By Alister BullCHARLOTTE, North Carolina (Reuters) - The Federal Reserve should threaten banks to make them raise more capital as a step toward restoring faith in credit markets, central bank policy-makers were urged on Friday."I think the most important thing for the Fed to do is not just use moral suasion, but a baseball bat with respect to the banking system," Paul McCulley, managing director at bond fund manager PIMCO, told a conference in response to a question from Fed Vice Chairman Donald Kohn.Kohn asked McCulley and other panelists at a credit market symposium hosted by the Richmond Fed whether market strain had persisted and whether the Fed's actions to relieve strain were working."If you are under strain, don't cut your dividend. Eliminate your dividend. You don't want to dilute existing shareholders? Well, dilute them," McCulley urged. "A more forceful move by the Fed beyond moral suasion on capital raising is necessary to fix that problem," he said.Bankers and policy-makers spent two days talking about credit strains and systemic risk as financial markets battle to regain their footing from the shock of the collapse of the subprime mortgage market.Richmond Federal Reserve chief Jeffrey Lacker said he was confident that measures taken by regulators and financial firms to make the system safer would yield results, but were not a silver bullet for current market woes."I am confident myself that the result of this (regulatory) response will be broadly beneficial, and will result in improvements in the efficacy of financial arrangements, even if the response doesn't result in the complete absence of financial market turmoil from now on," he said.Darryll Hendricks, managing director and global head of quantitive risk control at Swiss bank UBS, said that the Fed's emergency liquidity measures had helped to ease strains, but had not removed the fear of a truly damaging upset in markets."I think there is still this fear and uncertainty that you could wind up in a different equilibrium that is quite negative ... the bad equilibrium is depression, in my view," he told the audience.Boston Federal Reserve President Eric Rosengren told the conference that counterparty fear was driving LIBOR (London interbank offered rate) spreads above dollar swap rates.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.To ease these worries, Rosengren said banks should consider cutting their dividend to protect capital, rather than shrinking their balance sheet by crimping lending, which could further dampen economic activity."While actions taken by central banks are improving the supply of term financing, eventually the confidence in private counterparties to comfortably buy or sell term funds needs to be restored," he said."A key ingredient in this outcome is that counterparties are truly well capitalized and have a financing structure that does not make them susceptible to counterparty runs."(Editing by Tom Hals)
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