DAVOS, Switzerland (Reuters) - A bank-funded safety net to absorb large failures could help shield markets and rebuild trust in the financial system, but regulators backing the idea will need to strike a delicate balance.
Finding a solution to the "too big to fail" debate is the main outstanding regulatory headache yet to be addressed in a bid to overhaul the financial industry after the crisis.
But informal talks in the Swiss mountain resort of Davos showed that while banks and regulators agree on the need to build shock absorbers and toughen capital rules to curb bank risk, finding a consensus on how to limit the potential cost to taxpayers of emergency bail-outs could lead to critical delays.
"We need living wills or resolutions," European Central Bank President Jean-Claude Trichet said at the World Economic Forum.
"We have to strengthen infrastructure in order to minimize the fallout of a collapse. It is very complex and multidimensional and we have to work a lot."
Bankers attending the forum said rulemakers and the industry agreed there was a need for a wind-down mechanism for banks, but there was no consensus on what this should look like.
One controversial new idea debated at behind-the-scenes talks during the annual gathering was the possibility of creating a so-called "resolution fund" to manage crises at large institutions whose troubles could unsettle the broader system.
The issue is relevant for small countries with large banks, like Switzerland, that want to avoid seeing their economy threatened by a financial collapse, as was the case in Iceland.
The resolution fund, supported publicly by Deutsche Bank Chief Executive Josef Ackermann and Barclays President Bob Diamond, would be set up by imposing a levy on the global banks.
"I very much support it," said Davide Serra, a founder of investment fund Algebris, who holds stakes in several financial institutions. "It means that when there is a crisis, there is private capital, generated by them, that they can use."
Mario Draghi, who heads the powerful Financial Stability Board (FSB), said the FSB was working on a framework for the orderly resolution of bank failures which could involve an agency or equivalent authority.
Yet some industry practitioners were skeptical about setting up a fund or entity, which they said it would introduce moral hazard by bringing in a stronger safety net for banks.
"If we have a fund based on the contribution of all, maybe we would not trade so carefully because we would have this last-resort money -- and then the state," said Warsaw Stock Exchange head Ludwik Sobolewski.
Others pointed to the fact that making the fund operational and reliable could take years -- time the industry and the broader economy can ill-afford.
One tricky detail is how to manage such a fund, with many suggesting this delicate task should be done nationally, with FSB rules used as "a floor."
"That specific decision should be taken by each country," said Brazilian central bank governor Henrique Meirelles.
Speaking on the proposal, Barney Frank, the powerful chairman of the U.S. House Financial Services Committee, added: "No one is going to abrogate the independent sovereignty."
The issue is being discussed as part of proposals to be unveiled in an interim report due from the FSB in June.
But the industry is still a long way away from clarity, as the mere notion of what constitutes a potentially risky bank is elusive and some bankers fear the political backlash against them may sway the debate.
"A lot of the measures that we are suggesting in this area assume that we are able to identify which are the systemically important institutions: this is not an easy task," Draghi said.
Some stressed that focusing on the size of institutions alone was not the right approach.
"One can imagine firm limits on their size, I tend to prefer differential in capital ratios," said Stanley Fischer, central bank governor of Israel. "Too big to fail is not the right issue. We're looking for a resolution mechanism."
Political pressure, meanwhile, is building -- U.S. President Barack Obama has already stepped outside the G20 framework by unveiling plans to curb certain bank trading activities.
"It has taken 12 years to build Basel (regulations) but we don't have 12 years to build financial reform today," said Dominique Strauss-Kahn, Managing Director of the International Monetary Fund. "We need to speed up."
Editing by David Cowell