Fed Official Wants Improved Regulation

"Some reforms might impose significant costs and contribute to outcomes we would prefer to avoid. Ultimately, policy makers could find themselves relearning old lessons rather than improving social welfare," Minneapolis Fed President Gary Stern said in written comments to be delivered at a conference in Singapore on Monday.

Stern, who isn't a voting member of the Federal Open Market Committee this year, didn't address monetary policy or the current economic or market outlook in his prepared text.

His comments come as investors and regulators continue to grapple with the fallout from the downturn in the U.S. housing market amid broad concerns that the current credit crunch could lead to significantly weaker growth in the U.S.

Concerns are centered on banks and financial institutions, which have in recent weeks taken massive write-downs on their exposure to mortgages and structured finance products, many of which are based on riskier types of mortgage debt. Market turmoil has made it difficult, if not impossible, to price many of these products. Spreading risk aversion has also brought parts of the riskier debt markets to a near-standstill after several years of booming issuance.

Interbank lending rates have begun to rise again even after the Fed cut its benchmark rate by a total 0.75 percentage point in its past two policy meetings. Jittery investors have fled to the safe-haven of government bonds.

As the housing crisis has deepened and its fallout spreads, policy makers in the United States and elsewhere have faced calls to reform banking regulation. Particular flashpoints include the "originate to distribute" model of mortgage lending, in which banks no longer hold mortgage loans on their balance sheets but instead repackage them and sell them on to outside investors.

Bank regulators and politicians have said previously that this model will likely change as the dispersal of risk may have encouraged looser lending standards.

But Stern noted in his speech that this model also has a "core and fundamental economic advantage," as it leads to specialization in the lending process which in turn brings "cost efficiencies, innovation and a broadening of access to financial capital." It also allows financial institutions to diversify their assets, he noted.

"Actions to limit specialization and diversification would therefore likely be costly, with adverse consequences for economic performance and living standards," Stern noted.

Stern also addressed arguments that the extended period of low global interest rates in recent years had led to excessive liquidity which in turn drove risk premiums to historically tight and ultimately unsustainable levels. He noted that "preemptive rate hikes," particularly in the U.S., aimed at draining some of this liquidity wouldn't have been cost-free.

"Most of the tools which central banks have at their disposal are blunt instruments which do not permit policy makers to narrowly target their effects," he said, noting that a preemptive rate strike would have hit a wide range of households and businesses. In addition, "excesses in asset prices perceived in recent years seem related ... to innovation," he said.

Addressing the "too big to fail" problem -- the expectation that public support will be forthcoming for large banks and institutions that run into problems -- Stern noted it is policy makers' duty to limit spillover of problems at one firm into the broader markets and ultimately the economy.