A TOP White House econo-mic adviser says the Obama administration's proposed overhaul of financial rules preserves the policy of 'too big to fail', and could lead to future bailouts.

Former Federal Reserve Chairman Paul Volcker said yesterday that by designating some companies as critical to the broader financial system, the plans create an expectation that those firms enjoy government backing in tough times. That implies those financial companies "will be sheltered by access to a federal safety net," he said.

Financial crisis

In testimony prepared for the House Financial Services Commit-tee, Volcker said emergency measures by the Fed, Treasury and Congress during last year's financial crisis created the expectation that the government would step in to protect failing companies, their bondholders and stockholders.

Volcker said he does not differ with the administration on most of its proposals, and takes "as a given" that banks will be bailed out in times of crisis.

But he said he opposed bailouts of insurance firms like American International Group Inc, automakers' finance arms and others.

"The safety net has been extended outside the banking system," Volcker said. "That's what I want to change." He said the administration's proposal to create a new system for winding down large non-bank companies would make that easier.

The administration should make it clearer that "safety net" will apply only to traditional banks, not invest-ment companies or others, he added.

Volcker, 81, has emerged as one of the administration's internal critics. He serves as head of President Barack Obama's Economic Recovery Advisory Board, but has said the administration should take a slower, more methodical approach to overhauling the financial system.

Ample justification

Volcker served as Fed chairman from 1979 to 1987, when he tamed raging inflation, though at the cost of painful interest rate hikes that triggered a recession.

In recent speeches, he has expressed little enthusiasm for some of the initiatives under discussion in Washington, including regulating bankers' compensation. He has said there is "ample justification" for public anger at pay practices that were "wildly excessive" and encouraged risk-taking at the expense of stability. But he warned against too much political involvement.

In his remarks yesterday, Volcker endorsed a stricter separation between banks that hold deposits and investment banks. He said the "safety net" should be limited clearly to commercial banks, while investment banks should be excluded.

"Commercial banks are the indispensable backbone of the financial system," Volcker said, giving consumers safe deposit accounts and financial advice.

Investment banks take on more risk and face conflicts of interest when they combine consumer financial services with major corporate dealmaking. Volcker said it would be logical to prohibit commercial banks from trading in securities and derivatives.

The House committee is leading the effort to pass Obama's financial overhaul. Its chairman, Barney Frank, on Wednesday agreed to scale down a key pillar of the financial overhaul: A new regulator to protect consumers from unsafe financial products and activities.