U.S. Treasury Secretary Henry Paulson said on Wednesday that the United States must strengthen its process for regulators to unwind failing investment banks without threatening the stability of the financial system.
Adding some flesh to his plan for the Federal Reserve to take a broader regulatory role, Paulson said his first priority was to maintain market stability amid the current turmoil, but he wants to move quickly to address regulatory deficiencies exposed by the credit crisis which began nearly a year ago.
"In my view, looking beyond the immediate market challenges of today, we need to create a resolution process that ensures the financial system can withstand the failure of a large, complex financial firm," Paulson said in remarks prepared for delivery to the Chatham House think tank in London.
"To do this, we will need to give our regulators emergency authority to limit temporary disruptions.
These authorities should be flexible and -- to reinforce market discipline -- the trigger for invoking such authority should be very high, such as a bankruptcy filing," he added.
He said the perception should be avoided that an institution is "too interconnected to fail or too big to fail" and added that "we must improve the tools at our disposal for facilitating the orderly failure of a large, complex, financial institution." On the final leg of a five-day trip to Russia, Germany and Britain to discuss trade and economic issues, Paulson was due on Wednesday to meet in London Prime Minister Gordon Brown, finance minister Alistair Darling, Financial Services Authority Chairman Callum McCarthy and Conservative Party Leader David Cameron.
Paulson's remarks, made available in advance, come amid debate over what additional regulation is needed in the wake of a rescue of Wall Street investment bank Bear Stearns.
In March the Fed helped engineer a takeover of Bear Stearns by JPMorgan Chase and guaranteed a $29 billion loan to facilitate the transaction out of concern that a Bear Stearns bankruptcy could trigger a financial panic.
It also started making emergency loans to investment banks for the first time since the Great Depression.
Paulson last month said the Fed should be given permanent authority as a "market stability regulator" to make liquidity available to a broader range of financial institutions under certain circumstances if the financial system's stability is threatened.
Current Insolvency Procedures Inadequate
The United States has procedures for the orderly unwinding of insolvent commercial banks with insured deposits, in which their regulators, including the Fed for smaller state-chartered banks, administer claims and control insolvency proceedings.
Paulson on Tuesday said using these procedures for larger, complex institutions such as investment banks could mitigate market disruption but would not impose enough market discipline on the private sector.
And simply subjecting investment banks to normal bankruptcy proceedings "imposes market discipline on creditors, but in a time of crisis could involve undue market disruption," he said.
He called for a flexible approach that allowed authorities to provide government support focused on areas with the greatest potential for market instability, but said a government backstop should not go too far.
Knowing that Fed support is readily available could cause institutions to willingly take on too much risk, as they did in the run-up to the subprime mortgage crisis, he said.
"For market discipline to constrain risk effectively, financial institutions must be allowed to fail.
Under optimal financial regulatory and financial system infrastructures, such a failure would not threaten the overall system."
Legislative Process Starts
Paulson's speech did not reveal any specific plans to ask Congress for legislation, which would be required for such changes.
He and Fed Chairman Ben Bernanke are due to testify on July 10 on proposed regulatory changes before the U.S. House of Representatives Financial Services Committee, one of the panels that would draft such a bill.
The hearing is one of a series expected this summer on the state of the U.S. regulatory system, and Paulson's speech provided a preview of his expected testimony as the legislative process starts.
Along with better insolvency procedures, he said stronger market infrastructure was needed to reduce expectations that some firms cannot be allowed to fail.
"Important work is under way" in strengthening procedures and practices in the over-the-counter derivatives market and the tri-party repo system, he said, the latter referring to a $2 trillion segment of the government bond market in which traders use transactions similar to collateralised loans to "finance" positions.
He said an agreement between the Fed and Securities and Exchange Commission to share information on investment banks also would help inform the political process.
Beyond stabilising markets and bolstering the Fed's market stability role, Paulson said his third priority was promoting a capital markets regulatory blueprint which would replace today's patchwork of financial regulators with three super-regulators: the Fed for overall stability, a regulator for insured financial and prudential institutions, and a regulator for consumer protection.