A little over a year ago Henry Paulson, the US Treasury Secretary, set about the task of designing much-needed reforms in the US financial system.

Back then, when sub-prime mortgages were universally regarded as a fiendishly clever idea that was enriching investors everywhere, when ratings agencies, without a hint of irony, could solemnly declare that a bundle of said mortgages was as safe as a Treasury bond, and when Bear Stearns stock could be had for a mere $170 a share, the challenge for Mr Paulson was what to do about America's overregulated financial markets.

The worry then, you will recall, was that the onerous burdens placed on companies, principally by the post-Enron Sarbanes-Oxley 2002 legislation, were destroying US financial competitiveness. All those cumbersome accountancy rules and reporting requirements were driving business away from New York to London and Hong Kong. Wall Street's finest were demanding salvation, and in Mr Paulson, a fellow master of the universe from Goldman Sachs, they thought they had just the man to deliver them from regulatory evil.

A year later the general verdict on the state of US financial regulation is, shall we say, rather different. The nature and scale of the continuing crisis is widely interpreted as suggesting that, far from being overregulated, US companies have been getting away with murder and need to be controlled tightly by government regulators.

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Thus, Mr Paulson finds himself rather like an actor who has been preparing all year for the role of Tiny Tim in Charles Dickens's A Christmas Carol, only to be told on arrival he is going to play Scrooge.

Yesterday the Treasury Secretary took the stage and did a rather good job of remembering his new lines, while occasionally lapsing into the mien of his former character. (It was just as well he made his announcement yesterday and not today because people might have thought he was playing an elaborate April Fool's Day joke on them.)

In fact, the Treasury's bold new plan for financial regulation tries in appearances to glide past the overregulation-v-underregulation dialectic that is exciting commentators and policymakers (there is much talk of “transformative measures”), but it is a rather strange hybrid.

It clearly contains elements of the ideas to set markets free that Mr Paulson had in the days before the financial crisis. One of its main proposals is to merge the Securities and Exchange Commission (SEC) with the Commodities and Futures Trading Commission (CFTC). This looks at first like a simple tidying-up exercise.

The distinction between the two sets of markets has become rather blurred. But behind the plan is a quite radical change in approach to regulation. The CFTC follows a looser, principles-based approach to regulation while the SEC is a rather more stringent, rules-based body. It seems from the proposals that the new body would be quite a bit closer to the CFTC model.

Some of the other proposals also look like Wall Street-friendly moves, such as streamlining into one the vast number of regulators, including the Office of Thrift Supervision, for example.

But on the other side is the large, if somewhat ill-defined, new role for the Federal Reserve. The Fed would assume broad responsibility for financial stability, having the authority to “monitor risks across the financial system”. This worries the investment banks, which would, for the first time, fall under the Fed's sway. They fear that the central bank might, from an abundance of caution, tighten capital standards and force retrenchment from risky but rewarding financial activities.

Of course, none of this is likely to matter much. The proposals must be approved by Congress, a long shot in any circumstances, but virtually inconceivable in the dying days of the Bush Administration. There is a new mood in Washington after the financial disasters of the past year. Democrats are in charge and they sense that the public mood has become extremely hostile to unfettered free markets, which are blamed for the nation's present woes. More important, the way the crisis has unfolded changes the entire dynamic of financial regulation in the country.

The Fed's efforts to rescue the financial system - and especially its recent emergency measures to provide funding to investment banks and brokers - mark a Rubicon in US financial history. The central bank cannot very well be expected to provide the funding necessary as a backstop for the entire financial system without demanding a much closer and more critical look at the way in which financial institutions are run. Government agencies are going to be much more involved in determining capital and liquidity adequacy and, increasingly, in dictating the type of business that financial institutions can undertake.

It will probably take years for everyone to realise that this is not a good thing for the efficient functioning of capital markets. However, in any case, by then we shall be well into the next bubble and subsequent crash.

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