UPDATE 3-Fed's Tarullo warns on passing the buck on money-fund reforms

* SEC action is 'first-best' option; FSOC is 'second-best'

* Fed official still hopes SEC will adopt money market rules

* Tarullo also floats 'upper bound' on bank size

(Adds comments on limits to bank size)

By Jonathan Spicer

PHILADELPHIA, Oct 10 (Reuters) - It would be best if the Securities and Exchange Commission finally moved forward with money market reforms instead of leaving the job to the new U.S. financial risk council, a top Federal Reserve official said on W edn esday.

Fed Governor Daniel Tarullo said it was unfortunate that the SEC, the primary regulator of the $2.6 trillion industry, has so far failed to advance new rules for the market, which since the financial crisis has been viewed as posing a systemic risk.

In a wide-ranging lecture that touched on the limits and difficulties of crafting new rules in the wake of the 2007-2009 financial crisis, Tarullo, the U.S. central bank's point person on regulation, also floated the idea that the size of banks should be capped.

The Fed official's comments on money market funds, however, shed some light on how regulators intend to deal with the industry after SEC Chairman Mary Schapiro said on Aug. 22 that her agency would not formally put forward its reform proposals, since three of five commissioners opposed them.

That left the next move to the Financial Stability Oversight Council, or FSOC.

"Each of the options open to the FSOC and the rest of its constituent agencies is decidedly a second-best alternative as compared to a change in SEC rules to remove the fixed net asset value exception, to require a capital buffer that would staunch or buffer runs, or measures of similar effect," Tarullo said at the University of Pennsylvania Law School.

Any FSOC reforms would be worse for the funds themselves, he argued, because the tools available to the council "do not fit the problem precisely and thus will not regulate at the least cost to the funds while still mitigating financial risk."

The industry says money market funds are a safe investment with attractive returns, while critics worry that they are vulnerable to runs and create a false sense of security for investors who do not realize they are not backed by federal insurance.

Schapiro has argued that a series of reforms the SEC adopted in 2010 do not go far enough to prevent runs on funds like the one experienced in 2008 when the Reserve Primary Fund "broke the buck," meaning its net asset value fell below $1 a share.

On Sept. 27, U.S. Treasury Secretary Timothy Geithner called on the FSOC to formally ask the SEC to move forward with new rules. He also said the council should consider exercising other powers to regulate the money market fund industry more tightly.

The next day, Daniel Gallagher, a Republican SEC commissioner who had previously helped block the fund reforms, told Reuters he hopes the agency will consider a fresh package of reforms.

In a nod to those comments, Tarullo said: "My hope, of course, is that recent indications that other SEC commissioners are now willing to move forward with reforms will lead to the SEC adopting first-best measures in the near term."

While Tarullo sits in on FSOC meetings, Fed Chairman Ben Bernanke is the central bank's official representative on the council.

The FSOC's options include imposing restrictions on banks' and other firms' "ability to sponsor, borrow from, invest in, or provide credit to" money market funds that do not have structural protections, Tarullo said.

The council could also designate money funds as "systemically important" and thus subject to capital and liquidity rules included in the Dodd-Frank financial reform law, he said.

For non-banks in general, the FSOC is "actively considering" possible systemically important designees, Tarullo added.

Turning to bank acquisitions - which under Dodd-Frank are reviewed by the Fed for threats to financial stability - Tarullo said the fact that lawmakers did not set an "upper bound point" makes things difficult for regulators.

"To the extent that a growing systemic footprint increases perceptions of at least some residual too-big-to-fail quality in such a firm, notwithstanding the panoply of measures in Dodd-Frank and our regulations, there may be funding advantages for the firm, which reinforces the impulse to grow," he said.

"There is, then, a case to be made for specifying an upper bound," Tarullo said, adding, "It would be most appropriate for Congress to legislate on the subject."

(Reporting by Jonathan Spicer; Editing by Eric Walsh; Editing by Diane Craft and Dan Grebler)

((jonathan.spicer@thomsonreuters.com)(+1 646 223 6253)(Reuters Messaging: jonathan.spicer.reuters.com@reuters.net))