Policy makers reacting to the global financial crisis should avoid overstepping with harsh new rules that would have adverse economic effects and resist the urge to score political points, industry heads warned on Thursday.

The world's policymakers and regulators are working on a package of new global rules governing banks, derivatives trade, hedge funds and other parts of the complicated capital markets, aimed at avoiding future crises.

Banks and other industry players blamed in part for setting off the global recession could see their profits crimped, particularly if the most aggressive proposals in the United States and Europe become law.

You have to make choices as regulators between those elements of weakness in the financial system that need to be and should be corrected by the private sector itself, and those where you have to intervene, Malcolm Knight, Deutsche Bank AG's vice chairman, told a conference of financial regulators here.

Knight, addressing the International Organization of Securities Commissions (IOSCO), warned against creating an environment in which financial institutions have no incentives to securitize even the plain vanilla products.

The conference comes as a U.S. congressional panel convened its first meeting on Thursday to craft a final bill on financial regulatory reform.

The Obama administration is pushing for tough reforms, which it hopes to hold out as an example to other nations. The United States is further along than the European Union in implementing changes pledged last year by the Group of 20 countries.

The G20 will hold a summit in Toronto in two weeks, just as the U.S. congressional panel is due to be winding up its work on financial reform.

Knight was concerned about the G20's approach to regulating the securitization industry.

Securitization, which has been blamed for contributing to an implosion in the U.S. mortgage market, involves bundling together debt in a package by banks, which they then sell to investors.

The G20 paid lip service to understanding the economic importance of securitization, Knight said.

'ISSUES' WITH SWAPS

Another target of reform are complex over-the-counter derivatives, which likely will be funneled through clearinghouses and even exchanges once new rules are adopted.

The G20 has called for greater standardization and central clearing of the privately arranged contracts by the end of 2012 to cut risk. The market is now unpoliced.

Tim Ryan, head of the securities industry's main lobbying group, the Securities Industry and Financial Markets Association (SIFMA), said a U.S. proposal under the bill passed by the Senate that requires banks to spin off derivatives divisions makes absolutely no sense because it would push capital out of banks and would ultimately cost consumers.

Politics has crept into this debate over reform. It's a very attractive political issue, Ryan told the conference.

It's very easy to turn the financial service industry into the boogeyman, and because of that we have proposals that have crept into this legislation that make little sense if the standard is responsible reform.

It is unclear whether the controversial swaps proposal by U.S. Senator Blanche Lincoln will become law as the congressional committee hashes out a compromise bill. The final bill must be approved by both the Senate and the House of Representatives before being sent to President Barack Obama to be signed into law.

Goldman Sachs Group Inc President Gary Cohn told reporters at the conference in Montreal that the Lincoln proposal has issues.

While OTC markets have attracted substantial blame, Knight said there may also be problems with exchange-traded securities when exchanges do not harmonize their rules -- as evidenced by the May 6 flash crash on Wall Street, which drove the Dow industrials down some 700 points in the space of minutes.

REGULATORS RESPOND

But even as industry officials warned about the consequences of overly harsh regulation, top regulators said reform is critical.

I heard Tim Ryan say that he's worried that the politicians won't listen enough to the bankers. I think the big risk is that they will listen too much to the bankers, Hans Hoogervorst, chairman of the Netherlands Authority for the Financial Markets, told the conference.

Tony D'Aloisio, chairman of the Australian Securities and Investments Commission, said jurisdictions globally must maintain a sense of urgency or risk missing the opportunity to make smart reforms.

The financial crisis exposed fundamental flaws in the conventional wisdom of financial markets such as the deregulation mind-set and the so-called efficient market theory, he said.

As regulators, now is the time that we really have to maintain a sense of urgency to have these changes ... implemented in each jurisdiction, to move from the principles to implementation with a minimum of divergence, D'Aloisio said. Otherwise we're really going to miss the opportunity for much needed reform.

(Additional reporting by Rachelle Younglai and Jennifer Kwan; Editing by Leslie Adler)

Investment Goldman sachs