Treasury Secretary Henry Paulson addressed the House Committee on Financial Services yesterday. While he spoke of investor and financial institution discipline and improvements in market practices, Paulson made the nation's regulatory architecture his primary topic.

Progress that has been made since Paulson's announcement of the Blueprint for a Moderninzed Financial Regulatory Structure, first laid out in March: the President's Working Group (PWG) issuing a report analyzing the causes of the market turmoil, featuring recommendations on a “comprehensive” policy response; regulators “enhancing guidance, issuing new rules, and communicating more effectively across agencies.”

“We have been working together, while respecting our different authorities and responsibilities, to ensure the stabiilty of the financial system, because it is in the interest of the American people that we do so,” Paulson said, also adding that this responsibility is by far the “most important priority.”

When it was first announced, Paulson said the Blueprint would not be implemented immediately and that a long-term vision was in order. But in light of “the Bear Stearns episode and market turmoil,” he argued that regulatory reform move more swiftly in order to improve market oversight and market discipline.

The treasury secretary reminded members of the House Committee of recommendations the United States should take in the near term. For starters, reconsideration of the Federal Reserve's role and authority when it comes intervening to “mitigate systematic risk” for complex financial institutions —whether it is a commercial bank, an investment bank, a hedge fund, or another type of financial institution.

An MOU between the Security and Exchange Commission and the Fed 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,” Paulson said.

Because regulation alone can't “eliminate all future bouts of market instability,” Paulson says market discipline is absolutely necessary. “For market discipline to be effective, market participants must not expect that lending from the Fed, or any other government support, is readily available,” he said. “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.”

Paulson even when on to say that in order for market discipline to stay immune to risk, “financial institutions must be allowed to fail.”

There are two roadblocks that Paulson says that are propping up expectations of regulatory intervention in order for financial institutions to avoid failure. “They are that an institution may be too interconnected to fail or too big to fail,” he said, citing that steps are being made to improve infrastructure.

While the treasury secretary is aware of the “systemic impact” that can occur when financial institutions fail, i.e. Bear Stearns, he noted that in order to avoid that from happening, regulators must be given additional emergency authority to limit temporary disruptions—which he said should begin now.

“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,” he said. Jacqueline Gilbert