U.S. banks have not done enough to ensure they are well capitalized, and getting back to a system where retail and investment banking are separated would be attractive in terms of reform, Bill Gross, manager of the world's largest bond fund, said on Tuesday.

"Do we have a better example today than MF Global in terms of the mingling of those two particular aspects of capital allocation," Gross, who runs the $242.2 billion PIMCO Total Return portfolio, said at Charles Schwab Corp's IMPACT conference in San Francisco.

"So the closer we get back to separating the two, I suppose the better from the standpoint of reform."

MF Global , which is not a bank, but a futures broker run by former Goldman Sachs chief Jon Corzine, filed for Chapter 11 bankruptcy on Monday after a tentative deal with a buyer fell apart.

A top U.S. exchange regulator said the firm failed to protect customer accounts by keeping them separate from its own funds, leading to another shock for commodity markets scrambling to contain the fallout from the brokerage's bankruptcy.

"Wall Street sort of lost its way, in that investment banking became a function not of allocating capital properly, but levering capital and levering the returns on capital as opposed to transferring capital to productive industries," Gross said.

INVESTOR CONFIDENCE SHAKEN

He added that while many bankers are not in favor of increasing the industry's capital base, because firms make less money when they are less levered, investors need a banking system that is attractively and conservatively capitalized in order to regain confidence in the system.

"We didn't do that, we need to do that, we are making progress, but I think we need to go further," Gross said.

Gross, who is also co-chief investment officer of Pacific Investment Management Co., where he helps manage more than $1.2 trillion, was speaking on a panel along with Liz Ann Sonders, chief investment strategist at Schwab.

Sonders said that the MF Global situation seemed to be more a miss by the auditors than a regulatory problem.

"It's another hit to the confidence certainly of individual investors who have, maybe rightly so, felt that the whole game is rigged against them."

She said that much of the weakness in the markets on Monday and Tuesday may have had a lot more to do with liquidation on the part of MF Global than people think, because they were big players in many futures and commodities markets.

Markets were rattled on Tuesday by Greece's surprise call for a referendum over whether to proceed with a European Union deal to bail out the debt-laden country.

Gross said that the question was when, not if, Greece would default on its debt and that he thought it was a 50-50 call as to whether or not Greece would end up dropping the euro.

"Actually, I think they would do better, in my opinion, to drop out and then to come back," he said.

He said Iceland was a country that he thought had restructured its fiscal house in the right way.

"They basically told the banks to stuff it, to basically take their money and go home. Perhaps Greece should do that, or otherwise they're in for a five-, 10-, 15-year period of time of very difficult circumstances."

PIMCO is a unit of German insurer Allianz but is largely autonomous.

(Editing by Muralikumar Anantharaman)

European union Retail Goldman sachs Iceland