June 16 (Bloomberg) -- President Barack Obama, warning Wall Street not to forget how it almost caused the financial system to collapse, said “sensible” new rules are needed to tighten oversight and restore confidence in U.S. markets.

“Wall Street seems to maybe have a shorter memory about how close we were to the abyss than I would have expected,” Obama said in an interview with Bloomberg Television today at the White House. “All we’re doing is cleaning up after the mess that was made.”

The president will tomorrow unveil his proposal for revamping financial regulation, an effort likely to result in the most sweeping overhaul since the 1930s. Many of the changes will need to be approved by Congress, where jurisdictional and ideological clashes may delay and alter the shape of final legislation. Obama wants to sign the law by year-end, fulfilling a top domestic priority.

Crafted by Treasury Secretary Timothy Geithner and National Economic Council Director Lawrence Summers, Obama’s plan would put the Federal Reserve in charge of regulating companies whose collapse could damage the entire financial system. It would also create a new agency for overseeing consumer financial products, such as mortgages and credit cards.

The proposal encompasses areas ranging from derivatives to executive pay to the mortgage-backed securities that helped fuel the housing boom and then touch off the credit crisis.

‘Rules of the Road’

“We now need some sensible rules of the road so that people aren’t taking exorbitant risks,” Obama said.

The president also said he’d like the government, which has lent billions of dollars to shore up banks, insurers and auto companies, to get out of the financial sector when it can.

“As soon as this economy has stabilized, we want the free market to do what it does best, and that is produce jobs, invest,” he said.

Obama called the derivatives market “an entire shadow system of enormous risk” and pledged to make it more transparent.

“Derivatives are a huge potential risk to the system,” he said. “We are going to make sure that they have to register, that they are regulated, that you have clearinghouses.”

The administration has called for standardized derivatives to be traded on electronic markets, while saying more complex contracts should be cleared via central trade repositories. It also wants derivatives dealers to be subject to strengthened capital, recordkeeping and other requirements.

Derivatives Market

Derivatives are contracts whose values are tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

The government’s biggest rescue to date was for insurer American International Group Inc., which sold billions of dollars of derivatives contracts with insufficient reserves against the bets going wrong. Regulators have blamed AIG for “shopping” among agencies for the lightest oversight.

After considering ideas including merging a number of regulators, the administration’s plan leaves most agencies intact. Only one overseer, the Office of Thrift Supervision, will disappear.

The plan will also eliminate the thrift bank charters that are the OTS’s responsibility, an administration official said. Assuming the duties of the OTS and the Office of the Comptroller of the Currency will be a newly formed agency known as the National Bank Supervisor, the official said.

Harmonize Securities

The Securities and Exchange Commission, which regulates securities firms and markets, is likely to get additional powers, as will the Commodity Futures Trading Commission. The Obama proposal will call on the agencies to harmonize securities and futures regulations, the official said.

Not merging those two agencies is a “big mistake,” said Bill Brown, a former global co-head of listed derivatives at Morgan Stanley.

“This decision has no legal justification, and it represents a big victory for special interests,” said Brown, now a visiting professor at Duke University School of Law. “It’s a further indication that despite the president’s rhetoric, it is still business as usual in Washington in so many ways.”

Some lawmakers have pushed Obama to seize the political opportunity presented by the financial crisis and offer bolder changes. For instance, New York Democratic Senator Charles Schumer last week urged the administration to consolidate the patchwork of agencies overseeing the banking industry into one regulator.

Capital Cushions

Financial firms deemed too-big-to-fail will be required to maintain extra capital cushions, which are designed to curb the excessive risk taking that led to the collapse of last year of Bear Stearns Cos. and Lehman Brothers Holdings Inc.

Obama will also call for the Federal Deposit Insurance Corp. to be given the authority to wind down the biggest nonbank financial institutions should they fail.

Geithner, Federal Reserve Chairman Ben S. Bernanke and FDIC chief Sheila Bair have blamed the lack of such powers for limiting authorities’ options when Lehman approached bankruptcy in September. The FDIC under current law has authority to take over deposit-taking institutions.

While Obama will propose making the Fed the regulator of systemic risks, lawmakers have increasingly expressed skepticism, questioning whether the central bank has appropriately used its emergency lending powers during the crisis.

Bernanke’s Performance

Obama defended the central bank and praised Bernanke for doing “an extraordinary job” in trying circumstances.

“We have to have somebody who is responsible for seeing the risks of the system as a whole and not just individual institutions,” Obama said, referring to making the Fed the systemic risk regulator. “The Fed is best positioned to do that.”

The plan will include creating a broader council that will consult on systemic risks. The Treasury will chair the group, known as the Financial Services Oversight Council, said the administration official who briefed reporters.

Bair and some lawmakers have proposed giving the council the key powers over firms judged too big to fail. Asked last week whether he preferred the Fed or a council, House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, said “we’re still talking about that.”

To contact the reporter on this story: Robert Schmidt in Washington at rschmidt5@bloomberg.net

Last Updated: June 16, 2009 19:41 EDT