Nov. 6 (Bloomberg) -- Federal Reserve Governor Kevin Warsh said an economic recovery from the worst financial crisis in seven decades may hinge on how fast policy makers and financial institutions create new rules and ways of doing business.

Forming a ``new financial architecture'' quickly will better aid U.S. growth than an end to home-price declines or enacting policies to revive housing, which some observers say is at the root of the crisis, Warsh said today in a speech in New York.

The comments by Warsh, a key player in the Fed's response to the credit freeze this year, indicate officials see revamping how financial markets work as essential to averting a prolonged recession. Warsh, avoiding specific policy proposals, said the central bank should be prepared to reject ad hoc ``pleas for relief'' or turn them over to other government authorities.

``The speed and success of a new financial architecture is likely to be more consequential to economic growth than the design and implementation of well-intended housing policies alone,'' Warsh said in a speech to the New York University Money Marketeers.

Warsh said he sees ``some notable signs of improvement'' in markets, such as lower borrowing premiums, though ``financial markets overall remain strained.'' Data suggest the U.S. economy will probably be ``weak'' this quarter, as indicators have ``turned decidedly negative.'' He didn't discuss his outlook for interest rates.

``The depth and duration of this period of weak economic activity remain highly uncertain,'' said Warsh, 38, a former Morgan Stanley investment banker and White House aide who joined the Fed board in February 2006.

Failure, Merger, Takeover

The credit crisis, including $690 billion in losses and writedowns stemming from mortgage-related assets, has led to the failure, merger or federal takeover of several major banks and financial institutions. Goldman Sachs Group Inc. and Morgan Stanley received Fed approval to become bank holding companies, ending an era of independent investment banks on Wall Street.

The Fed has set up more than $1 trillion of loan programs to flood the financial system with cash while stepping in to rescue Bear Stearns Cos. and insurer American International Group Inc. from bankruptcy. The Fed cut its benchmark interest rate last week by a half-point to 1 percent, matching a 50-year low.

The moves have failed to prevent what economists say will be the worst recession in a quarter century. Last month employers probably cut payrolls by the most in five years, lifting the U.S. jobless rate to 6.3 percent, based on the median forecast of economists surveyed by Bloomberg News. The Labor Department reports the figures tomorrow at 8:30 a.m. New York time.

Fed Rescues

While the Fed has taken action this year ``when appropriate,'' other companies seeking Fed rescues shouldn't automatically expect it, Warsh said in the speech.

``We should resist the temptation to play a larger role than statutorily mandated or economically prudent,'' Warsh said. In some cases, the Fed may need to be ``cognizant of the perils of popularity and decline to take action, including when it may be more properly considered or better addressed by the fiscal authorities,'' he said.

Warsh didn't mention specific requests, such as a letter last month to the Fed and Treasury chiefs from Michigan lawmakers urging steps to ``promote liquidity'' in the U.S. auto industry after lending dried up and vehicle sales plunged.

Replying to audience questions, Warsh said the central bank hasn't hesitated to expand its balance sheet to stabilize markets, and ``we expect that trend to continue, at least for some time.''

`Crowd In'

``The goal of policy is to crowd in private capital,'' Warsh said. ``It is not to crowd it out by making the Fed's balance sheet the biggest one of them all.''

The comments were Warsh's most extensive in public since May. At that time, he said the Fed should resist calls for more interest-rate cuts even if the U.S. economy slows further, citing a rising threat of inflation. He referred then to the federal funds rate as a ``proverbial hammer'' in the Fed's toolkit.

House Financial Services Committee Chairman Barney Frank and other lawmakers plan next year to strengthen supervision by the central bank and other financial regulators. Fed Chairman Ben S. Bernanke called in August for a ``macroprudential supervisor'' to oversee risk in the financial system.

The government's new ``rules of engagement'' for markets should be ``clear in intent, consistent in application and reasonably predictable in effect,'' Warsh said. ``This policy formulation should allow financial firms to regain their footing and market participants, more broadly, to take new, constructive actions to facilitate the availability of credit.''

At the same time, financial institutions need to ``readily and steadily approach new ways of intermediating credit'' for a faster and stronger economic recovery, he said.

``If private market participants prove unable or unwilling to establish new business models, then the effects of the current financial market turmoil may be a significant drag on economic growth long after stability is ostensibly achieved,'' Warsh said.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Anthony Massucci in New York at amassucc@bloomberg.net.

Last Updated: November 6, 2008 20:50 EST