LONDON, Oct 6 (Reuters) - Flawed supervision of cross-border banks in the European Union needs changing to better handle banks that are too big for smaller countries to bail out, Britain's market watchdog said on Tuesday.
Under EU rules retail banks from one state have "passporting" rights to operate branches elsewhere in the 27-nation bloc, with supervision and deposit guarantees regulated by the home supervisor.
Financial Services Authority Chairman, Adair Turner, said Iceland -- which is not an EU member but part of the wider European Economic Area where the bloc's financial rules apply -- did not have funds to support Internet account depositors of troubled Icelandic banks in several EU countries.
Britain had to use its own taxpayer money to protect such deposits held by UK-based account holders and Turner wants changes to stop this happening again.
"Big banks, even middle sized banks from small EEA countries can be 'too big to rescue'," Turner told a City of London event in Brussels.
Removing branch "passporting" rights would be a non-starter but a planned pan-EU securities authority, due to be set up in 2010, should give host states the right to receive all prudential information about entire banking groups, Turner said.
Host states should be allowed to take "proportionate and measured" steps to restrict activities of branches if weaknesses are not adequately addressed by the home regulator, he added.
The EU also plans to set up a European Systemic Risk Board to spot asset bubbles and other risks building up in the financial system before they get out of hand, a core lesson from the credit crunch.
Past attempts to deal with system-wide risks, such as warnings from the International Monetary Fund, were easy to ignore or simply wrong, Turner said.
"The success of the ESRB will depend on the quality of its analysis... and the willingness of politicians to take its warnings seriously and to countenance potentially unpopular responses," Turner said.
A draft EU law to regulate alternative investment fund managers like hedge funds and private equity "create the danger of overly prescriptive regulation", he said.
The draft has a too simplistic approach to assessing leverage and too little differentiation between types of alternative investment fund, Turner added.
(Reporting by Huw Jones, editing by Ron Askew)