Stern says inaction raised financial crisis costs

WASHINGTON (Reuters) - 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 a speech to the Brookings Institution.

Stern, the Fed's longest-serving regional president, did not address the economic or monetary policy outlook.

The collapse of U.S. housing markets and the following credit crisis and recession have launched a debate over ways to strengthen financial supervision in order to prevent a repeat of one of the worst episodes of market turmoil since the Great Depression.

Stern acknowledged that determining the value of assets that have lost value because of association with mortgage defaults is difficult, but would not endorse relaxing mark-to-market accounting rules that financial institutions say are an obstacle to recovery.

Mark-to-market accounting is the best approach to determining asset values on the books of banks, even though malfunctioning markets pose difficulties, he said.

GREENSPAN: CAN'T FORESEE CRISES

Stern also said problems at U.S. mortgage finance agencies Fannie Mae FNM.N FNM.P and Freddie Mac FRE.N FRE.P were well recognized, but not tackled. He said the United States must balance the aim of fostering greater homeownership with the need to ensure financial stability.

Speaking at the same conference, former Fed Chairman Alan Greenspan said that one of the cornerstones of the regulatory overhaul effort -- creating a systemic risk regulator -- may be doomed to failure.

"The issue of knowing when the crisis will happen is not possible to human beings," Greenspan said.

The way to prevent firms from becoming so big that their failure risks damage to the broader financial system is by setting capital standards that take away the advantages of being so big, he said.

"If you can neutralize those who are too big to fail, their competitive advantage, it takes away their bigness as a protection," Greenspan said.

Stern, speaking about regulatory lapses that contributed to the crisis, said 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.

(Reporting by Ros Krasny in Chicago and Mark Felsenthal in Washington; Editing by James Dalgleish)