* Geithner says making progress in settling markets
* Toxic assets plan seen up and running in six weeks
* Must handle leftover bailout money carefully
* Geithner says too soon to wind down government aid (Adds comments on small banks' reluctance to take bailout funds, paragraphs 6-7)
By Glenn Somerville
WASHINGTON, May 20 (Reuters) - U.S. Treasury Secretary Timothy Geithner said on Wednesday the Obama administration was making headway in calming financial markets and would have a program to cleanse toxic assets from banks' balance sheets up and running by July.
He told the Senate Banking Committee the U.S. financial system was "starting to heal" after a period of severe trauma, crediting an array of emergency government programs for helping ease a crisis sparked by a surge in mortgage defaults.
But Geithner said the outlook remained fragile and the administration had to be cautious about how it uses the dwindling money left in a $700 billion financial rescue fund Congress approved in October.
"We still face a very challenging economic and financial environment, and we need to be careful to preserve substantial resources and flexibility to deal with future contingencies," he said.
Geithner estimated there was about $123.7 billion left in the fund, but he said that reflected a conservative forecast that banks would repay just $25 billion they have received. He added that Treasury might not finance other programs as fully as it currently plans.
The U.S. government has taken unprecedented steps to inject taxpayer capital into banks to try to foster lending and quell a financial crisis that has helped drive the U.S. and much of the world economy into deep recession.
Geithner drew attention to small banks' reluctance to seek bailout funds for fear of giving the government a chance to exert control over their business. This, he said, was something that must be dealt with because it could undercut the government's crisis-fighting efforts.
"We need to try to counteract that, because the insurance this capital provides is not valuable unless people are willing to come take it," Geithner said, but offered no insight into how to ease the stigma tied to government aid.
FACING BAILOUT CRITICS
Many big banks chafing under tough restrictions on executive pay are now lining up to return taxpayers' money.
Some Republican lawmakers argued those repayments should pay down U.S. debt rather than be recycled for further bailouts -- an interpretation of the law that Geithner disputed.
"I think it's important that the government ... has that flexibility, because we are still in an enormously difficult, challenging, fragile period of time and there may be circumstances where the necessary thing for the country is to use that authority carefully to support expanding these programs," he said.
Geithner said the administration had to act aggressively to avoid a financial meltdown. He conceded, however, that winding down the government's deep involvement in business was an important challenge ahead.
"Crises this severe don't burn themselves out. To fix them requires the action of government," he said.
But he added it was too soon to lay out a plan for withdrawing the government's unusual support for private firms. "I'm not prepared to talk to that today," he said. "We're not quite there yet."
SMALL BANKS TO GET AID
Geithner said financial companies were adjusting their operations so that they would be less vulnerable to shocks like the one they have gone through.
"Leverage has declined, the most vulnerable parts of the non-bank financial system no longer pose the same risk, and banks are funding themselves more conservatively," he said.
While public attention has largely centered on big banks, including the 19 that underwent "stress tests" to see whether they needed to raise more capital, Geithner said small banks also will get an expanded chance to qualify for taxpayer aid.
He said these companies would now have six months to make themselves into bank holding companies that would qualify for aid, or to reapply for aid if they are already eligible.
Geithner also said a plan to entice private investors to buy distressed assets from banks by putting up government capital alongside private money -- a cornerstone of the administration's financial rescue plans -- would begin operating over the next six weeks.
Geithner said a presidential task force set up to deal with
the collapsing U.S. auto industry would keep working with
General Motors Corp