LONDON (Reuters) – Tougher rules are needed to ensure financial stability, Bank of England Governor Mervyn King said yesterday, urging Britain's new government to "seize the opportunity" for banking reform.

In a foreword to be central bank's 2010 annual report, King said banks could not be allowed to remain 'too big to fail' and interest rates alone could not curb dangerous excesses building up in the financial sector.

"There is a need for additional policy tools," King said. "The system cannot be allowed to revert to its former ways as if nothing has happened. We must seize this opportunity for reform."

The BoE Governor has long argued for more decisive action to prevent a re-run of the crisis that pushed the global financial system to the point of collapse in 2008.

He was an early advocate of forcing retail banks to hive off riskier activities such as proprietary trading – an idea that has found favour with Britain's new finance minister George Osborne.

Britain's Conservative/Liberal Democrat coalition, which took power last month after 13 years of Labour rule, has agreed to set up an independent commission to investigate the issue of separating retail and investment banking.

It has also agreed to give the BoE greater oversight of macro-prudential regulation – the health of the financial system as a whole.

Under Labour, responsibility for policing the financial sector was split between the BoE, the Treasury and the Financial Services Authority regulator.

This tri-partite system was found wanting when money markets seized up, forcing major banks to go cap in hand to the central bank for emergency funding.

King gave a whole-hearted endorsement of the bank's inflation-targeting framework which he said should, and would, remain intact.

Consumer price jumped to 3.7 percent in April, almost double the central bank's two percent target, but King reiterated his confidence that the drift higher would prove temporary.

"Despite its volatility, inflation remains low by historic standards, and on track to meet the target in the medium term," King wrote.

"The framework has proved resilient to the stress of the financial crisis. It guided our monetary decisions going into the crisis, and it will guide them coming out of it."