WASHINGTON (Bloomberg) — Treasury Secretary Timothy Geithner said American International Group Inc. still poses a risk to the US financial system and cannot be allowed to default.

"I do not believe that the system today can withstand the effects of a failure of this institution to meet its obligations," Geithner told the Senate Banking Committee yesterday in Washington.

The Treasury is working with AIG, its trustees and management to separate the company's insurance businesses from its riskier and more troubled financial products division, Geithner said. For now, the government doesn't have the tools to shrink some of the outstanding financial claims on the company, such as derivatives contracts.

"We have no option now to selectively diminish the value of those claims without taking risk that you would have default and its consequences," Geithner said. As a result, the Treasury is not yet in a position to "walk back" the support it has provided to AIG, valued at as much as $182.5 billion.

Geithner said AIG's counterparties have to be repaid in full because the risks to the financial system will mount if they are not.

"I understand everyone's frustration with this issue and I would like nothing better to be in a different situation," Geithner said. "If AIG had defaulted, it would have been materially worse across the country and the world."