RPT-Fed's Dudley: Higher bank buffers could fuel risk-taking

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* Greater capital requirements could fuel risk taking

* Central bank can backstop liquidity. Moral hazard risk

* Contingent capital no substitute for resolution process

PRINCETON, NJ, Nov 13 (Reuters) - Banks could respond to bigger capital cushion requirements by taking on more risk, a top Federal Reserve official warned on Friday.

William Dudley, president of the New York Federal Reserve Bank, said requiring banks to have a greater liquidity cushion could lessen the likelihood of a liquidity crisis cascade but also made transactions more expensive.

"There is a cost to the firm from holding greater liquidity buffers in terms of lower returns on capital. So, requiring greater liquidity buffers would also tend to drive up intermediation costs. Banks could respond by taking greater risks," he said.

The prepared remarks to be delivered at Princeton University focused on lessons learnt from the crisis, and how a better financial system could be built.

Dudley, who as president of the New York Fed has a permanent vote on the Fed's policy-setting Federal Open Market Committee (FOMC), did not discuss the economic outlook or monetary policy.

He instead offered a number of suggestions on how to ensure the wide-spread freezing up of markets witnessed at the height of the global financial crisis does not happen again.

Dudley, who before becoming the New York Fed's president headed up its markets desk, said the central bank could provide a liquidity backstop to solvent firms.

"If the central bank is willing to provide backstop liquidity, then a lender that judges the financial firm to be solvent should be willing to lend," Dudley said.

But being a backstop could create more moral hazard. If firms and their investors know the central bank has their back it gives them an incentive to "run leaner" when times are good, increasing the risk of being their backstop, Dudley said.

To lessen this problem, central banks could charge financial firms for the value of the backstop, Dudley suggested. He cautioned that it would be difficult to put a price on the support.

Dudley also warned that use of instruments to ensure greater bank buffers, such as "contingent capital" -- debt that would convert to equity in times of duress -- "does not obviate the need for an improved resolution process."

There are bills in the U.S. Congress to help regulators deal with large troubled firms and ensure shareholders and creditors absorb some of the losses.

The bills come after the government used taxpayer funds to prop up firms that were considered a risk to the financial system, such as insurer AIG (AIG.N).

The Fed is working on structural changes to the financial system to make it more stable, Dudley said.

For example, the Fed has been working with dealers, clearing banks and investors to eliminate the instability of tri-party repo system, he said. The tri-party repo market is seen as an important part of the financial system's plumbing.

However, "exactly how the mechanics of the tri-party repo system will be adjusted is still a work in progress," he said.

There could be formal loss-sharing agreements to reduce the advantage for participants to get out early and exacerbate a liquidity crisis, he suggested.

He said another structural problem is tying collateral calls to credit ratings, a problem that exacerbated American International Group's downward spiral last year.

At the moment, if a firm's credit rating is lowered, it has to post more collateral to its counterparties. Regulators could require collateral requirements be independent of credit ratings, Dudley said.

(Reporting by Kristina Cooke; Editing by Andrew Hay)