Fed sees some healing in scarred credit markets

By Ros Krasny

CHICAGO (Reuters) - Top Federal Reserve officials on Thursday cited progress in alleviating months of turmoil in financial markets, but said a full return to normalcy was still some time away.

The recent credit woes underscore the need for banks to hold "generous" capital cushions, Federal Reserve Chairman Ben Bernanke said, as he urged banks to actively raise money and prepare for better times that lie ahead.

"I strongly urge financial institutions to remain proactive in their capital-raising efforts," Bernanke said in a speech at the Chicago Fed's 44th annual bank structure conference. This year's theme is "Credit Market Turmoil: Causes, Consequences and Cures."

"Doing so not only helps the broader economy but positions firms to take advantage of new profit opportunities as conditions in the financial markets and the economy improve," he said.

Bernanke and the New York Fed's William Dudley, who oversees financial markets for the U.S. central bank, provided plenty of grist for the analysis mill.

Fed watchers believe that the Fed is pushing banks to redouble efforts to get past the months-long credit crisis -- just as the Fed has raised its own game, innovating ways to bolster market liquidity when it was desperately needed.

Cary Leahey, an economist with Decision Economics in New York, said Bernanke was urging banks to redouble their efforts to get rid of less productive assets so that they can resume more normal lending patterns.

"The Fed thinks it has done a lot to ease the credit crisis and now the financial institutions have to pick up the ball and run with it," Leahey said.

Bernanke said the success of many banks in raising new capital has been encouraging, and praised the often contentious foreign-owned sovereign wealth funds for their role in supplying capital in a time of need.

"They have generally provided unleveraged, patient money, which is what is needed here. They have not asked for extensive control or management of the firms," the Fed chairman said.

Raising capital and repairing balance sheets will "allow for the extension of new credit, which supports economic expansion," he added.

RESPONDING TO ASSET BUBBLES

At the Chicago Fed's conference a year ago, Bernanke said he expected little spillover from problems in subprime mortgages to the broader economy.

In hindsight, Bernanke said it was evident that "problems occurred at each step of the credit-extension chain," and had contributed to the credit crisis that has driven the economy to the brink of recession.

In Philadelphia on Thursday, Fed Governor Frederic Mishkin said central banks can do more harm than good when they try to use interest rates to pop the type of asset price bubbles that led to the current crisis.