UPDATE 1-UK told to add break-up threat to bank reform

* Ring-fence plan falls "well short" of what is needed * UK should add legislation to carry threat of bankseparation * Simple derivatives should be allowed within "ring-fence" * UK bank shares dip, Barclays down 2.5 percent By Steve Slater LONDON, Dec 21 (Reuters) - Britain needs to introducelegislation that could break up banks if standards slip becausecurrent reform proposals fall short of what is needed, aninfluential panel of lawmakers said. The Parliamentary Commission on Banking Standards also saidon Friday the government could set tougher rules for how muchleverage banks were allowed, adding that the committee itselfwould consider whether to propose banning proprietary trading. Britain, going further than most countries in pushingthrough change, is forcing banks to separate, or "ring-fence",their domestic retail arms from riskier investment banking. "The proposals, as they stand, fall well short of what isrequired. Over time, the ring-fence will be tested andchallenged by the banks," PCBS chairman Andrew Tyrie said. "That is why we recommend electrification. The legislationneeds to set out a reserve power for separation; the regulatorneeds to know he can use it." The Treasury said finance minister George Osborne willconsider the proposals and respond when reforms are brought toParliament early next year. Osborne appears unlikely to go as far as the PCBS wants. Aprevious Commission, led by John Vickers, said a full break-upof banks was not needed, and Osborne may decide that if thering-fence plan proved to be flawed, the Treasury could thenintroduce fresh legislation to strengthen it. Britain wants to prevent a repeat of the need for taxpayersto bail out lenders, as happened in 2008 with a 65 billion pound($106 billion) double rescue of Lloyds Banking Group and Royal Bank of Scotland. The PCBS, asked to assess government plans before theirintroduction, said legislation should be introduced now becausebanks had to be discouraged from gaming the new rules for thering-fence to succeed. "All history tells us they will do this unless incentivisednot to," Tyrie said, adding politicians could be lobbied to putholes in the ring-fence too. "Additional powers are essential to provide adequateincentives for the banks to comply not just with the rules ofthe ring-fence, but also with their spirit," the Commission saidin its 146-page report. Bank shares fell up to 2.5 percent, underperforming a 1.1percent lower European bank index. "I would be concerned ... that a future,politically-motivated government or regulator could takedraconian action with impunity. It would be putting in place asimple mechanism for banks to be picked on and to be broken up,"Investec Securities analyst Ian Gordon said. "One could argue that threat is there anyway and could beimplemented," he said, adding the PCBS had added to uncertaintyabout reforms. The threat of break-up would be most damaging to Barclays - whose shares fell 2.5 percent - and to a lesserdegree to HSBC and RBS, analysts said. In a concession to most banks, the PCBS said banks should beallowed to sell simple derivatives within their ring-fencedoperation, which had been a point of contention. "MORE NEEDS TO BE DONE" The PCBS was set up after Barclays was fined for riggingglobal interest rates and banks were slammed for a series ofmis-selling scandals. Tyrie said the market rigging and corruption shown this weekat Swiss bank UBS "beggar belief. It is the clearestillustration yet that a great deal more needs to be done torestore standards in banking." Among plans to rein in risk-taking is a cap on leverage,which Britain plans to set at 33 times banks' capital - weakerthan an original proposal for a maximum of 25 times. The PCBS said it was "not persuaded by the government'srelaxation" of that leverage rule, adding the future regulator,the Financial Policy Committee, should set the leverage cap. Tyrie said it may also be appropriate for Britain to blockbanks from any proprietary trading - known as the Volcker Rulein the United States - and the PCBS will take evidence on thatearly next year. The cross-party commission, which includes Justin Welby, thenext Archbishop of Canterbury - the Church of England's mostsenior bishop - has spent the past three months deliberating thereform plans, taking evidence from the bosses of major banks aswell as regulators, politicians and central bankers. It said it was concerned too many reforms will be left tothe discretion of the future regulator, and said the power toforce bondholders to take losses when a bank hits trouble shouldbe included in primary legislation.