Bank regulation takes back seat to kick-starting economy

* Some argue ever more regulation will discourage lending

* European Commission may ease some proposed rules

* Without global policeman, implementation is hard

* Risks seen in growing area of shadow banking

By Huw Jones and John O'Donnell

LONDON/FRANKFURT, Feb 25 (Reuters) - As the banking crisis fades in memory, only to be replaced by a lingering economic slowdown, governments are losing interest in financial reform despite warnings that dangers still lurk.

The shift could mark the beginning of an era reminiscent of the more hands-off approach to regulation preceding the 2008 financial crash, albeit one that follows a raft of reforms - from capping bonuses to boosting capital - that have curbed banks' freedom to take risks.

It is a change of tack welcomed by some, from politicians to industry lobbyists, who argue banks should not be burdened with ever more regulation because it would discourage lending.

Others, however, warn of risks still hidden in a financial system with a growing "shadow banking" sector, where non-banks such as insurers and fund managers take on roles previously filled by banks. That area is just as opaque today as it was before the collapse of Wall Street's Lehman Brothers on Sept. 15, 2008.

"The bulk of legislative reform is now either in place or being put in place," said Anthony Browne, chief executive of the British Bankers' Association.

Priorities are already changing at the European Union's executive Commission, which proposed 40 draft laws in response to the financial crisis but may now ease some to aid the economy.

"I think it is only common sense now to step back a bit and say: 'Is every aspect of that absolutely right?' ...given that the biggest challenge that we face now is the lack of jobs and growth," EU financial services chief Jonathan Hill said this week.

Such words grate with some. "The pursuit of jobs and growth should not become a slogan for deregulation," said Christophe Nijdam of Finance Watch, a public-interest group that offers a counter-weight to industry lobbying.

REFORM FATIGUE

For some, it is high time to call a halt to the campaign to tame finance. Many parts of the global economy are struggling to grow, a problem that, in the euro zone at least, partly stems from banks' reluctance to lend as they comply with many new rules.

In the words of one official in Brussels, where much of the European regulation of recent years was drafted, "the world has moved on".

Banks must now hold at least three times more capital than before the crisis, making them far more resilient to shocks, as well as making it more expensive to engage in risk-taking.

In the euro zone, big lenders are now under the closer watch of the European Central Bank, rather than national supervisors.

"We need to have regulation that gets the investment we need," said Gunnar Hokmark, a Swedish member of the European Parliament who is involved in shaping regulation.

"If the European economy is now about getting investment, then we need to ensure that the banking system can work," said the lawmaker, who critics say is seeking, with tacit support from Germany, France and Britain, to dilute a draft EU law aimed at curbing risky trading activities at banks.

The final piece in this largely completed regulatory jigsaw is for the world's 30 biggest lenders, such as Deutsche Bank (LSE: 0H7D.L - news) , Morgan Stanley (Xetra: 885836 - news) and Goldman Sachs (NYSE: GS-PB - news) , to issue an additional buffer of bonds to protect them against accidents.

These bonds could then be "bailed in" or cancelled, with the loss borne by their owners, in order to keep banks afloat in a crisis without having to call on taxpayers.

Mark Carney, governor of the Bank of England and chairman of regulatory body the Financial Stability Board (FSB), is coordinating the reforms for the Group of 20 top global economies and wants the bonds buffer plan finalised in November.

Carney urged the G20 countries this month to mount a "big push" to complete the change, which is facing pushback from banks. But appetite is waning.

"I worry about reform fatigue, not surprisingly, both at the FSB and more generally," Carney said.

Others share his concerns and worry that, even if he succeeds, the new regime will fall short in making finance safe.

"The single greatest risk to financial stability remains excessive leverage in the banking system," said Robert Jenkins, a former member of the Bank of England's Financial Policy Committee.

"Some regulators continue to chip away at leverage. The banking lobby is chipping away at the chipping away, and the banking lobby is winning," Jenkins said.

SHADOW BOXING

With many of the rules in place, attention is shifting to the unwieldy task of implementation. But with no global policeman to enforce them consistently, there is a risk of chaos.

"We should not underestimate how big these implementation issues are," said Steven Maijoor, chairman of the EU's markets watchdog, the European Securities and Markets Authority.

Policymakers have, for example, yet to fully come to grips with new rules to make derivatives such as credit default swaps safer, after Lehman Brothers' collapse highlighted their dangers.

Rules requiring a secure 'clearing house' to complete the deal, just in case either buyer or seller goes bust, are spawning new powerful institutions in the $691 trillion market that some experts have compared with a nuclear-style, fresh too-big-to-fail threat for finance.

Much of the financial industry has meanwhile shifted to the $75 trillion fast-growing 'shadows', home to hedge funds, private equity investors or others providing credit.

But, as unemployment rises and the economy slows, there is little political interest in tackling this with a welter of new rules, for fear of crimping funding for the economy.

For some this is where the next financial crisis may be brewing, rather than in the now more transparent banking arena.

"The financial crisis destroyed millions of jobs and threw the economy into recession," said Finance Watch's Nijdam. "We do need free markets, but regulation is the key to making them serve society." (Additional reporting by Michelle Price in Hong Kong; editing by Alexander Smith and Mark Trevelyan)