Britain must be ready to adopt more unconventional measures so that debt cutting and the euro zone crisis don't crimp economic growth for years, Financial Services Authority Chairman Adair Turner said.
Turner, who has applied to be the next governor of the Bank of England from July 2013, strayed beyond his remit in a speech to financial leaders to show his willingness to embrace radical thinking to boost the recession-hit economy.
Policymakers face a tough trade-off between forcing banks to be better capitalised and ensuring the economy has enough credit. But this job has been made even harder by the euro zone crisis and the need for governments to cut debt.
The Bank's new risk watchdog, the Financial Policy Committee, of which Turner is a member, has been trying to reach a consensus on this issue.
"We have to find creative ways forward which as best possible both increase resilience and support lending and as a result, maintain nominal demand," Turner told an audience at the Mansion House in the heart of London's historic financial district.
Britain has already put together a package of measures in a bid to kick-start the economy, such as buying government bonds to inject cash into the economy, and giving banks incentives to lend money to businesses.
Turner said the benefit of quantitative easing, which many economists expect will be extended next month, may already be waning. On the other hand, more interest rate cuts may not have much impact given that rates are already close to zero, he said.
Yet without carefully designed policy responses, the deflationary impact on growth that the banks necessary deleveraging has could hurt the economy for many years ahead.
"So optimal policy also needs to include a willingness to employ still more innovative and unconventional policies," Turner said.
It was Turner's last FSA speech in the Mansion House, a stone's throw from the Bank, before the watchdog is scrapped early next year to make way for a new system of supervision divided between the central bank and a new standalone Financial Conduct Authority.
The aim is to plug supervisory holes opened up by the 2007-09 financial crisis that caught the FSA unawares, leaving taxpayers to bail out Northern Rock and buy most of Royal Bank of Scotland.
The FSA is one of the few watchdogs in the world to have formally accepted blame for pre-crisis supervisory failings that focused on "light touch" rules to keep London competitive with New York and other rival financial centres.
Such policies were based on "intellectual failure".
"In retrospect, it was a fool's paradise - the band playing on, oblivious to the dangers ahead," Turner said.
He had a baptism of fire, becoming chairman of the FSA just five days after U.S. bank Lehman Brothers crashed in September 2008, leading to a global market meltdown.
But as regulator he has been a hardliner, forcing UK banks to build up capital and liquidity reserves far ahead of new global requirements, though now making a partial U-turn as Britain's economy remains in the doldrums.
He said leaders of banks, whose high bonuses and mis-selling scandals have angered the public, are showing increasing signs of a cultural change.
Turner and King teamed up to oust Bob Diamond from his job as chief executive of Barclays in July after the bank was fined a record amount for rigging the Libor interest rate benchmark.
Turner faces competition for the top job at the Bank from its deputy governor, Paul Tucker, the bank's former chief economist, John Vickers, and others. Chancellor George Osborne is expected to announce his choice for the job in early December.
(Additional reporting by Sven Egenter; Editing by Hugh Lawson)