NEW YORK, May 14 (Reuters) - Federal Reserve Governor Michael Barr said Thursday that lowering banks' liquidity rules to reduce the size of the central bank's balance sheet 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 a speech to 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 changing rules to reduce banks' liquidity requirements as a way to shrink Fed assets would likely increase the risk that these institutions would need to turn 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," he said.

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 the real focus should be on how effective the Fed is at implementing monetary policy.

REGIME SHIFT

Barr's comments on the Fed's 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.

Barr formerly served as the central bank's vice chair for supervision, leading its bank regulatory policy work. 

Warsh, a former central bank governor, has been critical of how the Fed has used asset buying 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. When the Fed buys large quantities of longer-term bonds, it helps lower the cost of real-world borrowing. 

Warsh believes that asset buying during the 2008 financial crisis and its aftermath as well as during the COVID-19 pandemic left the Fed's balance sheet too large relative to the size of financial markets and that ongoing large holdings of bonds 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, which currently holds $6.7 trillion in assets, is now buying Treasury bills in a technical effort to maintain liquidity and align the balance sheet with the growth of the economy.

Warsh has also argued, to some controversy, that cutting the size of the Fed's balance sheet would allow the central bank to lower interest rates more 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 reserves, limits how far the Fed can shrink its holdings while maintaining control over its interest rate target.

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.

Barr said after his speech that he had not decided what he wants the Fed to do at the central bank's upcoming monetary policy meeting as officials wrestle with how to respond to an energy shock that's driving sharp gains in inflation of uncertain duration.