By Steve Beckner and Claudia Hirsch

NEW YORK (MNI) – Cleveland Federal Reserve Bank President Sandra
Pianalto said Wednesday that bank regulators didn’t focus enough on the
interconnectedness of financial institutions before the current crisis,
but that the Fed’s emergency steps prevented the economy from slipping
into a second Great Depression.

“We took action to stabilize the financial markets as we saw
markets freezing up,” Pianalto said, answering audience questions
following a speech to a Levy Institute of Economics conference.

The Fed used its emergency authority dexterously to “assist in
preventing failures of systemically important institutions,” she said.
And the U.S. central bank also “created (special liquidity) facilities
to get credit markets moving” again, she said.

“From a monetary policy perspective — we were very aggressive,”
Pianalto continued, pointing to the near-zero federal funds rate, which
has held at that historically low level since December 2008. The Fed
also more than doubled its own balance sheet to support credit markets.

“I do believe that if we had not taken these types of actions that
we might have seen a second (Great) Depression,” Pianalto said.

But she also said that before the financial sector’s implosion, the
Fed had been “very focused on individual institutions” and “failed to
recognize that some of those risks were being repeated in many of those
institutions.” Pianalto said the recognition of such interconnectedness
is one reason why she’s in favor of “horizontal reviews” across many
financial institutions, such as the bank stress tests of 2009.

“That’s an important lesson learned in this process,” she said.
Another is the imperative to eliminate the too-big-to-fail pitfall and
establish a “systemic-risk or macro-prudential supervisor that can be
effectively supervising these more complex institutions” — one which
also has resolution authority over such non-bank institutions.

A freshened regulatory system would be “flexible” and take a
multi-tiered approach to supervision, Pianalto said, reiterating her
prepared remarks.

As lawmakers and existing supervisors hammer out the details of
financial regulatory reform, Pianalto warned against going too far, too
fast.

“We need to be careful to not over-regulate,” she said.
“Regulations are static, but businesses are dynamic. We’ve learned over
the years that when you put in very strict requirements, individuals and
institutions figure out a way around those requirements.”

Identical concentration requirements for both large institutions
and community banks, for instance, wouldn’t be effective, she said.

“That’s why I’m recommending a more flexible, tiered approach,” she
said, “based on the risks that those institutions posed on the financial
system.”

She also said broad regulatory transformation must not occur
“hastily,” or supervisors risk spending years unwinding the wrong
reforms.

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