LONDON – The United States must build a tougher regulatory system that can allow financial institutions to fail without causing wider economic turbulence, U.S. Treasury Secretary Henry Paulson said Wednesday in London.

Both Britain and the United States must overhaul the outdated methods of their financial watchdogs to provide better advance warning of looming troubles in world markets, he said in remarks at London's Royal Academy of Arts. Paulson also said the U.S. Federal Reserve needs sweeping new powers that would make it easier to get information on financial institutions – and to intervene if necessary.

“This year, it is clear that Americans have come to expect the Federal Reserve to step in to avert events that pose unacceptable systemic risk,” Paulson said.

Banks in both Britain and the United States have suffered the impact of the global credit crunch in recent months and have needed government intervention.

U.S. investment bank Bear Stearns was spared from near collapse in March after the Federal Reserve orchestrated its sale to JPMorgan Chase & Co. In Britain, mortgage lender Northern Rock was nationalized in February after worries over its future triggered the first run on a British bank since 1866.

Both episodes undermined serious public confidence in financial markets.

But Paulson said the Federal Reserve currently has “neither the clear statutory authority nor the mandate to attempt to anticipate and prevent risks across our entire financial system.”

“We should create a system that gives us the best chance of foreseeing a crisis, including a market stability regulator with the authorities to avert systemic issues it foresees,” he said.

Paulson warned that major global markets must root out the perception that some financial institutions are too big, or too complex, to fail.

Markets need to be robust enough to withstand the collapse of a major firm, with government intervention an unusual act, he said.

“Government support should be an extraordinary event that requires the engagement of the executive branch,” Paulson said. “It should be focused on areas with the greatest potential for market instability and should contain sufficient criteria to ensure that the cost to the taxpayers is minimized.”

Paulson, on a foreign tour, meets later Wednesday with Prime Minister Gordon Brown. He is also holding a meeting Thursday with British Treasury chief Alistair Darling to discuss measures to promote stability in global financial markets.

“The U.S. economy is facing a trio of headwinds: high energy prices, capital markets turmoil and a continuing housing correction,” Paulson said.

He warned there were signs that Europe, and Britain in particular, is also facing a slowdown.

Paulson said that current problems were being exacerbated by the high cost of oil.

“High oil prices will, in all likelihood, prolong our economic slowdown,” he said.