07/06/2010 05:12 am ET Updated May 25, 2011

Hank Paulson's Wall Street Reform Proposals Stronger Than Pending Senate Bill

Former Treasury Secretary Henry Paulson outlined a number of "suggestions" Thursday to fix the nation's broken financial system and the outdated regulatory regime overseeing it, including reforming the derivatives trade, the securitization process, the credit rating agencies and lessening the reliance on megabanks.

Some of Paulson's suggestions will come as a delight to reformers; some of those same suggestions will come as a disappointment to those who believe the current pending reform legislation will fix the ills that plague the financial system.

"Our financial system cannot move forward without fortifying the weak parts of its infrastructure," Paulson said in his prepared remarks before the Financial Crisis Inquiry Commission, the panel charged with investigating the roots of the financial crisis.

Calling the financial regulatory system "archaic and outmoded" -- a frequent assertion made by many current and former policymakers -- Paulson, a former chief executive officer of Goldman Sachs, said these four reforms need to be addressed:


Megabanks can't dominate the system. Since September 2008, the nation's four largest banks have grown even larger and more dominant. Bank of America and JPMorgan Chase each have on-balance sheet assets in excess of $2 trillion (that doesn't include their off-balance sheet asssets), according to filings with the Federal Reserve. Citigroup has about $1.9 trillion. Wells Fargo has $1.2 trillion, plus at least another $1 trillion in off-balance sheet assets, according to filings with the Securities and Exchange Commission.

"In our haste to deal with the flaws in the non-bank financial system, we should not move ourselves back to a system of consolidated, monolithic commercial banks," Paulson said.

A few senators have proposed legislation to split up these financial behemoths. The Obama administration does not support it. Neither does Senate Banking Committee Chairman Christopher Dodd, the author of the overall reform bill.


Regarding securitization -- the process of bundling loans and selling slices to investors with a promise of regular payments -- Paulson said that "reforms are unquestionably required."

"Better disclosure is necessary," Paulson said. "Underwriters and originators should be required to retain some portion of what they sell. Requiring underwriters to keep some 'skin in the game' will properly align their incentives with those of investors who end up holding the bulk of the risk."

The House of Representatives included such a requirement in the financial reform bill it passed in December. The Senate version simply recommends such a requirement, ultimately leaving it to regulators as to how it's implemented and carried out.

Credit Rating Agencies

Largely blamed for worsening (if not playing a role in causing) the financial crisis, the House and Senate bills attempt to reform the much-maligned credit rating agencies. But the bills continue to allow credit ratings to be enshrined in law (investors in and issuers of securities essentially have to use them), something Paulson would like to change.

"[W]e must reform and strengthen oversight of rating agencies and eliminate those areas of
our securities regulations and laws that reference third-party ratings, which have tended
to serve as a crutch or an excuse, discouraging investors and regulators from doing the
necessary credit analysis," the former Treasury Secretary said. "These changes will provide the securitization market with powerful incentives to focus on creditworthiness and will lead to more responsible lending practices."


Paulson also came out in favor of reforming the way derivatives contracts are traded. Derivatives, financial instruments that derive their value from other assets and instruments, have largely been blamed for magnifying the effects of the financial crisis. The Obama administration and Congress are attempting to reverse a Congressional move from December 2000 that essentially banned the federal government from regulating the derivatives market.

The market, much of it traded over the counter, meaning outside of any real oversight, is so huge that federal regulators can not accurately judge its size -- they can only estimate.

"Standardized derivatives should be traded on a public exchange, and non-standardized contracts should be centrally cleared and should be subject to more regulatory scrutiny, transparency, and greater capital charges," Paulson said. "Such regulations will encourage standardization, promote transparency, and penalize excessive complexity with capital charges, thereby restoring these products to their proper function--mitigating, not enhancing, risk."

The Senate and House bills call for these moves, but they also include numerous loopholes. Paulson's clear language is stronger than what's in either chamber's legislation.

READ Paulson's full remarks below:

Hank Paulson before FCIC