This Weekend's Contemplation - Paulson Calls for Regulatory Changes

The implications of comments from the Secretary of the Treasury are far reaching. 1) He wants to include financial institutions other than banks under a regulatory umbrella like the FDIC. 2) He wants Presidential approval for the use of taxpayer funds to bail out a financial firm. The first comment clearly indicates to me that there is still considerable risk for the investment banks and some insurance companies. The second comment has so many pitfalls I don't even know where to start. For example, how do you handle the potential failure of some one like Bear Stearns, not agree to give them the money and watch the markets collapse?

Are you beginning to feel that somebody know something that we do not? Text in bold is my emphasis.From the LA Times:

U.S. Treasury Secretary Henry M. Paulson Jr. on Wednesday called for regulatory changes that would allow financial firms to fail without threatening broader market stability.

The Treasury chief also proposed steps providing for the president to approve of any use of taxpayer funds to aid a financial company. In a speech in London on Wednesday, Paulson identified a legal gap that leaves unspecified how to deal with failures of companies that don't take deposits, such as investment banks.

Paulson's proposals aim to tighten supervisors' oversight of lenders and dealers while at the same time discourage companies from depending on a government rescue if their bets go wrong. His speech comes a week before a congressional hearing to debate a regulatory overhaul in the wake of the credit crisis that caused the near-bankruptcy of Bear Stearns Cos.

"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 the speech at Chatham House, an international affairs research organization.

The Treasury chief noted that while there is a resolution mechanism for commercial banks, there is no such process for securities firms. Federal Deposit Insurance Corp. Chairwoman Sheila Bair has also urged that an agency be given power to take over and liquidate investment banks in an orderly manner. The FDIC has that power over lenders whose deposits it insures.

"We will need to give our regulators additional emergency authority to limit temporary disruptions," Paulson said. "Any commitment of government support should be an extraordinary event that requires the engagement of the executive branch."

Paulson participated in the talks that led to the Fed's assistance to Bear Stearns. His remarks Wednesday indicated he favors a formal process for the administration's consent to use taxpayer funds.

"That's a big signal," Arthur Levitt, former chairman of the Securities and Exchange Commission, said in a Bloomberg Television interview. Telling Wall Street that government aid would be subject to presidential approval "is pretty powerful medicine," he said.

The Fed invoked emergency powers as lender of last resort to give Bear Stearns a temporary loan in March and then to agree to take on $30 billion of the company's assets to secure its takeover by JPMorgan Chase & Co.

Some central bankers and former officials have said those actions, and the Fed's opening of direct loans to primary U.S. government bond dealers, created the danger of spurring more reckless lending by providing a backstop.

"Two concerns underpin expectations of regulatory intervention to prevent a failure," Paulson said. "They are that an institution may be too interconnected to fail or too big to fail. We must take steps to reduce the perception that this is so -- and that requires that we reduce the likelihood that it is so.

"The Treasury chief stressed that officials' first task "clearly" was ensuring market stability. Analysts see little chance of a regulatory overhaul being enacted by Congress this year, before a new administration takes office in January.

Paulson reiterated that the U.S. economy was in a "rough period."