Fed's Rosengren says banks must recapitalize

CHARLOTTE, North Carolina (Reuters) - A top Federal Reserve official said on Friday banks must raise capital to shield themselves from future losses and it would be better to cut dividends to achieve this rather than shrink their balance sheets.

"Many financial firms have raised significant capital. Unfortunately, while in many cases these equity issues have offset recent losses, they may leave little additional buffer should further credit losses occur," said Boston Federal Reserve Bank President Eric Rosengren.

"A number of large financial institutions have reduced their dividends, and given the potential for additional capital shortages, it goes without saying that financial institutions should continue to assess whether further reductions or cessation of dividends would be advisable," he told a credit market symposium here hosted by the Richmond Fed.

Rosengren, who is not a voting member of the Fed's interest-rate setting committee this year, said "truly well capitalized" counterparties were essential to easing counterparty risk concerns that have dogged the interbank market for months.

He blamed these fears for the premium of the LIBOR, or London interbank offered rate, above dollar swap rates, which he said was "unhinged."

The interbank cost of three-month borrowing of dollars rose on Friday by its biggest daily amount since the beginning of the credit crisis in August, as concerns that LIBOR quotes had been understated combined with growing doubts about the extent of further U.S. interest rate cuts.

"Certainly, raising capital by large financial institutions has been very, very helpful. But I would say that we are not all the way done with the process to get securitization, and some of these other things that would be signs of a fully functioning market, back," Rosengren told the audience during a question-and-answer session.

The Fed has slashed interest rates 3 percentage points since mid-September to protect the economy from declining home prices and the collapse of the subprime mortgage market, which has caused global financial turmoil and chilled growth.

Rosengren made plain that further credit losses that cause banks to rein in lending would hurt the economy and were foremost in policy-makers' minds as they weighed options.

"Financial institutions that choose not to raise capital through new equity issues or reductions in dividends are likely to react to capital losses by shrinking their balance sheets," he said.

"Where and how they choose to reduce credit can have macroeconomic implications, as the availability of credit can become a factor for some subsets of borrowers," Rosengren said.

Some markets continued to show signs of stress, Rosengren said, citing dire pricing in mortgage backed securities that imply very high default rates, disruption to commercial real estate, financing difficulties in the municipal bond market and the retreat by some firms from student lending.

"I would say that confidence in the rating system and the securitization process more generally has been disrupted. Ideally, we can't have all this flow back onto bank balance sheets," he said.

"We need the securitization market to right itself. In the long run, it is in everybody's interest to have a healthy securitization market. I don't think we have that right now," Rosengren added.

(Additional reporting by Glenn Somerville in Washington)

(Writing by Alister Bull; editing by Gary Crosse)