The underperforming global economy should not be allowed to delay financial system reforms, a senior official at the Financial Stability Board (FSB), a global watchdog set up by the Group of 20 nations, said on Tuesday, adding that the FSB will propose new rules on so-called shadow banking by year-end.

Bank of Canada Senior Deputy Governor Tiff Macklem, who chairs a key FSB committee, pushed back against bankers who argue now is not the time to impose tougher new capital standards on lenders due to the recession in Europe and a weak U.S. economy.

The current challenges are not an excuse for delay. Quite the opposite, Macklem said in a speech in Toronto.

In a risky world, the need to make the financial system safer and restore confidence is vital. If there is a reproach to be made, it is that progress has not been faster, he said.

The roll-out of the new capital rules for banks around the world, known as Basel III, is the biggest and most immediate test, he said.

The FSB groups central bankers, regulators and finance officials tasked with implementing the G20's mandate to rewrite financial sector regulations to avoid another global financial crisis.

Macklem chairs the FSB committee on standards and implementation. The FSB is headed by Bank of Canada Governor Mark Carney.

Among the FSB's next reform targets are nonbank players such as hedge funds and money market funds, often referred to as the shadow banking sector and currently beyond the reach of regulators.

Macklem said the FSB will draft policy recommendations for regulations for the sector by the end of this year, covering five areas:

* the interactions of regulated banks with shadow banking entities and activities

* money market mutual funds

* other shadow-banking entities

* securitization

* securities lending and repos.

Policymakers are concerned that risky transactions in the $60 trillion shadow-banking sector are growing in light of the crackdown on traditional banks, and that could trigger the next chapter in the financial crisis.

Macklem said reforms of the sector should strike a balance between preserving the benefits of shadow banking, such as innovation and diversification, while limiting risks.

The FSB is significantly enhancing the resources devoted to monitoring implementation, Macklem said, and has enough teeth to see the process through under its current structure.

Some commentators are concerned that the FSB lacks the authority to enforce the rules, and have argued that it must evolve to a treaty-based organization with the power to sanction its members, he said.

While this may ultimately prove to be the case, so far, this has not been demonstrated.

The speech contained no reference to Canadian monetary policy.

(Reporting By Jennifer Kwan; Writing by Louise Egan; Editing by Jeffrey Hodgson, Janet Guttsman and Peter Galloway)