The euro zone's debt crisis could substantially damage the U.S. economy if not contained, the Federal Reserve's No. 2 official warned on Friday as she urged bold action by Europe.

Concerns about European fiscal and banking issues have contributed to strains in global financial markets that pose significant downside risks to the U.S. economic outlook, Fed Vice Chair Janet Yellen told a conference sponsored by the Chicago Federal Reserve Bank and the European Central Bank.

While U.S. banks have manageable direct exposure to sovereign debt in the smaller European countries, they have substantial links to banks in larger European countries, some of which are facing funding difficulties, Yellen said.

In light of such international linkages, further intensification of financial disruptions in Europe could lead to a deterioration of financial conditions in the United States, she said. We are monitoring European developments very closely, and we will continue to do all that we can to mitigate the consequence of any adverse developments abroad on the U.S. financial system.

In her talk, largely an overview of the regulatory steps the Fed has and will take to shore up the stability of the financial system, Yellen said she would not rule out using monetary policy as a stabilizing tool, at least on the margin.

In a separate speech in Washington, San Francisco Fed President John Williams took a more aggressive stance.

Although macroprudential policies are the appropriate first line of defense against financial instability, these defenses are not impregnable, Williams told a conference at the International Monetary Fund. In all likelihood, monetary policy will need to play a more active role.

The Fed slashed interest rates to near zero in December 2008 in the midst of the financial crisis. It has kept them there since, and also bought $2.3 trillion in long-term securities to help support recovery from the deepest recession in decades by pushing borrowing costs still lower.

Political and economic turmoil in Italy, the euro zone's third-biggest economy, has spurred fears of a possible break-up of the 17-nation currency bloc. Italy's borrowing costs reached unsustainable levels in recent days and the region appears unable to afford a bailout should there be a need for one.

Fears over Italy eased somewhat as the country moved closer to a national unity government, following Greece's lead in seeking a respected veteran technocrat to pilot painful economic reforms in an effort to avert a euro zone bond market meltdown.

Yellen urged European officials to solidify and follow through on rescue pledges. While a euro zone crisis-fighting plan announced in October was a step in the right direction, details remain murky, she said.

The continued rise in sovereign debt spreads for some countries, more generalized market volatility, and political turmoil that we have seen in recent days speak to the need for forceful action to stabilize the situation, she said.

U.S. bank regulators plan to begin their 2012 series of bank stress tests in a couple of weeks, Yellen said, a process that will determine which banks are strong enough to pay dividends and buy back shares.

Tests of banks' capacity to withstand crises have become a routine part of U.S. regulatory scrutiny, which was strengthened in the wake of the 2007-2009 financial crisis.

I think publishing all supervisory information we have and get in the course of our work with the banks is probably not something we are contemplating, Yellen said, but information sufficient to give market participants information about the health of major financial institutions and their ability to withstand stresses and shocks, I think is important, and we are certainly thinking about doing that.

(Reporting by Ann Saphir in Chicago, Mark Felsenthal in Washington and Pedro Nicolaci da Costa in San Francisco; Editing by Chizu Nomiyama)

International Monetary Fund