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Shadow Banking System Probe: Geithner, Paulson To Testify

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WASHINGTON — The two leading architects of the financial bailout made the case Thursday that Congress must give regulators more power to curb risk-taking on Wall Street.

Treasury Secretary Timothy Geithner told a special panel investigating the financial crisis that the government should have acted more aggressively ahead of the crisis. He used his testimony to push for the Obama administration's financial regulatory overhaul, which has reached a critical point in the Senate.

His predecessor, Henry Paulson, also told the Financial Crisis Inquiry Commission that a reworking of the regulatory system was needed. But Paulson, who led the Bush administration's response to the crisis in 2008, cautioned that overly stringent regulation could stifle innovation.

A sobering reminder of how fragile the financial system remains came Thursday when stocks plunged on one of the most turbulent days in Wall Street history. A computerized selloff possibly caused by a simple typographical error triggered the biggest drop ever during a trading day. The Dow Jones industrials slid nearly 1,000 points in afternoon trading before recovering to a loss of 347 points.

Geithner testified that the financial crisis could have been "less severe" if the government had moved faster to limit the damage. When he became the Obama administration's Treasury secretary, Geithner continued the $700 billion bailout program for the financial system that began in the fall of 2008 under Paulson.

"I do not believe we were powerless," he said. "I would say that if the government of the United States had moved more quickly to put in place better-designed constraints on risk-taking ... then this would have been less severe."

The government "didn't move quickly enough and forcefully enough to try to contain the damage," Geithner said.

The bipartisan inquiry panel, chartered by Congress, is examining the origins of the crisis that sent the country into the most severe recession since the 1930s.

A fundamental cause of the crisis, Geithner insisted: the lack of authority for regulators to restrain risk-taking by financial firms operating outside traditional rules. The legislation before Congress would help fix that by giving regulators authority over firms in the so-called "shadow" banking system, he said.

He pressed the need for new rules for financial institutions, such as requiring them to hold larger capital cushions.

"We're still living with the same system that produced this crisis," Geithner said. "Without reform, the system will be more vulnerable, less stable, than in the past."

He warned that big banks now expect the government to bail them out for the good of the broader system, a dangerous precedent set by the government's reaction.

Geithner said the focus must be on making failures less damaging. The legislation would create new rules allowing regulators to dismantle large financial companies at risk of collapse. It would be similar to the way the Federal Deposit Insurance Corp. closes small banks, but financed through money collected from banks and investors.

Geithner also warned against affording exemptions in the legislation from new rules for certain types of financial activities. "We have to create a strong set of rules that no institution can escape," he said.

Paulson said the problems of the giant institutions were compounded by "a financial regulatory system that was archaic and outmoded."

He said the government-brokered rescue sale of Wall Street firm Bear Stearns to JPMorgan Chase & Co. in March 2008 held off the financial crisis for much of that tumultuous year.

"If Bear had not been rescued and it had failed, then the meltdown we began to see after Lehman had gone would have started months earlier, and we would have really been in the soup," Paulson told the panel.

Paulson helped engineer the buyout of Bear Stearns as it veered toward collapse. The Federal Reserve provided a $29 billion federal backstop to JPMorgan Chase in the deal.

Paulson said the Bear Stearns rescue highlighted weaknesses in the regulatory system, but officials were unable to fix them before Lehman Brothers collapsed six months later.

With no suitor available to rescue Lehman, there was no choice but to allow it to fail, he said.

Critics have said Lehman should not have been allowed to fail, and the decision not to rescue it set off the panic that nearly froze global lending markets. Architects of the federal bailout, including Paulson and Geithner, have said they simply didn't have the power to save the company without private sector help.

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