Stressing the importance of preserving "financial stability" to maintain economic prosperity, New York Federal Reserve Bank President William Dudley Thursday said failures of the biggest financial firms must be prevented, not just dealt with after they happen.

Dudley said so-called "too-big-to-fail" banks or "systemically important financial institutions" (SIFIs), as regulators call them, pose multiple problems, Dudley said in remarks prepared for delivery to the Global Economic Policy Forum in New York.

First, their implicit government guarantees give SIFIs "a funding advantage" over smaller firms and creates "an uneven playing field," he said. Second, "this funding advantage creates incentives for financial firms to become bigger and more complex."

And third, Dudley said "as the banking system becomes more concentrated and complex, that just increases the financial stability risks, making the too big to fail problem even more acute."

Summarizing his preferred solution to the "too-big-to-fail problem," Dudley said "building a credible resolution regime is necessary but not sufficient."

He supported the "single-point of entry" resolution framework proposed by the Federal Deposit Insurance Corporation, in which the FDIC would place an insolvent major bank holding company into receivership and place its assets in a "bridge" holding company,

But he said "at least as much effort should be made to lower the risk of failure of such large, complex firms."

"Not only does this include higher capital and liquidity requirements, which we are implementing, but also building incentives into the system so that firm managements will act more forcefully and much earlier to put their firms on more solid ground before they encounter greater difficulties," he added.

Contrary to the suggestions of, among others, FDIC director and former Kansas City Fed President Thomas Hoenig, Dudley said he is "not yet convinced that breaking up large, complex firms is the right approach."

"In particular, these firms presumably exist, in large part, because there are scale or network effects that allow these firms to offer certain types of services that have value to their global clients," he said.

Dudley said "these benefits might be lost or diminished if such firms were broken up. In addition, the costs incurred in breaking up such firms need to be considered."

"Finally, the breakup of such firms would not necessarily result in a significant reduction in overall systemic risk if the resulting component firms were still, collectively, systemic," he said.

In closing remarks, Dudley said "the recent financial crisis underscores the importance of financial stability as a necessary condition for a vibrant economy."

Some of Dudley's colleagues, notably current Kansas City Fed President Esther George, have argued that the Fed itself is jeopardizing financial stability by holding interest rates very low for long periods, but that is not an issue Dudley addressed in his text.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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