In the 1987 cult horror film Evil Dead II, the hero’s right hand becomes possessed and does battle with its owner, who is finally forced to saw it off.

Treasury Secretary Henry Paulson, now dealing with his very own horror show in the melting credit markets, can probably relate. Paulson, the former chairman and CEO of Goldman Sachs, has strived to regulate the financial markets with a light touch. Yet the most recent report of the President’s Working Group on Financial Markets, which Paulson chairs, shows financial regulators are being pulled inexorably by the worsening credit crisis to use a heavier regulatory hand or even intervene directly in the market.

Indeed, Friday, just one day after the report was released, the Federal Reserve was forced to back a bailout of Bear Stearns. And earlier in the week, the Fed poured some $200 billion of liquidity into the market. The report of the President’s Working Group itself contains recommendations that translate into increased regulatory oversight of everything from credit-rating agencies to banks to institutional investors to mortgage brokers. The report also recommends that regulators intervene with other standard-setting bodies, notably the Financial Accounting Standards Board and the Basel Committee on Banking Supervision.

The President’s Working Group was formed in 1987 by Ronald Reagan in response to Black Monday (October 19), and includes the chairs of the Treasury Department, the Federal Reserve, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. In a cover memo about the latest report to President Bush, Paulson noted that the group’s recommendations should be implemented “with an eye toward not creating a burden that exacerbates today’s market stresses” — a clear reference to regulatory burdens.

To be sure, some of the group’s recommendations continue to demonstrate the current Administration’s traditional reliance on voluntary efforts by industry. For example, while the report calls for greater disclosures about securitization, it urges that they be drafted by the American Securitization Forum. That’s the same group that crafted the so-called Hope Now plan that allowed banks to alter securitized mortgages, an effort touted by Paulson and the President as preferable to direct government intervention.

But the report is also rife with recommendations for new or stronger regulation. Citing a “significant erosion of market discipline,” the report says overseers of institutional investors — such as the Department of Labor, state treasurers, and the SEC — should “require” those investors to obtain better risk information and ensure they do not rely solely on credit ratings.

As for the failure of credit-rating agencies to foresee the crisis until too late — behavior that has bedeviled regulators for years — the report “welcomes” the voluntary improvement efforts the agencies have already made, including plans to create separate ratings systems to distinguish between ordinary corporate bonds and structured products. But the report’s apparent reliance on self-policing may have less to do with a philosophical preference for private-sector solutions and more with just how intractable improving rating-agency performance has proven to be. Moreover, the report warns, “The PWG will revisit the need for changes to CRA oversight if the reforms adopted by the CRAs are not sufficient.”

The report also urges a degree of self-policing for banks, widely viewed as the primary culprits of the current meltdown. It says it will support the formation of a private-sector group to review the report by the Counterparty Risk Management Policy Group II, a 2005 banking-industry effort that examined the financial world’s handle on risk. The first iteration of that group was formed in the wake of the collapse of hedge fund Long Term Capital Management in 1998.

But the report also contains some substantial regulatory changes for banks. It says the SEC and banking regulators should develop guidance to address a raft of risk-management failures by banks. Likewise, the need for banks to hold greater liquidity and capital cushions is a recurring theme in the report. Although one such mention says banks should be encouraged to do so through incentives, the frequency with which capital cushions are mentioned makes it unlikely that banks will be able to avoid new regulated minimums. Indeed, the report urges the Basel Committee on Banking Supervision to “review” capital requirements for most structured products “with a view toward increasing requirements on exposures that have been the source of recent losses to firms.”

Likewise, the report says “regulators should require” more detailed and comprehensive disclosure of off-balance-sheet commitments at banks — a move that could indirectly force banks to increase their capital reserves. Indeed, it says, financial institutions should be required “to hold capital and liquidity cushions commensurate with firm-wide exposure (both on- and off-balance sheet) to severe market events.”

The report also urges FASB to reexamine consolidation and securitization. That, too, could result in requirements that would force banks to consolidate securitization trusts they currently hold off-balance-sheet, which in turn would also result in an increase of regulatory capital.