The U.S. economy is "under significant stress" and will not recover until the financial system is stabilized and credit flows improve, Thomas Hoenig, President of the Kansas City Federal Reserve, said Thursday.

Hoenig called for a plan to deal with failure at the largest financial firms -- those often branded as "too big to fail" because of their systemic nature -- that is framed around what is best for the overall economy, not just for one group.

"The restoration of normal financial activity depends on how we deal with the problems of our largest financial institutions," Hoenig told a Tulsa Metro Chamber of Commerce meeting in Tulsa, Oklahoma.

For even those massive firms, "failure does have to be an option in an economic system such as ours," he said, adding that as part of the resolution process, management at failed firms should be replaced.

"We simply cannot add more capital without a change in the firm's ownership and management and expect different outcomes in the future," he said.

Hoenig said a financial institution has "failed" when the value of its assets is less than the value of its liabilities, or if it suffers a massive loss in liquidity to the point where liquidity is insufficient to meet current payment obligations.

"It does not matter what size the firm is. Although a bank might still be open and operating, if it is insolvent by these definitions, it has failed."

TIME FOR AD-HOC MEASURES OVER

Hoenig, who is not a voting member of the Federal Open Market Committee in 2009, said his proposals were not a call to "nationalize" failing firms.

"Though a bridge institution is the most likely outcome when a large financial firm fails, the goal is for the firm to be reprivatized as quickly as possible," he said.

Hoenig said that ad-hoc measures were not surprising when the financial crisis first erupted in 2007.

"However, more than a year has passed and the challenge that still remains is to define a plan that addresses the significant asset problems embedded in our largest institutions," he said.

There is now both an acute lack of confidence in the market's remedy for large financial firms, and growing public dissatisfaction with huge tax-payer funded bailouts, he said.

Hoenig said all failed banks, big or small, should face the same kind of resolution process, "or else an incentive will be created for banks to take on excessive risks in an effort to grow large enough to gain favorable treatment."

That bias toward large banks was seen when the first round of TARP funds was parceled out in 2008, he said: $125 billion was given to the largest nine largest financial firms without an in-depth review of their condition.

"All other banks received TARP funds only if their primary regulator concluded they were strong enough to weather the crisis and continue as an ongoing concern."