ECB's Weber says "shadow banking" next target

LONDON (Reuters) - Regulators want to target the "shadow banking" sector next as part of wider reform of financial rules but countries are split over how to do this, European Central Bank policymaker Axel Weber said on Thursday.

Regulators typically mean entities such as hedge funds, private equity, money market funds and special investment vehicles when referring to 'shadow banking'.

"We need to shine some light into the shadow banking sector," Weber, who is also president of Germany's Bundesbank, told students at University College London.

Weber likened the power of hedge funds and other parts of the so-called 'shadow banking system' to the force the sea exerts on coastal defenses.

"Basel III (banking rules) and special rules for systemically important institutions are certainly important instruments in safeguarding the stability of the financial system. However, the best dike is of little use when there is a whole ocean at your back," he said.

"With stricter rules for the regular banking sector there is a clear danger that more and more activities will flow around the newly erected dikes and add to the ocean of unregulated activity at our back, thereby increasing systemic risk." he added.

"Thus, we have to turn our heads, take a close look at the shadow banking sector, understand what is going on there and ultimately control the systemic risks that we have identified."

SPLIT OVER APPROACHES

The Group of 20 leading economies in the world (G20) have already asked its regulatory task force, the Financial Stability Board to come out with recommendations for cracking down on shadow banking before year end.

Weber said there is no consensus yet among G20 countries on the best way to regulate the sector, saying member countries were split between two approaches:

-- direct regulation: this would mean imposing banking capital and liquidity requirements on shadow banking entities;

-- indirect regulation: many parts of the shadow banking system like hedge funds are linked to mainstream banking through loans and therefore there would be higher capital requirements on banks with exposures to the shadow banking sector.

"Given that shadow banks pursue similar activities as regular banks, they accumulate similar risks which might easily become systemic, flooding back into the regulated part of the financial system.," Weber said.

He said regulators needed to first define their targets in the shadow system, categorize them by the activities they perform, monitor them and finally tie them to new regulation.

On a broader note, Weber backed his UK counterpart, Bank of England Governor Mervyn King, who said the problem of banks being too big to be allowed to fail had yet to be solved.

King was portraying the feeling across the regulatory scene, Weber said.

"Things cannot change in a measured way. There will have to be fundamental change ... If institutions are too big to fail, they are too big to exist," Weber said, echoing an earlier King speech.

Weber shocked financial markets last month by announcing he would quit as Bundesbank President at the end of April and ruled himself out of the race to become the next head of the ECB.

(Reporting by Huw Jones; writing by Marc Jones; Editing by Patrick Graham, Greg Mahlich)