WASHINGTON — The push to create a receivership mechanism for failing investment banks gained momentum Wednesday with Treasury Secretary Henry Paulson's endorsement.
A former chief executive of Goldman Sachs & Co., Mr. Paulson said federal regulators must be empowered to unwind large nondepository institutions.
"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," Mr. Paulson said during a speech in London. "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."
Mr. Paulson's comments were similar to a call two weeks ago by Federal Deposit Insurance Corp. Chairman Sheila Bair, who said that investment firms must have a receivership process similar to that for commercial banks.
But observers said Mr. Paulson's comments would carry more weight with lawmakers as they begin next week to debate regulatory changes needed to avert a future government rescue similar to the Federal Reserve Board's intervention to save Bear Stearns this March.
"This is a guy who's a private-sector, free marketer individual coming up with something like this — that's a deep statement," said Ernest Patrikis, a former general counsel at the Federal Reserve Bank of New York who is now a partner in Pillsbury Winthrop Shaw Pittman LLP.
"Not only is he an investment banker, he's a Goldman Sachs banker. With him saying it now, with his background, it carries a lot of weight."
Mr. Paulson kept many of his comments vague, but he could be forced to be more specific when he testifies July 10 at the House Financial Services Committee along with Fed Chairman Ben Bernanke.
The hearing is the first of several on the need for a regulatory revamping, and it is to touch on the Treasury's reform blueprint released four months ago.
In his speech Wednesday, Mr. Paulson built on the blueprint, saying new regulatory receivership powers must be kept flexible and that "the trigger for invoking such authority should be very high, such as a bankruptcy filing."
He also said he wants to fight the perception that some institutions are too big to fail. "We should consider ways to ensure that costs are imposed on creditors and equity holders," he said.
"Any commitment of government support should be an extraordinary event that requires the engagement of the executive branch," he said. "It should be focused on areas with the greatest potential for market instability and should contain sufficient criteria to ensure that the cost to the taxpayers is minimized."
Such a system is already in place for commercial banks. Under the Federal Deposit Insurance Corp. Improvement Act of 1991, the FDIC, Fed, and Treasury secretary, in consultation with the president, can jointly invoke the systemic risk exception to prevent the failure of a bank if its collapse would wreak havoc on the financial system. The cost of such a bailout would be borne by the rest of the banking industry, which would face a special insurance premium assessment.
Regulators must also take prompt corrective action to prevent a failure or minimize the cost of its collapse.
In a speech two weeks ago, Ms. Bair advocated similar requirements for investment banks and offered the FDIC as the receiver for such institutions.
"There should be a prompt corrective action-like mechanism with mandatory triggers for supervisory intervention and, if necessary, closure if capital is not restored," she said.
Though Mr. Paulson did not go so far, he said the bankruptcy process governing investment banks could affect the system adversely.
"Bankruptcy imposes market discipline on creditors but in a time of crisis could involve undue market disruption," he said.
He acknowledged, however, that a regulatory receivership process could "reduce market discipline" because creditors could perceive some government backing. This is not his intent, he said.
"For market discipline to constrain risk effectively, financial institutions must be allowed to fail," Mr. Paulson said. "Under optimal financial regulatory and financial infrastructures, such a failure would not threaten the overall system."
His comments continued the debate over extending bank-like regulation to investment banks.
The Securities and Exchange Commission and the Fed are still working on a memorandum of understanding governing enhanced central bank supervision of investment banks, Mr. Paulson said, and it is expected to be released soon.