Regulatory Failures Aided Financial Crisis, Paulson, Geithner to Tell FCIC Panel

Watch the hearing live on C-SPAN here.

Washington – The inability of regulators and Congress to keep up with new products in financial markets helped trigger the nation’s deep financial crisis, the former and current treasury secretaries will testify today.

In prepared remarks to be given before the Financial Crisis Inquiry Commission, former Treasury Secretary Henry Paulson said excesses in financial markets and weakened lending standards were partly to blame, but so were regulatory failures.

“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 prepared for delivery. “In addition, our regulatory system was Balkanized, outdated, and lacked the infrastructure to oversee these markets.”

Congress writes the laws of the land, so Paulson’s reference to outdated regulations was an implicit jab at lawmakers, who now are writing the most sweeping legislation to revamp financial regulation since the Great Depression.

Timothy Geithner, the current treasury secretary and formerly the head of the Federal Reserve Bank of New York during the near collapse of financial markets in Sept. 2008, was more direct.

“A large parallel financial system emerged outside of the framework of protections established for traditional banks,” he said in reference to the so-called shadow banking system that provided banking services to individuals and companies. “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.”

The bipartisan inquiry commission, charged by Congress to issue a report on the causes of the financial crisis, today is concluding two days of hearings on the shadow banking system. It’s looking 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 did not 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 legal authority to look across the broad financial system to prevent risks. Geithner was implying a huge failure of the federal government in reining in a parallel financial system. But in concluding remarks, he also took a public stand against a bill recently passed by the Senate Agriculture Committee to 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 risk involved in their derivative operations would actually leave regulators with less information and less influence over a market that is now largely unregulated.

How to regulate the derivatives, which mostly involve bets between two private parties, remains a contentious issue as lawmakers work to pass a comprehensive bill to revamp financial regulation.