* Duchy's image hit by Madoff scandal, waning bank secrecy
* Tougher regulation seen as threat, some say
* Others see maintaining reputation of safe centre as key
By Lisa Jucca
LUXEMBOURG, May 19 (Reuters) - Down in Clausen, a trendy area near Luxembourg City's landmark gorge, the professionals smoking cigars and sipping mid-week wine in a brewery-turned- sushi bar seem oblivious to the threat to their economy.
But in the high-rise steel and glass buildings that dot Europe's investment funds capital, the market turmoil and its consequences for the small land-locked Grand Duchy are a recurrent talking point.
Luxembourg, where the financial sector accounts for 45 percent of the economy, is facing two specific headaches: its tradition of bank secrecy is crumbling, and ripples of Bernard Madoff's fraud have cast a pall over its successful funds industry.
"We have to accept that our reputation has been a bit tarnished by Madoff, even if this is an (isolated) incident," said John Li, Chairman of the Supervisory Board of consultancy KPMG Luxembourg.
Luxembourg's no-quibble procedures for fund registration, stable political scene and well-educated workforce have helped it become Europe's top funds centre -- followed by France. At the pinnacle of its growth, in 2007, its funds managed assets worth 2 trillion euros ($2.7 trillion).
That figure dropped by a quarter after the financial storm hit in 2008. Madoff's fraud made matters worse: investors lost $1.7 billion to Madoff in Luxembourg, mainly via the large mutual fund Luxalpha.
Combined with a global crackdown on secretive offshore centres led by countries such as the United States and Germany, the impact on the country's lean financial system may be heavier regulation: Luxembourgers and foreign investors fear that could threaten its ability to market its funds abroad.
"The big challenge for Luxembourg is to remain a safe but flexible financial centre even after the crisis," said 29-year-old Laurent Muller, who along with his brother runs family-owned corporate tax advisory business Paddock.
"Overregulation is not what we are looking for right now."
Sally Wong, CEO of the Hong Kong Investment Funds Association, told fund managers at a conference earlier this year the questions about Madoff and Luxembourg had reached board level among her clients.
"One board member asked me the other day: what is the impact of Madoff on Luxembourg, what is going on there?"
FINANCIAL BY DEFINITION
Besides relatively affordable gasoline and Villeroy & Boch porcelain, finance defines Luxembourg: advertisements for its banks plaster even the brochures handed out by the tourist office.
Nestled between Belgium, Germany and France, this nation whose 490,000 people are typically quadrilingual has impressed rivals with its ability to evolve into a sophisticated financial centre from being heavily dependent on steel.
ArcelorMittal, headquartered in Luxembourg, is still the world's largest steelmaker with 10 percent of global output. The industry built up on the Grand Duchy's seam of iron ore now only accounts for 11 percent of the country's economy.
Founded around a 1,000-year old fortress and a centuries-old crossroads for European armies, Luxembourg first attracted capital around the time of Congo's independence in the 1960s as rich Belgians moved wealth from the former colony, bankers say.
Other waves coincided with the rise of the left in France and the start of a withholding tax in Germany in the 1980s.
Luxembourg became the world's third-richest country by output per head after it jumped on the funds bandwagon when the financial products took off in the 1980s.
It now administers an estimated $1 trillion of foreign wealth or 14 percent of the wealth stashed abroad globally, making it the world's third-largest offshore centre, and it has more than 70,000 people working at its banks.
In contrast to offshore leader Switzerland, which manages about $2 trillion and caters for the ultra-rich, Luxembourg banks have mainly served middle-class French and Germans.
FRENCH ATTACK
America was the epicentre of the Madoff scandal, but Luxembourg's situation was complicated in January by a diplomatic offensive launched by its funds rival France,
French funds managed assets of about 1.3 trillion euros in 2007 according to European funds industry association EFAMA and France is, lawyers say, home to many of the wealthy investors who have lost money on the Madoff Ponzi scheme.
French Minister Christine Lagarde asked the European Union to review rules governing mutual funds in light of the Madoff scandal, in what was widely seen as an attack on the way Luxembourg had applied them.
Luxembourg strongly rejected such criticism and Peter De Proft, director at EFAMA, said that of 35,000 funds available to the broad public, only four were affected by Madoff, which was the only significant fraud to hit the country's industry in 20 years.
While fighting to restore its reputation on the Madoff front, Luxembourg is also under pressure from cash-strapped western nations to let foreign tax authorities access untaxed wealth hidden in bank secrecy strongholds around the world.
The Duchy, together with other major offshore centres, decided in March to relax its strict privacy rules, allowing banks to pass some tax-related client data to foreign authorities to pursue tax cheats. But local support to bank privacy continues strong.
"It's not for banks to do the policing," said KPMG's Li.
Nonetheless, as more and more financial segments are caught in the regulatory net, Luxembourg hopes that its EU status and expertise in the funds industry can help it outperform offshore islands that solely rely on untaxed money and murky hedge funds.
"If there is one lesson to be learnt from the financial crisis is that there is huge value in good and safe regulation," Claude Kremer, Chairman of Luxembourg's funds association.
"Those exotic centres that are doing unregulated funds will necessarily see a shift of business towards regulated centres. And there Luxembourg can play a really important role."
(Additional reporting by Michele Sinner; Editing by Sara Ledwith)