U.N. calls for tougher financial regulation

GENEVA (Reuters) - The United Nations called on Tuesday for tougher regulation of financial markets to deal with the "crisis of a century" and warned that the global policy response risked creating a prolonged deflationary downturn.

Adding its voice to those blaming the free-market model of the United States and Britain for the crisis, the United Nations Conference on Trade and Development (UNCTAD) said considerable public intervention was now needed to avoid greater damage to the financial system or real economy.

"The market-fundamentalist argument against stronger regulation based on the idea that market discipline alone can most efficiently monitor banks' behavior has clearly been discredited by this crisis," it said in a policy brief.

UNCTAD proposed several quick regulatory fixes:

-- Reassess the role of credit-rating agencies which have made the market more opaque instead of increasing transparency;

-- Create incentives for simpler financial instruments, ending the regulatory stance that creates a bias in favor of sophisticated but poorly understood financial products;

-- Deal with maturity mismatches in non-bank financial institutions which leave such firms funding long-term liabilities in volatile short-term markets;

-- Limit credit deterioration linked to securitization, as banks that sell off loans quickly are less interested in monitoring the quality of borrowers. One solution is to force banks to keep part of the loans they make on their books.

"TREMENDOUS NEGATIVE IMPLICATIONS"

UNCTAD said the global policy response was confused, with U.S. efforts to revive its economy contrasting with reactive, even contractionary, moves in other big countries.

The European Central Bank was providing liquidity but was retaining a hawkish monetary stance at a time when fiscal policy remained bound by the EU's stability and growth pact, it said.

Policymakers have failed to grasp the full implications of the acceleration of the U.S. deleveraging process -- depreciating toxic assets and reducing debt, the weak dollar and the uncertainty of Americans, it said.

"Such forces can have tremendous negative implications for the world economic outlook as a whole," UNCTAD said.

The painful effects of unwinding unsustainable debt must be compensated for by a policy stimulus from surplus countries such as Japan and some large Eurozone members reducing their surplus to avoid recession or a depression, it said.

UNCTAD said inflation concerns were misguided.

"The risk of a prolonged downturn or depression is far more important, as the slowdown will further reduce commodity prices... Deflation, not inflation, may actually be the main economic policy challenge," it said.

Only governments or central banks can stabilize markets when confidence has been lost and other actors are cutting spending and cleaning their balance sheets at any price, UNCTAD said.

"Governments and central banks must also recognize that a modern financial market chasing higher and higher returns based on the expectation of ever-rising prices in certain sectors or certain assets is a beast that must be tamed before it causes acute damage and threatens the whole system," it said.

(Editing by Dominic Evans)