In the wake of Treasury Secretary Tim Geithner's call for a systemic risk regulator, a top Fed official addressed the notion that certain banks are too big to fail. Minneapolis Federal Reserve Bank President Gary Stern warned Thursday of the pitfalls of continuing conventional supervision and regulation to address systemic risk.

Speaking before the Economic Club of Minnesota, Stern also reiterated his economic outlook, predicting that economic growth likely kick into high gear by the middle of 2010. However, the policies in place suggest that a modest recovery will likely take effect in the near future.

Many financial markets remain strained, and credit issues are likely to weigh on the economy for some time, Stern said in prepared remarks. In part as a consequence, the recession is likely to persist through mid-year and the initial stage of the recovery seems likely to be subdued.

Healthy growth will likely resume in the middle of 2010, Stern predicted. However, the policies in place suggest that growth will resume in the near future, Stern said.

Destiny did not require society to bear the cost of the current financial crisis, he said. To at least some extent, the outcome reflects decisions, implicit or explicit, to ignore warnings of the growing TBTF problem and a failure to prepare for and address potential spillovers. We should not make this mistake again.

Although he noted that there will be a role for conventional supervision and regulation in the future, he offered advice based on years of researching the problem in order to help avoid two potentially serious pitfalls.

They include asking more from regulation than can be delivered, and too much regulation, creating an inefficient financial sector with negative consequences for economic performance.

In terms of his first concern, Stern warned that simply adding resources and regulations to the problem of systemic risk will not be able to have a significant impact by themselves if they do not address the front-loaded incentive structure. That compensation structure, which offered large short-term bonuses, has been cited as one of the root causes of the current financial crisis.

Reasons for this conclusion include the inevitable lag between supervisors' identification of a problem and its ultimate correction, the incentives of management to find ways around regulation, and the time inconsistency problem which frequently makes forbearance look attractive, Stern explained.

In the current episode, supervisors have been unable once again to prevent excessive lending to commercial real estate ventures, a well-known, high-risk, high-return business which contributed importantly to the banking problems of the late 1980s and early 1990s, he added.

Stern suggested a systemic focused supervision, or SFS, which focuses on reducing spillovers. The three pillars of the program - early identification, enhanced prompt corrective action, and stability-related communication - are aimed at addressing the too big to fail problem while avoiding the pitfalls previously mentioned.

I have cautioned about placing an excessive burden on conventional bank supervision and regulation, although clearly such policies have a role to play, Stern said. More constructively, I suggest prompt emphasis on SFS as a means of addressing TBTF and as a contribution to aggregate financial stability going forward.

In terms of the Fed's commitment to prices stability, Stern noted the two major concerns of FOMC members: concerns that the liquidity injected in the market today could lead to inflation down the road and a concern that deflation could take hold as global economic activity continues to decline.

Although he would not dismiss either concern, Stern did note that the threat of deflation should diminish commensurately should economic growth return to the U.S.

With regard to inflation concerns, Stern noted that there is ample time to withdraw excess liquidity as appropriate, and in this regard the Federal Reserve remains firmly committed to long-run price stability.

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