Years of inaction dramatically raised the economic costs of the U.S. financial crisis, highlighting the need for a new approach, a top Federal Reserve policy-maker said on Tuesday.
Policy-makers did not prepare for the 'too big to fail' flood; indeed, they situated themselves in the flood plain, ignored the flood warning, and hoped for the best, Gary Stern, Minneapolis Federal Reserve Bank president, said in Washington.
Stern, the Fed's longest-serving regional president, did not address the economic or monetary policy outlook in prepared remarks to the Brookings Institution.
Officials vastly underestimated the scale of problems created when companies are seen as too big and systemically interconnected to be allowed to fold, he said.
But looking ahead, Stern said imposing draconian levels of regulation would create an excessive cost to the economy and likely hurt growth for years.
As matters stand today, risk-taking of large, complex financial institutions is not constrained by supervision and regulation nor by the marketplace, Stern said.
Instead, Stern reiterated a plan he floated several months ago to combat the 'too big to fail' issue, centered on early identification of problems, prompt corrective action and clear communication related to maintenance of stability.
This systematic focused supervision is aimed at limiting the spillover from failing institutions.
Our approach does not simply seek to limit systemic risk, but takes the next step of directly trying to address TBTF by putting creditors at risk of loss, he said.
Without the risk of loss, the cycle of moral hazard and excessive risk-taking will be repeated, Stern warned.
Stern said some regulatory reforms being mooted, such as simply reducing the size of companies deemed too big to fail, were ideas born out of desperation.
Certain elements of proposed tighter supervision also seem doomed to failure, he said.
The track record of (supervision and regulation) does not suggest it prevents risk-taking that seems excessive. True, long shots occasionally come in, but ... a 15 seed rarely beats a number two.
A truly draconian regulatory regime could conceivably succeed in diminishing risk-taking, but only at excessive cost to credit availability and economic performance.
The United States should seek to strengthen supervision where feasible, but acknowledge that this is not a credible check on the risk-taking of many firms, Stern said.
(Reporting by Ros Krasny; Editing by Neil Stempleman)