ABU DHABI - A Federal Reserve official said on Monday that the U.S. economy still faced significant weaknesses and urged policymakers to allow large financial institutions to fail if needed.

We still have significant weaknesses to work through in the economy in the U.S. and coupled with a rapidly rising level ... (of) debt and enormous moral hazard issues, we have a great deal of work ahead of us, said Kansas City Fed President Thomas Hoenig.

Data showed last week that U.S. consumer sentiment had soured in early November on grim job prospects while a larger-than-expected trade deficit had analysts scaling back estimates for third-quarter U.S. growth.

Turning to regulatory issues, Hoenig said that all financial institutions needed to be allowed to fail, no matter their size.

As we look at reform and the way forward I think the most important think we need to do is to make first of all an accurate assessment of fundamental weaknesses in our financial system and then begin to create better foundations, he said.

Hoenig was speaking at a central bank event in Abu Dhabi, the capital of the United Arab Emirates.

Our institutions must be allowed to fail no matter what their size or political influence, he said.

U.S. regulatory agencies have been embarrassed by flaws in financial oversight that failed to prevent a financial crisis that has triggered a painful recession, cost millions of jobs, and required hundreds of billions of taxpayer bailout money for banks.

The Fed has drawn sharp criticism from some lawmakers for its handling of the financial crisis, particularly its controversial decisions to extend emergency loans to large firms such as insurer AIG, which it did not directly supervise.

Our reluctance to deal with 'too big too fail' provides these largest institutions with important advantages over any competitors who are not seen as important, Hoenig said.

Hoenig also put the spotlight on credit ratings agencies, saying policymakers needed to examine fee structures and incentives, calling into question how the agencies earned fees from the companies they were supposed to rate in an objective manner.

Even if we put regulatory restrictions on the rating agencies trying to make them behave, incentives overwhelm (the additional safeguards). Incentives always overwhelm, he said.

(Additional reporting by Rania Oteify; Writing by Thomas Atkins; Editing by Kim Coghill)

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