Plosser: Fed should be leery of financial rescues

NEW YORK (Reuters) - The U.S. Federal Reserve should be careful about not encouraging excessive risk by continuously rescuing the financial system and must set a clear benchmark for when its role as lender of last resort should be employed, a top Fed official said on Thursday.

Philadelphia Federal Reserve President Charles Plosser's comments came as investors worry about the possibility that Lehman Brothers could run into trouble similar to that of Bear Stearns, whose problems prompted the Fed to orchestrate a buyout of the firm by JP Morgan.

"Policy interventions in financial markets run the risks of increasing moral hazard and inhibiting efficient price discovery," Plosser said at New York University's Stern School of Business.

"Moreover, interventions intended to quell instability can, by creating moral hazard, actually make instability more severe in the long run."

To avoid such pitfalls, Plosser said the central bank should develop clear benchmarks for when a particular situation qualifies as systemic risk.

"Specifying in advance the conditions or states of the world under which the central bank will lend is an essential first step," he said.

Plosser also reiterated his oft-stated belief that maintaining price stability is the primary function of the central bank, adding that low inflation was also the best way to ensure sustainable economic growth -- the other half of the Fed's dual mandate.

TWEAKING THE MODELS

Plosser spent much of his remarks discussing the role of shortcomings in the models that financial institutions use to assess risks, defending the benefits of new and more complex financial products but acknowledging that there was room for improvement in the way the potential for defaults is gauged.

He noted that predicting the behavior of consumer loans was made difficult by a relatively short range of available historical data, adding that the central bank should play a crucial role in beefing up techniques for risk measurement.

"While there have been enormous advances in this type of modeling over the last two decades, there are still notable weaknesses," Plosser told the group of NYU business school students and professors.

"Therefore, improving these modeling methodologies and increasing transparency, as well as obtaining better measures of model uncertainty, will be factors in improving the functioning of certain financial markets. The Federal Reserve and other banking regulators have been devoting more resources to looking at this modeling apparatus for the purpose of assessing bank risk management."

Still, Plosser argued that the baby should not be thrown out with the bath water when it comes to the creation of exotic financial products. Attempts to regulate markets too heavily, he said, could inhibit future improvements in the functioning of markets.

"Financial innovation as a whole is beneficial to society and has improved the functioning of our capital markets," Plosser said. "That does not mean that every new innovation will succeed, but that is the nature of progress and we should take care that regulatory functions do not unnecessarily inhibit such innovation."

(Reporting by Pedro Nicolaci da Costa, Editing by Dan Grebler)