* Liikanen group recommends structural change to make banks safer
* Regulators at European Commission to consider the proposals
* Lobby groups warn against changing bank structure
By John O'Donnell
BRUSSELS, Oct 2 (Reuters) - An EU advisory group called on Tuesday for banks' traditional deposit-taking business to be legally separated from higher risk activities, drawing fire from the industry even though it stopped short of demanding a full break up of lenders.
Recommendations of the group, set up by the European Commission, aim to shield taxpayers from having to fund further bailouts and to protect savers from any more banking collapses after more than five years of crisis.
In their report, the group argued for a "legal separation of ... particularly risky financial activities from deposit taking", including banks' trading on their own behalf as well as "activities closely linked with securities and derivatives".
Such reforms, if written into EU law, would have major consequences for many of the continent's top lenders.
"Our objective was that the trading activity of the banks would not be so big that it could topple the group," said Hugo Baenziger, a committee member and who, as chief risk officer of Deutsche Bank, helped to steer one of Europe's biggest investment and retail banks through the crisis.
The group's report to the Commission drew on elements of banking reform in Britain and the United States.
Ring-fencing investment banking would make it easier for the part of the bank that holds savers' deposits and lends to businesses to keep running even if other arms of the group collapsed, some banking experts say.
It would affect European banks such as Britain's Barclays , Deutsche Bank and France's BNP Paribas and Credit Agricole, which engage in retail banking alongside riskier trading in stocks, debt and other securities.
The industry's strongest critics have said these businesses should be conducted by entirely separate banks.
Bank lobby groups were critical of the report. The Association for Financial Markets in Europe, a group that represents big banks including HSBC and Deutsche Bank, cautioned against radical structural change, arguing that regulation and markets were already altering banks.
"We do not believe that further changes to the structure of the banking industry are necessary," said Simon Lewis, the group's chief executive.
The German Banking Industry Committee, which represents German banks, also criticised Liikanen's recommendation to curb trading, which it said would hamper risk management.
Uncertainty over whether the report of the group, which was led by Bank of Finland Governor Erkki Liikanen, will be implemented is likely to compound investors' nervousness in an industry where new rules are already set to curb banks' earnings.
Liikanen underscored the need for reform. "In Europe, banking is critical," he said as he outlined what he described as a "design" that could be introduced over the long term to limit runaway risks in banking. "It's more important to the European economy than any other area of the world because financing of the economy ... goes through the banking."
Property crashes in Spain, Ireland and other EU countries have led to huge losses for banks, and the group said real estate lending should be underpinned by larger capital reserves.
An audit of Spanish banks last week found they needed an extra 59.3 billion euros in capital largely due to losses on property lending, and the euro zone has already agreed to lend up to 100 billion euros to fund this.
The group also called for a mechanism to impose losses on bondholders in the case of a bank's bailout or collapse, suggesting that bankers should accept this risky type of bond as part of their bonus.
Although the report will fuel a debate about reforming banks it is unlikely that the Commission, the EU's executive, will respond soon with new regulation.
European policymakers, struggling to contain the regional debt crisis and associated banking troubles, are set to give priority to creating a banking union that would eventually allow euro zone countries to support banks jointly.
"This report will feed our reflections on the need for further action," said Michel Barnier, the European Commissioner in charge of regulation, who will now consider the findings.
"We are going as quickly as possible," he told reporters, commenting on the regulatory drive. "Because the big worry for the financial sector, for companies and for citizens is that they need a stable framework as quickly as possible."
For now, Brussels is expected to pursue safeguards such as larger capital reserves for risky business or rely on new powers to be granted to the European Central Bank to keep banks in check.
New rules that demand banks set aside capital by holding back profits will make them less risky for shareholders and taxpayers.
The United States, is pursuing its own structural reforms through the introduction of curbs on proprietary trading, where banks trade for their own benefit and in doing so take on risk.
Britain chose safeguards for depositors by shielding that part of a bank's business after Royal Bank of Scotland's rush to extend its investment arm resulted in the largest state bailout of the crisis in Europe.
A panel of experts headed by John Vickers, a former chief economist at the Bank of England, recommended that the retail arms of banks be "ring-fenced" by a cushion of extra capital beyond the international norm.