Speaking before the Senate Banking Committee in Washington, D.C., Federal Reserve Vice Chairman Donald Kohn warned that banks need to strengthen reserves in order to improve liquidity.

Kohn told the committee that bank reserves have not kept up with rising problems and that the problems may extend to consumer loans. "Stronger capital positions also will allow banking institutions to participate in and support the rebound in lending that will accompany the strengthening of the U.S. economy," said Kohn.

Kohn stated that financial institutions must understand liquidity needs. "Over the coming months, we expect banking institutions to continue to face deteriorating loan quality. House prices are still declining sharply in many localities and losses related to residential real estate--including loans to builders and developers--are bound to increase further," said Kohn.

Kohn told the committee that the Federal Reserve must improve regulatory supervision where necessary and that Basel II must be implemented carefully.

By Steve Stecyk and edited by Cristina Markham