IMF says beware of knee-jerk subprime rules

WASHINGTON (Reuters) - Greed may have played a bigger role than lax regulation in the subprime crisis and supervisors should be wary of slapping new rules on banks in a knee-jerk response, a senior IMF official said.

The biggest risk facing economies hit by the crisis is that banks will overreact and restrict lending in a way that would threaten to choke off economic growth, said Jonathan Fiechter, deputy director of the monetary and capital markets department of the International Monetary Fund.

"We've had major credit crunches in this country after this kind of phenomenon and not surprisingly, surveys show that banks are increasing their underwriting standards," Fiechter told Reuters. "You have to resist the overreaction."

Fiechter's comments come one day after central bankers and finance officials from G7 industrialized countries approved a broad reform outline that called on banks to improve stress-testing and fortify access to funding in times of trouble. The G7 avoided calls for a sweeping overhaul.

"We don't need a quick knee-jerk reaction because the financial markets have become so complex that we want to avoid the law of unintended consequences," he said.

Leading up to the subprime meltdown, investors devoured complex, engineered assets in their hunger for profit, many of them ignoring the risks, he said.

"We still have problems with greed, problems with incentives, problems with poor underwriting," he said. "There are people out there buying assets who have no idea what they are buying."

"There is a risk that the complexity of the instruments has gotten way beyond the ability of all but very few people to understand them."

DEEP FREEZE

The problems in the U.S. subprime mortgage market, which has seen a wave of foreclosures, spread quickly worldwide because the loans were packaged into complex financial securities and resold to investors.

The turmoil triggered a tightening of credit conditions in August, prompting central banks around the world to respond with massive injections of liquidity to ensure the global financial system did not freeze up.

The financial sector still has a long way to go to sort out the crisis as innovations in structured instruments may have allowed lenders to offer loans under generous conditions, while complicating problem solving, Fiechter said.

Lenders who originated the loans have long left the picture, selling the loans to other investors -- who then sold them further -- which has now made it difficult for the lender and the borrower to come to terms in times of trouble.

Uncertainty persists about the scope of the crisis and whether many of the problems can be solved, he said.

"Right now we have a market failure. We have assets that we all agree are worth much more over the long term than one can get today. There has been a freeze-up in the market because of the great uncertainty over what the value in the long term of these assets is going to be," he said.

The role of the IMF in the wake of the crisis is to analyze and enlighten, not regulate, he said. The IMF has bolstered its effort in recent years to prevent and resolve financial crises.

"The role of the fund is to point out some of the risks," Fiechter said. "I don't believe that the role of the fund, especially in terms of banking supervision, is to set standards."