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LONDON (Reuters) - Britain needs to introduce legislation that could break up banks if standards slip because current reform proposals fall short of what is needed, an influential parliamentary panel said.
The Parliamentary Commission on Banking Standards also said on Friday the government could set tougher rules for how much leverage banks were allowed, adding that the committee itself would consider whether to propose banning proprietary trading.
Britain, going further than most countries in pushing through change, is forcing banks to separate, or "ring-fence", their domestic retail arms from riskier investment banking.
"The proposals, as they stand, fall well short of what is required. Over time, the ring-fence will be tested and challenged by the banks," PCBS chairman Andrew Tyrie said.
"That is why we recommend electrification. The legislation needs to set out a reserve power for separation; the regulator needs to know he can use it."
The Treasury said Chancellor George Osborne will consider the proposals and respond when reforms are brought to Parliament early next year.
Osborne appears unlikely to go as far as the PCBS wants. A previous Commission, led by John Vickers, said a full break-up of banks was not needed, and Osborne may decide that if the ring-fence plan proved to be flawed, the Treasury could then introduce fresh legislation to strengthen it.
Britain wants to prevent a repeat of the need for taxpayers to bail out lenders, as happened in 2008 with a 65 billion pound ($106 billion) double rescue of Lloyds Banking Group and Royal Bank of Scotland.
The PCBS, asked to assess government plans before their introduction, said legislation should be introduced now because banks had to be discouraged from gaming the new rules for the ring-fence to succeed.
"All history tells us they will do this unless incentivised not to," Tyrie said, adding politicians could be lobbied to put holes in the ring-fence too.
"Additional powers are essential to provide adequate incentives for the banks to comply not just with the rules of the ring-fence, but also with their spirit," the Commission said in its 146-page report.
Bank shares fell up to 2.5 percent, underperforming a 1.1 percent lower European bank index.
"I would be concerned ... that a future, politically-motivated government or regulator could take draconian action with impunity. It would be putting in place a simple mechanism for banks to be picked on and to be broken up," Investec Securities analyst Ian Gordon said.
"One could argue that threat is there anyway and could be implemented," he said, adding the PCBS had added to uncertainty about reforms.
The threat of break-up would be most damaging to Barclays - whose shares fell 2.5 percent - and to a lesser degree to HSBC and RBS, analysts said.
In a concession to most banks, the PCBS said banks should be allowed to sell simple derivatives within their ring-fenced operation, which had been a point of contention.
The PCBS was set up after Barclays was fined for rigging global interest rates and banks were slammed for a series of mis-selling scandals.
Tyrie said the market rigging and corruption shown this week at Swiss bank UBS "beggar belief. It is the clearest illustration yet that a great deal more needs to be done to restore standards in banking.
Among plans to rein in risk-taking is a cap on leverage, which Britain plans to set at 33 times banks' capital - weaker than an original proposal for a maximum of 25 times.
The PCBS said it was "not persuaded by the government's relaxation" of that leverage rule, adding the future regulator, the Financial Policy Committee, should set the leverage cap.
Tyrie said it may also be appropriate for Britain to block banks from any proprietary trading - known as the Volcker Rule in the United States - and the PCBS will take evidence on that early next year.
The cross-party commission, which includes Justin Welby, the next Archbishop of Canterbury - the Church of England's most senior bishop - has spent the past three months deliberating the reform plans, taking evidence from the bosses of major banks as well as regulators, politicians and central bankers.
It said it was concerned too many reforms will be left to the discretion of the future regulator, and said the power to force bondholders to take losses when a bank hits trouble should be included in primary legislation.
Editing by Dan Lalor