BUSINESS
04/06/2010 05:12 am ET | Updated May 25, 2011

Remorseful Citigroup Banker John S. Reed Parts With Former Colleagues, Calls For Fundamental Financial Reform

The remorseful former banker who made Citigroup what it is today came to Capitol Hill on Thursday and systematically debunked the arguments that his former colleagues use to defend the practices that nearly crashed the financial system.

John S. Reed, 70, served as chairman and CEO of Citicorp from 1984 to 1998. After the 1998 merger with Travelers Group that created Citigroup, Reed served as chairman and co-CEO for two years. Late last year, he apologized for his role in creating the nation's third-largest bank, a $1.9 trillion behemoth that's now 34 percent-owned by the Treasury Department.

"There seems to have been a key failure that none of us anticipated," Reed said in a prepared statement at a Senate Banking Committee hearing, "namely, individual institutions which are thought to take steps and exercise judgments to insure their self-preservation turned out 'not to have' or been incapable of so doing.

"This clearly means that in designing a robust system, we cannot count on that capacity."

Reed came out against the culture that has dominated Wall Street for the past generation. He said policymakers should not rely on banks to do what's in their own best interest. And he also endorsed reforms related to the broken system of federal banking regulation, the government-sponsored housing finance system, the scope of the financial system, and the way consumer credit is extended.

Reed's proposals read as if they came from a consumer advocate.

Among them:

  • The capital held by financial firms to protect against potential losses "should be significantly increased, maybe doubled." He added that he thinks the concept of "risk adjusted capital," a complex system used by regulators to judge whether a bank has adequate cash, "is flawed."

  • The industry should be "compartmentalized" to limit the spread of failures and to preserve "cultural boundaries."
  • Traded products (to the extent possible) should flow through exchanges. Much of the derivatives market is currently in the dark, traded over the phone rather than through a centralized exchange where regulators could know what's going on.
  • A consumer-focused financial protection agency with a "clear and separate mandate" should be created.
  • The Wall Street Journal noted a particular exchange:

    In response to a question from Senator Bob Corker (R-Tenn.), who called Reed's testimony "fascinating" given that he presided over Citigroup at a time when it was expanding in all these areas, Reed said it was exactly that experience that informs his view now.

    "I learned a lot," Reed said, joking that this may be the first time he has ever agreed with former Federal Reserve chairman Paul Volcker on anything. "There's no question that when we put Travelers and Citi together we created a monster."

    "My honest belief having experienced it...is that the system would be stronger if we could provide for some separation where major depositories are not major actors in the capital markets," Reed said.

    Coming from the man who presided over the firm that was among the first to create collateralized debt obligations -- bundled loans whose cash flow is sold to investors -- his swipe against securitized products and derivatives was particularly jarring. He said they were "flawed as credits" and were not distributed to "knowledgeable investors."

    Reed has gone further than the Obama administration, joining some members of Congress, including Republican Senator John McCain of Arizona, in calling for a separation between commercial banking and investment activities. For the past decade, the country's biggest banks have engaged in both.

    Reed called Congress's 1999 repeal of the 1933 Glass-Steagall Act a mistake. Though Citigroup was formed before the law was officially revoked, the company had the Federal Reserve and the Clinton administration's blessing to go ahead with the merger.