UPDATE 3-Ex-Fed chief Volcker sees 70's-style inflation risks

But while many Democratic lawmakers are pushing for tougher reforms of the financial markets in the wake of the worst housing downturn since the Great Depression, Bush administration officials say new regulations cannot take away all the risk.

"I put the most faith in the market and market discipline," Edward Lazear, chairman of the White House Council of Economic Advisers, told Reuters in an interview on Tuesday.

Appearing before the Senate panel, Volcker stopped short of recommending the Federal Reserve be the sole consolidated regulator of the financial markets. But he said because of its independence it was better suited to be the key regulator in today's complex markets.

"Because of (the Fed's) independence, it is in a better position to resist the political pressures of regulation," Volcker said.

"MORAL HAZARD"

The former central banker defended the Fed's role in brokering the buyout of Bear Stearns Cos BSC.N by JPMorgan Chase & Co (JPM.N), but warned that there has been a moral hazard created by the transaction.

"There is a moral hazard once you say you are going to protect all the creditors in a credit crisis. They are going to expect you to do it the next time," he said, referencing the notion that investors take greater risks when they believe the government will protect them from losses.

But he added that the burden to fix the credit market cannot be placed solely on the Federal Reserve.

"Don't push all this help for the credit markets on the Federal Reserve. That's the way to destroy the Federal Reserve because it does need its independence," he said.

Volcker also questioned the effectiveness of housing finance giants Fannie Mae (FNM.N) and Freddie Mac (FRE.N) in the housing crisis.

"Where were Fannie Mae and Freddie Mac? What kind of a system have we got when the agencies who are supposed to be reflecting the interest of the mortgage market are out serving the interests of their stockholders?" he asked. (Reporting By Joanne Morrison; Editing by Gary Crosse)