Dec. 8 (Bloomberg) -- U.S. regulators should rise to the “challenge” of encouraging an expansion in bank lending amid a weakening economy and continuing financial-market turmoil, Federal Reserve Vice Chairman Donald Kohn said.

The “job” of regulators is “to create an environment in which, in the short run, banks can step in to fill as much of the gap as possible that has been left by still-dysfunctional markets,” Kohn said today in Washington.

With the benchmark interest rate at 1 percent, Fed Chairman Ben S. Bernanke said this month the central bank has “limited” room to cut rates to stem a 12-month-long recession. Policy makers, planning to meet Dec. 15-16, may take less conventional measures, such as buying Treasury securities, he said.

The U.S. economy lost 533,000 jobs last month, pushing up unemployment to 6.7 percent, as a worsening credit crunch deepened the slump.

“In recent weeks, bank lending appears to have dropped back, consistent with the significant tightening of terms and standards reported by bank loan officers in recent quarters as well as the weakening of economic activity,” Kohn said during a panel discussion sponsored by the Office of Thrift Supervision.

The Fed, seeking to reverse a downturn in housing, said last month it will buy as much as $600 billion of debt issued or backed by government-chartered housing-finance companies.

After the announcement, mortgage rates fell more than at any time in at least seven years. The reaction “demonstrated how illiquid the markets are,” Kohn said as part of a panel in response to a question.

‘Many Fronts’

“There isn’t any one solution” for the housing crisis, he said. “We will have to attack it on many fronts.”

Financial institutions have reported credit losses and writedowns on mortgage-related assets totaling $980 billion since the beginning of 2007.

“Additional capital, liquidity backstops and regulatory encouragement should all reinforce financial stability and set the stage for increased bank lending,” Kohn said. “We want banks to be willing to deploy capital and liquidity, but they must do so in a responsible way that avoids past mistakes and does not create new ones.”

An overhaul of financial regulation should focus on ensuring economic stability as well as the safety and soundness of banks and Wall Street firms, Boston Fed President Eric Rosengren said in a speech today. “Inadequate oversight can cause periods of financial turmoil that are quite destructive.”

Kohn, 66, is the most experienced central banker at the Board of Governors. He took office in August 2002, after serving as a close adviser to former chairman Alan Greenspan as secretary to the FOMC from 1987 to 2002. He was also director of the Monetary Affairs Division from 1987 to 2001.

To contact the reporter on this story: Steve Matthews at smatthews@bloomberg.net

Last Updated: December 8, 2008 12:20 EST