UPDATE 1-Fed's Stern says crisis shows urgent reform need

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By Ros Krasny

WINONA, Minn., Nov 13 (Reuters) - The U.S. Federal Reserve has taken appropriate action to stem the worst credit crisis in decades, but the situation highlights the urgent need for reforms, a top Fed policy-maker said on Thursday.

"The Federal Reserve has responded to unprecedented times with equally unprecedented actions ... Such actions were appropriate given the challenges we faced," said Gary Stern, president of the Minneapolis Fed.

In a speech to faculty and local business leaders at Winona State University in Minnesota, Stern said it is "critical" that the steps taken by the Fed succeed in restoring stability.

"We have seen some important progress in recent weeks in funding markets," he said. "That said, significant strains continue in some markets and among financial institutions."

Stern, a voting member of the Federal Open Market Committee in 2008, did not address the economic outlook or prospects for the Fed's next policy meeting in December.

Financial markets lean toward the Fed cutting its benchmark lending rate to 0.75 percent or even 0.5 percent in December from the current 1 percent. The rate has been slashed from 5.25 percent since September 2007.

Stern focused on the role of asset prices in Fed policy formulation and proposals for what he termed urgent reforms to address the issue of "too big to fail," or the implicit promise that if large banks and financial institutions get into trouble, the government will bail them out.

"Left unchecked, the too-big-to-fail embers remaining from our emergency response will likely contribute to future financial conflagrations," Stern said.

The issue "rests at the very top of the ills elected officials, policy-makers and bank supervisors must address," he said.

Stern reiterated the details of a plan he first floated in August, focused on early identification of problems, more aggressive and faster corrective action and communication with market participants.

"If we had grasped the net of connections of large financial firms in, say, 2006 instead of 2008, we might have taken steps to figure out how we might contain the ability of this network to spread risk," he said.

Even so, Stern said he was skeptical that the Fed could have foreseen the situation as it has played out, especially the carnage that the housing market collapse would create.

"I certainly make no claim for having foreseen how the decline in housing prices would spill over so aggressively to the financial sector and real economy," he said. (Reporting by Ros Krasny; editing by Gary Crosse)