Officials at odds on Fed's role as market saviour

By Pedro Nicolaci da Costa

NEW YORK (Reuters) - There is internal disagreement at the U.S. Federal Reserve regarding the central bank's role as a safety valve for battered financial markets and troubled banks, according to policy-makers' remarks on Thursday.

Donald Kohn, the institution's influential vice-chairman, said in Congressional testimony the Fed stood ready to act again if needed to shield the financial system from the failure of a major financial institution.

He defended the central bank's role in funding JP Morgan's emergency buyout of Bear Stearns in March, but declined to comment on the health any other specific firms.

"Our judgment was that had Bear Stearns BSC.Nbeen allowed to walk into bankruptcy court, that would have disrupted the financial system and had very serious effects on the economy," Kohn told the Senate Banking Committee.

But two of his colleagues, Richmond Fed President Jeffrey Lacker and his Philadelphia counterpart Charles Plosser, seemed leery of such actions, fearing they might encourage excessive risk taking and foment future crises.

The comments come as investors worry about the possibility that Lehman Brothers LEH.Ncould run into the sort of issues that brought Bear Stearns to its knees, with speculation rife about a possible acquisition of Lehman by another major bank.

"Policy interventions in financial markets run the risks of increasing moral hazard and inhibiting efficient price discovery," Plosser told students and faculty at New York University's Stern School of Business.

"Moreover, interventions intended to quell instability can, by creating moral hazard, actually make instability more severe in the long run."