WASHINGTON — Treasury Secretary Timothy Geithner and his predecessor Henry Paulson on Thursday blamed financial regulators and Congress for failing to keep up with trends in finance that allowed excesses to build until they caused a deep crisis.
"Inside and outside the traditional banking system, financial institutions overreached, financial services were misused and financial products were misunderstood," Paulson, a former CEO of Goldman Sachs, said in remarks to the Financial Crisis Inquiry Commission. "In addition, our regulatory system was Balkanized, outdated and lacked the infrastructure to oversee these markets."
Because Congress writes the laws that govern the regulatory system, Paulson's reference to outdated regulations was an implicit jab at lawmakers, who now are writing the most sweeping legislation to revamp financial regulation since the Great Depression.
Geithner, who headed the Federal Reserve Bank of New York during the near-collapse of financial markets in September 2008, was more direct.
"A large parallel financial system emerged outside of the framework of protections established for traditional banks," he said. "The shift in mortgage lending away from banks, the growth of the relative importance of non-bank financial institutions, the increase in the size of investment banks and the emergence of a range of specialized financing vehicles are all manifestations of this phenomenon."
Geithner described efforts by Congress and regulators to stem the growing crisis as "fundamentally inadequate."
Paulson defended the Bush administration's response to the brewing crisis, arguing that preventing the collapse of investment bank Bear Stearns in March 2008 avoided an even larger crisis.
"I believe that if Bear had not been rescued and it had failed, the meltdown we began to see after Lehman Brothers (on Sept. 15, 2008) would have started months earlier and we probably would have been in the soup," Paulson said.
He suggested that the United States narrowly avoided another Great Depression. "Could you imagine the mess we would have had? … So I think you would have seen other investment banks go quickly."
The bipartisan inquiry commission, which Congress has charged with issuing a report on the causes of the crisis, concluded two days of hearings Thursday. It looked at how investment banks such as Bear Stearns effectively imploded through heavy short-term borrowing from non-bank lenders while investing in long-term debt instruments such as bonds backed by U.S. mortgages.
Regulators and lawmakers stood by as a parallel banking system emerged with far less oversight and regulation, Geithner said.
"Over time, the size of this parallel banking system grew to the point where it was almost as large as the entire traditional banking system. At its peak, this alternative banking system financed about $8 trillion in assets," he said, noting that bank regulations didn't apply to this parallel system.
Additionally, the Securities and Exchange Commission had no legal authority to set and enforce capital requirements on investment banks. No regulator had the legal authority to look across the broad financial system to prevent risks. Geithner is implying a huge failure of the federal government in reining in a parallel financial system. In concluding remarks, however, he also took a public stand against a bill the Senate Agriculture Committee passed recently that would force banks to divest of their operations that trade in complex instruments called derivatives.
"The lesson of this crisis, and of the parallel financial system, is that we cannot make the economy safe by taking functions central to the business of banking — functions necessary to help raise capital for businesses and help businesses hedge risk — and move them outside banks, and outside the reach of strong regulation," the treasury chief said.
His view echoed comments late last week by Federal Deposit Insurance Corp. Chairwoman Sheila Bair, who worried that separating banks from the risks involved in their derivative operations would leave regulators with less information and less influence over a market that's now largely unregulated.
How to regulate derivatives, which mostly involve bets between private parties, remains a contentious issue as lawmakers work to pass a comprehensive bill to revamp financial regulation.
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