July 15 (Bloomberg) -- Investors led by two former U.S. securities regulators are urging that an independent board monitor firms that pose a risk to markets, breaking with the administration’s plan to give the job to the Federal Reserve.

A committee led by former Securities and Exchange Commission Chairmen William Donaldson and Arthur Levitt also said the U.S. should consider limiting banks’ proprietary trading, merge some agencies and bring insurance companies under federal supervision. The group, in a report released today, says it’s offering a “bolder” overhaul of market rules than proposed by the Treasury Department last month.

The Fed’s “credibility has been tarnished by the easy credit policies it pursued and the lax regulatory oversight that let institutions ratchet higher their balance sheet leverage and amass huge concentrations of risky, complex securitized products,” the report by the Investors’ Working Group said.

Lawmakers are considering legislation that would enact President Barack Obama’s regulatory overhaul, the most sweeping change to financial oversight since the 1930s. Backed by a group of pension funds, the report might sway Democrats in Congress, especially those concerned that the central bank has too many conflicts and inadequate accountability.

Obama proposed that the Fed become the main overseer of firms whose collapse could roil markets, and bring hedge funds and private equity under federal scrutiny. The plan would create an agency to monitor consumer financial products. Treasury Secretary Timothy Geithner urged quick action by Congress.

‘Too Much Weight’

“The Obama plan is a thoughtful exercise, but I think it’s deficient in terms of giving too much weight to the Federal Reserve Board and to the Treasury,” Levitt said in a Bloomberg radio interview today. Fed oversight of monetary policy “may be at variance with the investor protection mandate, which is so much part of the program to bring back investor confidence.”

The debate on overhauling the regulations is occurring after a year of shocks on Wall Street sparked by the collapse of the subprime mortgage market and the deepest recession in a half century. Since September, the government has been forced to prop up such firms as Citigroup Inc., Bank of America Corp., American International Group Inc., General Motors Corp. and housing finance companies Fannie Mae and Freddie Mac.

Outdated Regime

Congress passed the $700 billion Troubled Asset Relief Program last year to help unlock the credit markets and rescue the largest banks after millions of investors lost their savings in the global stock market plunge. Some of the blame, the report noted, should be pinned on the outdated U.S. regulatory regime that has, at times, been overly friendly to industry.

The report is sponsored by the Council of Institutional Investors and the CFA Institute Centre for Financial Market Integrity. The council represents public, union and corporate pension funds with combined assets of more than $3 trillion.

The task force members include Brooksley Born, former chairman of the Commodity Futures Trading Commission; Bill Miller, chief investment officer of Legg Mason Capital Management Inc. and Harvey Goldschmid, former SEC commissioner, now professor at Columbia Law School.

“This is probably the only diverse non-partisan group that represents investors, their views, their priorities, their programs,” Levitt said.

Levitt, a Democrat who headed the SEC from 1993 until 2001, is a board member of Bloomberg LP, parent of Bloomberg News. He is a senior adviser to the Carlyle Group and a consultant to Goldman Sachs Group Inc. Donaldson, the Republican SEC chairman from 2003 through 2005, works at his own firm in New York.

‘Full-Fledged Regulator’

The recommendation for a systemic-risk oversight board is a short-term solution, the group said. Once the credit crisis has eased, a “full-fledged regulator” for companies deemed too- big-to-fail should be put in place, the report said.

The group is suggesting an independent oversight board, while some lawmakers propose a federal council comprised of the heads of the Fed, the Treasury and bank regulators to monitor for systemic risks.

“A council of regulators would have blurred lines of authority -- ultimately no one would be in charge or accountable -- and could be hamstrung by the usual jurisdictional disputes,” the report said.

‘Serious Concerns’

“Other serious concerns stem from the Fed’s recent regulatory failures -- its refusal to police mortgage underwriting or to impose suitability standards on mortgage lenders -- and the heavy influence that banks have on the Fed’s governance,” it said.

Proprietary trading at banks and their holding companies, “creates potentially hazardous exposures and conflicts of interest,” the report said.

“Banks should focus on their primary purposes, taking deposits and making loans,” the group said.

Lehman Brothers Holdings Inc.’s collapse last September spurred Goldman Sachs Group Inc. and Morgan Stanley to convert into bank holding companies, overseen by the Fed, to gain access to the U.S. rescue fund. Though they are building deposit bases, their earnings still hinge on trading.

Goldman yesterday posted its highest quarterly profit, $3.44 billion, as revenue from trading reached an all-time high.

Credit-Rating Companies

The report goes further than the Treasury proposal and recommends stiffer rules for credit-rating companies, which have drawn fire from investors for maintaining top rankings on mortgage securities months after the U.S. housing market started collapsing in 2007.

Fees from grading debt should “vest over a period time” so that ratings-companies aren’t compensated in full for assessments that turn out to be wrong, the report said. The document said Congress should make it easier for investors to sue companies such as Standard & Poor’s, Moody’s Investors Service and Fitch Ratings when their ratings incorrectly gauge the risk of a bond defaulting.

The report recommended that in the longer term, the U.S. should subject insurance companies to federal oversight and merge the SEC and the Commodity Futures Trading Commission, a step the administration considered but abandoned amid political pressure.

To contact the reporters on this story: Robert Schmidt in Washington at rschmidt5@bloomberg.net; David Scheer in New York at dscheer@bloomberg.net.

Last Updated: July 15, 2009 11:38 EDT