U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke are calling on the U.S. Congress to tackle regulatory reform in financial markets.

Appearing today before the House Committee on Financial Services, Paulson maintained that conditions in financial markets are improving, but he called the existing regulatory architecture and authorities “outdated and less than optimal”.

Apart from the weaknesses revealed by the current market turmoil, Paulson stressed there’s a need to reform the financial regulatory structure. Earlier this year, Treasury proposed a new model based around three primary regulators: one focused on market stability across the entire financial sector, another focused on safety and soundness of institutions supported by a federal guarantee, and a third focused on protecting consumers and investors.

“A major advantage of this structure is its timelessness and its flexibility and that, because it is organized by regulatory objective rather than by financial institution category, it can more easily respond and adapt to the ever-changing marketplace,” he said. “If implemented, these recommendations eliminate regulatory competition that creates inefficiencies and can engender a race to the bottom.”

Paulson noted that when this new model was proposed, he said that it represented a long-term vision that would not be implemented soon. “Since then, the Bear Stearns episode and market turmoil more generally have placed in stark relief the outdated nature of our financial regulatory system, and has convinced me that we must move much more quickly to update our regulatory structure and improve both market oversight and market discipline,” he stressed.

He reiterated his call for immediate steps to move toward a more optimal structure, such as giving the Fed the authority to access necessary information from complex financial institutions, and the tools to intervene to mitigate systemic risk in advance of a crisis.

Paulson also noted the importance of market discipline, saying, “For market discipline to effectively constrain risk, financial institutions must be allowed to fail.” But, for that to be allowed to happen, the system must be prepared to deal with such a failure, and so, Paulson noted that regulators should be able to invoke additional emergency authority to limit temporary disruptions. “These authorities should be flexible, and – to reinforce market discipline – the trigger for invoking such authority should be very high, such as a bankruptcy filing,” he said.

For his part, Bernanke addressed three issues: the supervisory oversight of primary dealers; the need to strengthen the financial infrastructure; and the possible need for new tools for facilitating the orderly liquidation of a systemically important securities firm.

He reiterated a suggestion that legislation may be needed to provide a more robust framework for the prudential supervision of investment banks and other large securities dealers, and said Congress should consider requiring consolidated supervision of those firms and providing the regulator the authority to set standards for capital, liquidity holdings, and risk management.

Bernanke also repeated his assertion that, because robust payment and settlement systems are vital for financial stability, the Congress should consider granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems.

Finally, he said that, in light of the Bear Stearns episode, the Congress may wish to consider whether new tools are needed for ensuring an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy, together with a more formal process for deciding when to use those tools.