Paulson joins chorus of concern about liquidity

Henry Paulson
Kirsten Chang | CNBC
Henry Paulson

Henry Paulson on Wednesday became the second former Treasury secretary in a week to express concern about the potential for liquidity troubles in financial markets due to changes in the activities of Wall Street firms.

The chorus of concern about the limited liquidity in both corporate bonds and Treasurys gets louder daily, with high-profile figures like JPMorgan CEO Jamie Dimon saying recently that volatility in the bond and currency markets is a "warning shot across the bow."

Former Treasury Secretary Larry Summers last week said regulators should make a priority of addressing bond market liquidity, brought on in part by efforts to make institutions safer after the financial crisis.

Pauslon, also a former Goldman Sachs CEO, was speaking on "Squawk Box." When asked whether restrictions on Goldman Sachs' business in the past few years has been good or bad, Paulson said he was worried about the limitations on market making.

Read MoreSummers agrees with Dimon: There's a liquidity problem

"I will tell you one of the things that concerns me the most is what's happening to market making because I think that many people don't understand the incredibly important role that banks, investment banks and institutions play in helping people manage risk and providing liquidity to the markets," he said.

Read MoreFed official warns 'flash crash' could be repeated

Paulson said, however, the U.S. financial system is in better shape compared to other parts of the world, like Europe where banks did not go through the same recapitalization. "For all of the financial institutions in the U.S., we have the broadest, deepest, best financial system in the world," he said.

Last week, Dimon used his annual letter to JPMorgan shareholders as a soap box to warn about the issue. He also said the mini "flash crash" on Oct. 15 that sent the 10-year yield sharply and suddenly lower was "unprecedented" and the type of "event that is supposed to happen only once in every 3 billion years or so" though he noted the event was easily absorbed by the market.

Bond market participants blame post-financial crisis regulations aimed at making the activities of financial institutions safer by restricting capital use. In the Treasury market, they also point to the fact that the Fed holds a huge amount of Treasurys on its more-than-$4 trillion balance sheet, limiting availability of those securities to the market.

Another issue often discussed by traders is the reduced head count at Wall Street's primary dealers and the fact that they are less able to put capital into the markets.

"I thought regulatory authorities made a mistake when they looked at each institution, and said, 'You'll be safer if you withdraw from the markets a bit,' and then forget that if all institutions withdraw from the markets a bit, the markets would be less liquid. The markets themselves would be less safe. That would, in the end, hurt all institutions," Summers said.

Paulson said he hopes views of the banking industry will change.

"I'm also very concerned because I look at finance as being a noble industry," said Paulson. He said financial institutions were important emissaries in opening new economies, and in generating reforms.

"I look forward to the day when banks aren't being scapegoated for all the problems in the world ... many of which start with bad government policies."