Paulson urges banks to raise fresh capital

Hank Paulson called on financial institutions to raise more capital and reduce dividends in order to strengthen their balance sheets as he set out the US government's regulatory response to the credit crisis yesterday.

The US Treasury secretary backed plans to make it -easier for banks to issue "covered bonds" in order to finance mortgages kept on their own books, as an alternative to selling them on to investors as mortgage-backed securities.

He said the Treasury was aware that "a number of hedge funds are now facing difficulty" and it was monitoring the sector closely.

"We are encouraging financial institutions to continue to strengthen balance sheets by raising capital and revisiting dividend policies," Mr Paulson said. "We need these institutions to continue to lend and facilitate economic growth."

The Treasury secretary laid out a set of policy recommendations, designed to avoid a repetition of the credit crisis. This was expansive in scope, but he rejected calls for regulators to break up credit rating agencies, or to force banks originating mortgage-backed securities to maintain a stake in the securities they issued, or to regulate bankers' pay.

Rather than single out credit rating agencies as the culprits in the credit crisis, Mr Paulson argued that all participants in the financial system - including investors and regulators - had contributed to the debacle and had to change their practices.

"There is no single simple solution to the problems that have emerged from the mortgage securitisation process," Mr Paulson said. "Yet we have determined that market participants' behaviour must change." He said US regulators had concluded that mortgage brokers needed to be subject to a nationwide licensing system and tougher enforcement.

Credit rating agencies would be required to disclose conflicts of interest and to distinguish more clearly between the ratings they give to structured credit products and ordinary debt.

Issuers of mortgage securities would have to provide additional information as to the extent of the due diligence they perform on loans that they bundle up and sell on to investors. Investors would have to improve risk management practices and rely less on credit ratings.

Regulators, meanwhile, would review the way in which credit ratings are embedded in regulations, and "at a minimum" would distinguish in regulations between similarly rated structured credit products and ordinary debt.

Banking regulators will revisit the Basel II bank capital rules to make sure they deal appropriately with banks' off-balance sheet exposures to vehicles such as conduits and structured investment vehicles (SIVs), as well as strengthen guidance on liquidity risk.

Mr Paulson also called for the creation of a "dedicated industry co-operative" to improve market infrastructure in the over-the-counter derivatives market, similar to the existing Depository Trust and Clearing Corporation, which would promote standardisation of OTC -products and more efficient settlement.

The Treasury secretary said that, ultimately, the senior management of financial companies were responsible for managing their risks and establishing the correct incentives for decision-makers. He rejected a role for government in this, saying the market would deliver the right -outcomes.

Additional reporting by James Politi in Washington

Proposals

* Tougher disclosure requirements for banks and Wall Street firms * Introduction of a nationwide licensing system for mortgage brokers and new rules for credit rating agencies * Strengthening state and federal oversight of mortgage originators and brokers * Global bank regulators should revisit the Basel II banking capital requirements to ensure risk-taking banks hold sufficient capital and refine standards on how banks manage liquidity * Financial institutions need to raise more capital and reduce their dividends to strengthen their balance sheets