U.S. Treasury secretary Henry Paulson, Jr. said that markets in the United States are on track to recovery, but that the journey will likely be choppy.

Speaking to the group, Women in Housing and Finance, Paulson said that while certain sectors of the capital markets are still under stress, markets are making progress. “As I have said before, we expect to be working through this for some time as de-leveraging and re-pricing of risk continue,” he noted. “Revaluation of assets and overall market conditions are creating a challenging earnings environment and pressure for some financial institutions. While stressful in the near-term, this re-pricing of risk is necessary and will set the stage for greater confidence and market improvements.”

Paulson added that he expects the process of raising capital by U.S. financial institutions, “to continue and broaden”.

“I believe market conditions will continue to improve, but not in a straight line,” Paulson said. “Increasingly, our capital markets will reflect the underlying economy. And in that regard, a significant downside risk is housing, which we continue to monitor.”

He also grappled with the issue of policy changes that may be required in the wake of the market turmoil. he reported that the Treasury is working with the Federal Reserve and the Securities and Exchange Commission to define what sort of regulation brokerage firms should face now that they also have access to Fed funding.

The parties are working to formalize this role in a Memorandum of Understanding, he reported. “Some issues are easy to resolve – the Fed must have information and access so that it can assess its potential borrowers and counterparties. A more difficult issue is how this newly formalized relationship evolves when these temporary facilities eventually close and how, depending on its scope, the MOU will be perceived by the marketplace,” he said.

“As the Fed and the SEC work through the immediate issues associated with the primary dealers’ current access to the Fed’s facilities, we must also begin in earnest the serious work it will take to transform our current regulatory structure into something that meets the objectives we laid out in [a reform proposal published earlier this year],” Paulson added. “This will not be done easily or quickly, nor will it be done in a single step. But we must begin to modernize our financial regulatory structure to reflect the breadth of financial institutions that finance the U.S. and global economy.”

Perhaps the most difficult question in that process is how to create an entity that performs the function of the proposed market stability regulator, he suggested. “To act as market stability regulator, the Fed would need appropriate authority to respond to and proactively address systemic risks – whether it be a risk posed by a commercial bank, an investment bank, a hedge fund, or another type of financial institution. To perform this function, it is vital that the Fed have information and access across all types of financial institutions. But information gathering alone is not enough. We must also define the scope of the Fed’s role in identifying and constraining risk-taking that can detrimentally affect the financial system. This likely requires authority to intervene to prevent the build up of conditions that create significant risk to the stability of the financial system,” he suggested.

He also said that market infrastructure and operating practices in the OTC derivatives market must be strengthened, and the wind down procedures for non-depository institutions need to be clarified. “Creating a more stable environment will mitigate the likelihood that a failing institution can spur a systemic event,” he said.