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By Huw Jones
LONDON, Nov 2 (Reuters) - Breaking up Britain's banks to legally separate retail from investment banking could increase risks in the system and higher capital is key, the country's top financial watchdog said on Monday.
Adair Turner, chairman of the Financial Services Authority, said there was no "silver bullet" to tackling the so-called "too big to fail" issue with systemically important banks.
Tougher capital rules must form the core of regulatory responses even if scrutiny of banks is more intense, he said.
"Our ability to see bumps in the road ahead is imperfect so we need more shock absorbers," Turner told an FSA conference.
"The extreme narrow banking proposal is clearly doable in practical terms, a law could be passed which achieved this effect, but I believe would fail to address the most vital problem and could produce a financial system even more vulnerable to instability than today's," Turner said.
"Such a division would clearly not be a policy response sufficient in itself," Turner added.
The G20 group of leading countries agreed in September that all systemically important financial institutions should have contingency plans in place for a speedy, orderly wind up by the end of 2010.
Such plans are expected to focus on so-called living wills in a bid to lessen the need for public bailouts in future. Banks fear they will be forced to simplify their structures and face prohibitively heavy capital charges on risky activities such as trading.
G20 finance ministers take stock of their financial pledges, including how to tackle too-big-to-fail firms, in St Andrews, Scotland, on Friday and Saturday.
Momentum for regulatory reform appears worryingly to have slowed because markets have stabilised and the subject matter of reform is complex and controversial, said Philipp Hildebrand, vice chairman of the Swiss National Bank's governing board.
The most prominent banks should not resist fundamental change but support efforts to bring this about, he added.
"What has been missing is a bold and international political commitment to put in place a framework for orderly resolution of large cross border institutions," Hildebrand said.
"I am not proposing to create a global resolution regime to replace national regimes," he added.
Banks say if tougher capital rules are brought in too soon, they will crimp their ability to keep lending and aid economic recovery.
"We should give plenty of time -- 2013, even more if we need to -- but we need to be clear as to where the banks need to go," Hildebrand said. The G20 has set an end-of-2012 deadline for hiking capital requirements as long as economic recovery is assured by then.
Many of Britain's banks have had to be shored up at huge
cost to the taxpayer, and the UK government will this week
announce a sector overhaul as rescued banks Royal Bank of
Scotland
However, the financial crisis has also sparked a debate on whether bank's need clear legal separation of commercial and riskier investment banking activities.
Bank of England Governor, Mervyn King, has called for such break ups but has also been rebuffed by the UK government.
Turner said such a "Glass Steagall" approach -- named after a now defunct U.S. law -- could be best pursued through heavier capital requirements on riskier banking operations.
Such heavier capital requirements are being worked out by the international Basel Committee on Banking Supervision and will make a "very major contribution to addressing the 'too big to fail' problem," Turner said.
"We need a fundamental review of the trading book capital regime and a bias to conservatism for riskier and purely proprietary activities," Turner added.
Speakers backed central clearing of derivatives contracts to cut risk, a step already underway and backed by the G20.
"It's a low-hanging fruit and needs to be picked," Hildebrand said. They can become a "single point of failure" and must have sufficient resources, he added.
Clearing of credit default swaps has already begun in the
United States and European Union with several listed firms,
including Eurex
Shyamala Gopinath, deputy governor of the Reserve Bank of India, said central counterparties should be run as not-for profit utilities. (Reporting by Huw Jones, Editing by Andy Bruce and Toby Chopra)