UPDATE 2-US group calls Fed 'tarnished,' demands risk monitor

* Report calls Federal Reserve's credibility "tarnished"

* Ex-SEC chairs Donaldson, Levitt: Obama plan falls short

* Investors demanding independent body to police risk (Recasts; adds Donaldson and Levitt comments, details)

By Jennifer Ablan and Jonathan Stempel

NEW YORK, July 15 (Reuters) - Some major U.S. investors and former securities regulators warned against letting a "tarnished" Federal Reserve take charge of preventing systemic risk in financial markets, rejecting a central plank of the Obama administration's response to the global credit crisis.

The Investors' Working Group, a coalition led by former Securities and Exchange Commission Chairmen William Donaldson and Arthur Levitt, on Wednesday urged the United States to create an independent watchdog to police risk management.

This is the most significant stance by an outside group to date and will help fuel the heated debate over financial regulation and strengthen Congressional opposition to the administration's push for the Fed to monitor large, interconnected financial firms whose failure would compromise the banking system.

The investor community warned against "serious drawbacks" that could result from giving the Fed more oversight of systemically important companies, citing the central bank's "competing responsibilities" to oversee monetary policy and manage the U.S. payments system.

"The Fed has an independent role, full employment and steady interest rates," Donaldson said in an interview. "That's a huge job. If you start to give them other things to do, you begin to dilute the principal role that they have."

The group said the new watchdog, the Systemic Risk Oversight Board, would be appointed by the president, be accountable to Congress, have a full-time staff, and perhaps could evolve into a full-fledged regulator.

It also called for new limits on banks' proprietary trading, more regulation of derivatives, higher capital requirements for banks, subjecting insurers to federal supervision, and requiring more "meaningful" oversight of credit rating agencies.

The group represents investors who oversee some $3 trillion of assets. Among its members are former Commodity Futures Trading Commission chair Brooksley Born; money managers Jeremy Grantham of GMO LLC and Bill Miller of Legg Mason Capital Management Inc (LM.N); a top official of the California Public Employees' Retirement System, the largest U.S. public pension fund, and personal finance columnist Jane Bryant Quinn.

BLAMING THE FED

While calling reforms proposed June 17 by President Barack Obama "a start," the group said "bolder" measures are needed to extricate markets from the worst financial crisis since the Great Depression. It rejected as "disastrous" the idea that agencies should use a "light touch" in policing markets.

Since September, the government has bailed out several companies, some more than once, including American International Group Inc (AIG.N), Bank of America Corp (BAC.N), Citigroup Inc (C.N), mortgage financiers Fannie Mae (FNM.P) and Freddie Mac (FRE.P) and General Motors Corp (MTLQQ.PK).

"The lack of sufficient authority, resources and will on the part of regulators helped fuel the financial meltdown at least as much as the absence of systemic risk oversight," the group said.