Written by Steven K. Beckner

ATLANTA, Ga. (MNI) - Kansas City Federal Reserve Bank President Thomas Hoenig Tuesday said that "dismemberment" of some large financial institutions is something that should be considered.

Hoenig, participating in a panel at the annual convention of the Allied Social Science Associations, said he is hopeful of passage this year of legislation that would provide for a "resolution mechanism" for dealing with failing financial institutions.

However, he expressed reservations about a House bill that would empower the Treasury Department, rather than a firm's primary regulator, to decide when a firm needs to be taken over by the government.

He said Congress needs to take its time and get it right.

Hoenig emphasized the need, as he has before, to deal with the "too big to fail" problem.

Responding to a suggestion made by University of Maryland Professor Carmen Reinhardt, Hoenig said, "dismembering firms is a fair thing to consider."

He said regulators "have people who are experts who understand what's going on inside institutions" who could figure out how to "carve out" some parts of a financial institution if they are taking undue risks with taxpayer backing.

Hoenig acknowledged that if some unspecified parts of a bank are "separated out" or divested there might still be "systemic risks," but he said resolution of a smaller firm would "become more effective."

Hoenig said there is a strong tendency in financial crises to bail out firms, but he said that in some instances "you have to allow institutions to fail and then have renewal."

He emphasized the need to have an FDIC-style resolution authority to deal with insolvent institutions which could seize a systemically important financial firm before it fails, change management, impose losses on shareholders and "put creditors in an adverse position."

Under Hoenig's scheme shareholders would be "wiped out," while "longer term secure creditors are protected but don't have immediate access to their funds."

He said regulators should "designate banks in advance that are systemically important" and make clear what steps will be taken if they become insolvent. In the meantime, he said regulators should apply certain rules, such as "substantially higher" capital requirements and loan-to-value ratios. He suggested banks with $50 billion or more of assets should be so designated.

"You really do need to have process for dealing with failing institutions," said Hoenig.

"Preparation is really important," he said. "We have to define 'systemic' to get things started to deal with this issue" of too big to fail.

The larger "systemic" banks and their creditors should be "put them on notice ...not that they're going to be bailed out, but that they're not going to be bailed out ... so creditors are not as protected."

Hoenig said that if creditors know they bear more risk in the event of failure, he said that should "begin to mitigate moral hazard."

Hoenig emphasized that, within the universe of banks deemed systemically important, "the primary regulator would designate if you become insolvent and you must take control."

He noted that a House bill would give that designating authority to the Treasury. He warned that a decision by Treasury could "be politically motivated" and could "delay resolution" as firms to "try to get a bail-out."

"People have told me you've got to strike when the iron is hot" on regulatory reform," he said, "but it's also important to do it right ... . If it takes a little longer I'm OK with that."

** Market News International **