Henry Paulson

In our Blueprint, we suggested an optimal regulatory structure for the long term in which the Federal Reserve would take on a different but important role as market stability regulator focused exclusively on the market as a whole. We raised for debate whether it was optimal to have a regulator that serves as the system's lender of last resort and also focuses on the safety and soundness of individual institutions. We questioned whether these sometimes conflicting responsibilities should be separated in order to better channel market discipline. We also noted that where the system was at risk additional regulatory authority to complement market discipline would be needed.

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We should evaluate whether the resolution, or winding down, process for large complex institutions should be modified to help mitigate disruption to the financial system and improve market discipline. This requires addressing a number of difficult questions, including whether we need to assign a particular regulatory agency to oversee resolutions and how any potential intervention is justified and explained.

Finally, we must review the emergency authorities of the Federal Reserve, Treasury and other financial regulators, and update them to reflect the current financial system. To be effective in the future, our regulatory system needs an overhaul.

Clearly, these are difficult questions. They will not be resolved quickly. Nor will they be resolved in one single reform effort. The solutions will evolve, as regulators and market participants consider the issues. Recent events have revealed the disconnect between the ever-evolving financial system and our outdated regulatory framework. Dedicated and innovative regulators have found ways to address current issues within the bounds of authorities created when the financial system was markedly different.

Of course, the mere creation of a market stability regulator can increase moral hazard and decrease market discipline. The expectation that a regulator will intervene to protect the system must be limited to the greatest extent possible. In other words, we must limit the perception that some institutions are either too big or too interconnected to fail. If we are to do that credibly, we must address the reality that some are. To do that, we must strengthen market infrastructure and operating practices in the OTC derivatives market and the tri-party repo system and clarify the resolution, or wind down, procedures for non-depository institutions. Creating a more stable environment will mitigate the likelihood that a failing institution can spur a systemic event.

Strengthening market infrastructure will reduce the expectation that an institution is too interconnected to fail. We need to strengthen our practices and financial infrastructure in the OTC derivatives market and in the tri-party repo system. Important work is underway in each of these areas, and needs to be completed quickly.

So how do we strengthen market discipline? Today's priority is clearly market stability. However, looking beyond the immediate turmoil, we need to design carefully and put in place a stronger capacity for resolution and crisis intervention that reinforces market discipline....

To address the perception that some institutions are too big to fail, we must improve the tools at our disposal for facilitating the orderly failure of a large complex financial institution. As former Federal Reserve Chairman Greenspan often noted, the real issue is not that an institution is too big or too interconnected to fail, but that it is too big or interconnected to liquidate quickly.

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As I have continually noted, the financial landscape has changed, and non-bank financial institutions play a significantly greater role. We need to consider broadly the resolution regime in light of these changes. It is clear that some institutions, if they fail, can have a systemic impact, so we must give regulators the authorities to limit that impact and facilitate an orderly failure. 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. 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. And as part of this process we should consider ways to ensure that costs are imposed on creditors and equity holders. Any commitment of government support should be an extraordinary event that requires the engagement of the Executive Branch.

Today we are also looking more broadly for ways to increase the availability and lower the cost of mortgage financing to accelerate the return of normal homebuying activity. We are working with FDIC, the Federal Reserve, the OCC and the OTS to explore the potential of covered bonds, which is one promising financing vehicle to do just that. Covered bonds provide funding to an issuer, generally a depository institution such as a commercial bank or thrift, through a secured debt instrument collateralized by a pool of residential mortgage loans that remain on the issuer's balance sheet. Interest is paid to investors from the issuer's cash flow. In the event of a default, covered bond investors' primary recourse is the pool of mortgage loans, and secondary recourse is an unsecured claim on the issuer. Covered bonds have been widely used in Europe to finance residential and commercial real estate, and municipal bonds. At the end of 2006 the European covered bond market was over 1.9 trillion Euros.

And, as Treasury seeks to encourage new sources of mortgage funding in the United States, improve underwriting standards and strengthen financial institutions' balance sheets, covered bonds have the potential to serve these purposes and reduce the costs for first-time home buyers, and for existing homeowners to refinance.

There are many countries around the world that don't have market-determined currencies. There is no country as big as China and as integrated as they are into the global economy in terms of goods and services. And so in some ways it's an unnatural act.

During Q&A session

We need to do some things to strengthen the infrastructure we have, the over-the-counter derivative market, the tri-party repossession market, and that which is secured financing between institutions.

If you've got a squirt gun in your pocket, you may have to take it out. If you've got a bazooka and people know you've got it, you may not have to take it out. You're not likely to take it out. I just say that by having something that's unspecified, it will increase confidence and by increasing confidence it will greatly reduce the likelihood it will ever be used.

As reported by Reuters.

"We've worked on different ways of expanding the TALF," Paulson said. "There's a lot of work (that) has been done on an aggregator bank (and) other ways of leveraging TARP funding to let it go further when it comes to dealing with illiquid assets."

In a surprise visit to the Treasury news room, as reported by Dow Jones