NEW YORK, May 14 (Reuters) - Federal Reserve Governor Michael Barr said Thursday that lowering liquidity rules to get the central bank's balance sheet smaller is a bad idea and could undermine the safety of the financial system.

"There has been a lot of discussion of late about reducing the size of the balance sheet of the Federal Reserve to reduce our 'footprint' in the financial system," Barr said in the text of a speech to be delivered in New York before a gathering held by the Money Marketeers of New York University.

"I think shrinking the balance sheet is the wrong objective, and many of the proposals to meet this objective would undermine bank resilience, impede money market functioning, and, ultimately, threaten financial stability," Barr said, adding: "Some would actually increase the Fed's footprint in financial markets."

Barr said that allowing banks to hold less liquidity as a tool to shrink Fed holdings would likely increase the risk of these institutions turning to Fed liquidity facilities in times of trouble.

"If anything, the bank stresses of 2023 suggest that liquidity requirements should go up and not down," given what happened to banks during that period.

What's more, he said, "the size of the Fed's balance sheet is the wrong measure of the Fed's footprint in financial markets" and in a system where creating reserves is "costless" for the Fed, the real focus should be on how effective the Fed is at implementing monetary policy.

"The current regime has achieved" monetary policy objectives "for many years" and "effective policy implementation also supports smooth market functioning," Barr said.

REGIME SHIFT

Barr's comments on the state of Fed asset holdings come as the central bank may be poised to make changes to its strategy under Kevin Warsh, the almost certain successor to Jerome Powell as leader of the institution.

Warsh, a former central bank governor, has been critical of how the Fed has used asset buying over recent years to help smooth financial markets in times of stress and to augment monetary policy's stimulative power when interest rates are at near-zero levels.

Warsh believes that asset buying during the financial crisis and then again during the COVID-19 pandemic has left the Fed's balance sheet too large relative to the size of financial markets and that ongoing large-scale holdings of bonds somehow distort market pricing.

Fed purchases of Treasury and mortgage bonds during the pandemic more than doubled the size of Fed holdings to $9 trillion by the summer of 2022, and subsequent efforts to shrink holdings lopped more than $2 trillion off the Fed's balance sheet.

The Fed is now buying Treasury bills in a technical effort to maintain liquidity levels and align the balance sheet with the growth of the economy, and the overall size of Fed holdings currently stands at $6.7 trillion.

Warsh has also argued, to some controversy, that cutting the size of the Fed's balance sheet would allow the central bank to move its interest rate to a lower level than would otherwise be the case.

SHRINKAGE

The challenge for Warsh's critique is that the current system of tools used by the Fed to control interest rates, in a financial system flush with lots of reserves, limits how far the Fed can shrink its holdings while maintaining control over its interest rate target.

Some in the Fed, as well as academics, have argued that regulatory changes allowing financial firms to keep less liquid cash on hand could pave the way for the Fed to shrink its holdings.

Meanwhile, outgoing Fed Governor Stephen Miran said in recent work that cutting the size of Fed holdings is contractionary for the economy, so the Fed can offset that restraint by cutting its rate target.

That said, allowing banks to hold less liquidity at a time of rising economic turbulence comes with its own risks, and some academics have said lower reserve holdings would likely increase the risk of financial instability.