WASHINGTON — At long last, Gary Stern has been vindicated.

The president of the Federal Reserve Bank of Minneapolis spent more than a decade warning of the dangers posed by institutions considered "too big to fail." But even right up until the rescue of American International Group, many denied the problem existed.

"People said, 'You're exaggerating the problem,' " he said in an interview this week. "Now one thing has clearly changed — people will acknowledge that 'too big to fail' is a very big public policy problem that needs to be addressed."

Stern, the longest-serving Fed president still in office, even wrote a book on the subject in 2004. He said the solutions he offered then, involving a complex balance of more regulation and better market discipline, would work now.

In a speech Tuesday at the Brookings Institution, Stern said failure to solve the "too big to fail" problem would have serious consequences.

"If this situation goes uncorrected, the result will almost surely be inefficient marshalling and allocation of financial resources, serious episodes of financial instability, and lower standards of living," he said.

Speaking on the same panel, former Federal Reserve Board chairman Alan Greenspan acknowledged Stern was right all along, but said the central bank could not admit it before the financial crisis.

"Gary was taking a position in which the board itself could not," Greenspan said. "The reason we could not was that saying that something is 'too big to fail' essentially goes against the statute at that time of the United States government. The classic case of course was Fannie [Mae] and Freddie [Mac]."

The former Fed chief argued the central bank was in a bind because it could not counter the position of the government, which explicitly said the government-sponsored enterprises were not backed by the full faith and credit of the United States.

Such a stance would "essentially say that the Congress has implemented a law, signed by the president of the United States, which is going to be abrogated in some form or another."

In the interview, Stern effectively dismissed that argument as "legalistic."

Regardless of why the risk posed by financial institutions went unnoticed in Washington, Stern said the first step to curbing "too big to fail" was to expose creditors to risk. "A fundamental problem with 'too big to fail' is that uninsured creditors who nominally ought to suffer losses if the institution who owes them money fails are protected by, essentially, the government," he said.

Ron Feldman, Stern's co-author on the book and a senior vice president at the Minneapolis Fed, gave an example of a hypothetical institution with 1,000 subsidiaries spread out across various countries.

He said regulators should look at an institution and question whether it could be resolved easily. If not, he said, the supervisors need to start asking questions.

"You would say, 'I want you to explain to me exactly why you have those subsidiaries,' " he said. " 'I want to understand what their purpose is and I want to work with you in such a way that the economic benefits are there, but the difficulties to me as the resolving authority are no longer present.' "

Feldman said regulators should have authority to compel cooperation in this process. "If they are unwilling to work with you, then you've got the authority to move forward and try to organize them in a different way," he said.

The point of this process would be to eliminate the spillovers that have forced the government to rescue financial giants over the past year. Still, with jitters continuing to pervade markets, Stern and Feldman said their process could not be initiated until the market turmoil ends.

A more immediate alternative that has gained traction as the crisis has deepened would simply reduce the size of an institution that could present a threat to the economy. But Stern said the incentives of market participants would be a better starting point.

"If that doesn't solve every problem and then you decide we're going to have to figure out some way to shrink these really big guys or impose some activity restriction on them, you can do that," he said. "But let's start with the obvious place to start. Let's try to get the incentives right here."

Stern also argues that prompt corrective action requirements should be revamped so regulators can tackle problems that may arise in the future instead of waiting for capital triggers to be crossed.

Other proposals are emerging as well. Sandra Pianalto, the president and chief executive of the Federal Reserve Bank of Cleveland, proposed a system Wednesday that would put financial institutions into one of several tiers. Those that fell into the systemically significant tier would be regulated more closely.

Regulation "should offset or remove any advantages to becoming systemically important in the first place, perhaps encouraging institutions to shrink, become less opaque, or lower their risk profiles," Pianalto said in a speech in Columbus, Ohio, for Ohio Bankers Day.

Still, Stern said he is skeptical of hopes expressed by Federal Deposit Insurance Corp. Chairman Sheila Bair that the government can stamp out the "too big to fail problem."

"Can you put yourself in a position where the government never intervenes to restore financial stability?" he asked. "I think the answer to that is no. … Can you make the frequency with which you intervene a lot less frequent? I think you could do that."

Stern would not say whether the Fed should become the regulator for systemically important institutions, as some lawmakers, including House Financial Services Committee Chairman Barney Frank, have proposed. But he said the regulator should not be expected to prevent all problems.

"If you give them an assignment that says there will be no major bouts of instability or financial shocks, nobody can do that," he said. "If you're really serious about this, the objectives have to be achievable."

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