Paulson's regulatory reform testimony

First, Americans have come to expect the Federal Reserve to step in to avert events that pose unacceptable systemic risk.

But the Fed does not have the clear statutory authority nor the mandate to do this; therefore we should consider how to most appropriately give the Federal Reserve the authority to access necessary information from complex financial institutions whether it is a commercial bank, an investment bank, a hedge fund, or another type of financial institution and the tools to intervene to mitigate systemic risk in advance of a crisis. The MOU recently finalized between the SEC and the Federal Reserve is consistent with this long-term vision of the Blueprint and should help inform future decisions as our Congress considers how to modernize and improve our regulatory structure.

Market discipline is also critical to the health of our financial system, and must be reinforced, because regulation alone cannot eliminate all future bouts of market instability.

For market discipline to be effective, market participants must not expect that lending from the Fed, or any other government support, is readily available.

I know from first hand experience that normal or even presumed access to a government backstop has the potential to change behavior within financial institutions and with their creditors.

It compromises market discipline and lowers risk premiums, ultimately putting the system at greater risk. For market discipline to effectively constrain risk, financial institutions must be allowed to fail.

Today two concerns underpin expectations of regulatory intervention to prevent a failure. They are that an institution may be too interconnected to fail or too big to fail.

Steps are being taken to improve market infrastructure, especially where our financial firms are highly intertwined - the OTC derivatives market and the tri-party repurchase agreement market, which is the marketplace through which our financial institutions obtain large amounts of secured funding. It is clear that some institutions, if they fail, can have a systemic impact.

Looking beyond immediate market challenges, last week I laid out my proposals for creating a resolution process that ensures the financial system can withstand the failure of a large complex financial firm.

To do this, we will need to give our regulators additional 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.

Any potential commitment of government support should be an extraordinary event that requires the engagement of the Treasury Department and contains sufficient criteria to prevent costs to the taxpayer to the greatest extent possible. This work will not be done easily. It must begin now, and begin in earnest. Thank you."