UPDATE 2-Kohn says bank access to Fed cash comes at a price

(Adds details, Kohn remarks, analyst comments)

By Pedro Nicolaci da Costa

NEW YORK, May 29 (Reuters) - Wall Street firms should be subject to greater regulatory scrutiny if they wish to continue relying on the Federal Reserve to soothe the ongoing credit crisis, Fed Vice Chairman Donald Kohn said on Thursday.

Kohn said financial markets remained "far from normal" despite the central bank's best efforts to stem a withering of liquidity that first began with rising defaults in the mortgage sector and housing-linked bonds.

The Fed official stressed that Wall Street firms that have been able to obtain safe sources of funding from the Fed during the credit crisis are likely to face closer scrutiny.

"The more extensive the access, the greater the degree to which market discipline will be loosened and prudential regulation will need to be tightened," Kohn told a conference at the New York Federal Reserve Bank.

"Unquestionably, regulation needs to respond to what we have learned about the importance of primary dealers and their vulnerabilities to liquidity pressures," he added.

Apart from undertaking extraordinary measures to keep financial institutions well-funded, including a bail-out plan in which JP Morgan purchased rival Bear Stearns, the Fed has lowered interest rates sharply since mid-September.

Its benchmark rate has been reduced to the current 2 percent from 5.25 percent, although inflation concerns are now expected to keep policy-makers on hold.

Kohn said such actions were aimed at addressing a grave and largely unforeseen event.

"The scope and duration of disruptions to market liquidity that we have experienced since last summer have greatly exceeded what market participants, prudential supervisors, and central banks thought likely or even possible," he said.

These extreme circumstances require a wide-ranging reconsideration of regulatory policies and margin requirements for financial institutions, Kohn added.

As a part of the solution to the Bear Stearns debacle, the Fed extended access to its discount window for emergency lending beyond commercial banks to investment firms.

RECORD BORROWING

Indeed, the Fed coughed up a record daily average of $15.95 billion to banks through this window in the latest week, and another $12.33 billion to primary dealers, according to Fed data released on Thursday.

"Either banks are getting less shy about using this thing, or they are having greater stress," said Michael Feroli, U.S. economist with JPMorgan in New York.

This help does not come without consequences, Kohn said. More debate was needed, he proposed, regarding the recurrence of such access in the future.

"One possibility would be to confine such borrowing to circumstances in which the Federal Reserve judges that the stability of the financial system is at risk," he said. "Another would be to grant broker-dealers the same sort of regular access enjoyed by commercial banks." (Additional reporting by Mark Felsenthal and John Parry; Editing by Neil Stempleman)