way we could have saved Lehman would have been by breaking the law and I'm not sure I'm willing to accept those consequences for the Federal Reserve and for our system of laws. I just don't think that would be appropriate. So, I wish we had saved Lehman but -- and we tried very, very hard to do so -- but it was beyond our ingenuity or capacity to do it.

BERNANKE ON EXECUTIVE COMPENSATION

For capitalism to work you have to have incentives tied to performance and I think one of the things people are very upset about is the fact that it seems like a lot of people who drove their companies into the ditch walked off with lots of money. That's not good capitalism and that's not a good ethical outcome either.

BERNANKE ON MAKING SURE RESOLUTION REGIME WORKS

Barring some midnight session of Congress which rewrites the law, I don't see any way that it would be feasible for the government to bail out a firm in the same way that happened during the crisis. So it's very important that we make sure our methods that we do have, the resolution regime etc., that they work and that's something we are very much engaged on.

BERNANKE ON LEHMAN'S LACK OF CAPITAL

The unanimous opinion that I was told and I heard from both the lawyers and from the leadership of the Federal Reserve Bank of New York was that Lehman did not have sufficient collateral to borrow enough to save itself, and therefore any attempt to lend to Lehman within the law would be futile and would only result in loss of cash.

It wasn't just a question of legality, it was a question of whether there was anything we could conceivably do that would prevent the failure of the firm. And therefore it was with great reluctance and sadness I conceded that there was no other option. There was never any discussion that says 'here's how we can save Lehman, should we do it or not?.' The discussion was 'there is no way' and that was my belief and that's how I proceeded, because, as I said, if I could have done anything to save it, I would have saved it.

BERNANKE ON LESSONS LEARNED FROM CRISIS

The most important lesson of the crisis is to end too big to fail. I believe that in a much different way than we did before the crisis, we now have the tools to address that.

In particular tougher regulation and oversight will reduce the risks. The existence of a resolution regime will increase market discipline because creditors will know they can lose money. Strengthening the resilience of the financial system itself will reduce the incentive of the government to intervene in these situations.

BERNANKE ON PRESSURES ON FIRMS TO DOWNSIZE

My projection is that even without direct intervention by the government, that over time we're going to see some break up and some reduction in size and complexity of some of these firms as they respond to the incentives created by market pressures and by regulatory pressures as well.

FROM PREPARED TEXT:

BERNANKE ON TOO BIG TO FAIL

If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved. Simple declarations that the government will not assist firms in the future, or restrictions that make providing assistance more difficult, will not be credible on their own. Few governments will accept devastating economic costs if a rescue can be conducted at a lesser cost; even if one administration refrained from rescuing a large, complex firm, market participants would believe that others might not refrain in the future. Thus, a promise not to intervene in and of itself will not solve the problem.

The new financial reform law and current negotiations on new Basel capital and liquidity regulations have together set into motion a three-part strategy to address too-big-to-fail.

BERNANKE ON USING MONETARY POLICY AGAINST ASSET BUBBLES

Generally, financial regulation and supervision, rather than monetary policy, provide more-targeted tools for addressing credit-related problems. Enhancing financial stability through regulation and supervision leaves monetary policy free to focus on stability in growth and inflation, for which it is better suited. We should not categorically rule out using monetary policy to address financial imbalances, given the damage that they can cause; the FOMC is closely monitoring financial conditions for signs of such imbalances and will continue to do so. However, whenever possible, supervision and regulation should be the first line of defense against potential threats to financial stability.

BERNANKE ON REGULATORY IMPROVEMENTS

To facilitate swifter, more-effective supervisory responses, we have increased the degree of centralization of the oversight and control of our supervisory function, with shared accountability by senior Board and Reserve Bank supervisory staff and active oversight by the Board of Governors. Supervisory concerns will be communicated to firms promptly and at a high level, with more-frequent involvement of senior bank managers and boards of directors and senior Federal Reserve officials. Where necessary, we will increase the use of formal and informal enforcement actions to ensure prompt and effective remediation of serious issues.

Ben Bernanke