Nov. 17 (Bloomberg) -- Federal Reserve Bank of Kansas City President Thomas Hoenig said the central bank should provide emergency lending programs only to financial institutions that create credit and handle payments.

``The focus should be on protecting the intermediation process and payments mechanism,'' Hoenig said today in the text of a speech in New York. ``I would argue for at least drawing a sharp line between banking and commerce, with our discount window only used to fund institutions and markets that play strictly a financial role.''

The Fed has tried to mitigate the worst credit crisis in seven decades by channeling more than $1 trillion in loans to banks and corporations and reducing the benchmark interest rate to 1 percent. Some central bank credit has gone to nonbanks, such as insurer American International Group Inc., and U.S. automakers are also seeking federal assistance.

President-elect Barack Obama said yesterday the government needs to provide a ``bridge loan'' or other help to auto companies on condition that management, labor and lenders come up with a plan to make the industry ``sustainable.'' ``For the auto industry to completely collapse would be a disaster,'' he said in an interview broadcast on CBS News's ``60 Minutes.''

General Motors Corp., Ford Motor Co. and Chrysler LLC need federal aid before Obama takes office Jan. 20, United Auto Workers President Ron Gettelfinger told reporters on Nov. 15.

Impasse In Congress

Democrats would like to use part of $700 billion in bank rescue money approved this year to help automakers, a move opposed by U.S. Treasury Secretary Henry Paulson and President George W. Bush. An impasse in Congress may put more pressure on the Fed to provide temporary assistance.

Loans and other assistance from the Fed and the Treasury have brought several unintended consequences because the U.S. lacks a framework for aiding troubled nonbank financial institutions, Hoenig said at an Institute of International Bankers conference.

``Many of the steps taken have raised important issues with regard to moral hazard and the subversion of market discipline, equitable treatment of different institutions and segments of the market, and public interference in credit allocation,'' Hoenig said.

Hoenig, Richmond Fed President Jeffrey Lacker, and Philadelphia Fed President Charles Plosser have called for a framework limiting emergency central bank credit.

``An expanded role for the discount window may bring central banks more directly into allocating credit as collateral requirements are selectively relaxed, and lending is used to support specific segments of the market,'' Hoenig said.

`Especially Concerned'

The Kansas City Fed president said he was ``especially concerned'' that loans to institutions beyond banks put the Fed in the position of ``mixing banking and commerce.''

``Such assistance could put public authorities into the process of allocating credit and selecting the winners and losers,'' he said. ``A long-standing concern is that central bank lending should not be used to prop up insolvent institutions.''

Leaders of the Group of 20 nations agreed on Nov. 15 to strengthen regulation of financial markets while calling for a ``broader policy response'' to avert a global recession.

The U.S. Treasury has set aside $250 billion of a $700 billion taxpayer-funded bailout package for direct capital injections into banks. Fed Vice Chairman Donald Kohn said on Nov. 12 that financial firms had inadequate capital and liquidity going into the crisis.

Impose Leverage Ratios

Authorities need to impose leverage ratios for financial institutions, Hoenig said. Basel II, an international accord geared toward allocating capital on the basis of risk, is complex, easy to evade and ``pro-cyclical,'' he said.

Hoenig said he would support a rule linking the suspension of dividends to the loss of earnings.

Fed officials have cut the main lending rate by 4.25 percentage points during the past 14 months. Still, the economy suffered its biggest decline since 2001 in the third quarter, contracting at a 0.3 percent pace. Consumer spending fell at a 3.1 percent annual pace in the quarter, the first decline since 1991 and the biggest since 1980.

The jobless rate rose to 6.5 percent in October, the highest rate in 14 years, as companies fired 240,000 workers after a loss of 284,000 in Sept.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Anthony Massucci in New York at amassucc@bloomberg.net

Last Updated: November 17, 2008 10:27 EST