Hank Paulson Tries To Figure Out How To Allow Financial Firms To Fail

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Henry Paulson focused on market discipline yesterday, saying we need reforms that would allow the unwinding of failed financial institutions. Speaking at Chatham House, the British think tank, on the financial markets and regulation, Paulson said that the Treasury Department and other policymakers were focused on "the immediate turmoil," seeking to promote market stability and minimizing the negative impact of stresses in the capital markets. However, further regulatory reforms, such as the Blueprint put out by the Treasury in March, were also necessary, both to fix problems exposed recently and to head off future problems.
Paulson delivered an accurate state-of-the-union on the financial markets, commenting on deleveraging and noting that US and UK financial institutions had recapitalized greater than 95% of their losses to date. Frankly, It's nice to see a policy maker so-grounded in the reality-base community.

CNBC focused on oil prices and housing, which were two of the three "headwinds" that he identified as facing the US economy. But Paulson's speech emphasized the third headwind, turmoil in the capital markets. Paulson spoke about oil only briefly, including stating that high crude prices were likely to "prolong our economic slowdown." On housing, he stated that his policy was "to avoid preventable foreclosures" while also allowing the correction in order to stabilize prices. From our vantage it looked like advice to Congress to avoid tampering with the housing market with taxpayer dollars, while acknowledging that some amount of these mortgages require workouts for an optimal economic outcome.
The focus of Paulson's speech was the need for market discipline and how to achieve this in reforms of the regulatory structure. "Too complicated to fail" was the chief target; he called for better regulation in derivatives and other steps to reduce counterparty risk from a failing financial firm and cut down on systemic risk that a firm's collapse would pose.
Allowing financial firms to fail is a key aim of Paulson's reforms. He stated a desire for regulators to have the necessary tools at their disposal to both reduce the risks posed to market stability by failure and also to "facilitate an orderly failure." Criticizing the limited number of options available at the present, such as the Fed's lender-of-last-resort powers, he tipped his hat to the changes due for the Bank of England, which gains remit over market stability and the new resolution regime for financial firms. His proposals for regulatory reform won't pass Congress this year, but this speech effectively focused the debate on ways that "too big to fail" and moral hazard can be mitigated.
One question: what exactly was Paulson doing giving a speech in London so close to Independence Day? He even praised the Bank of England. Suspicious!

--Senior patriotism correspondent Andrew.