WASHINGTON (MNI) – U.S. Treasury Secretary Tim Geithner said
Thursday regulators must have the authority to control risk in the
shadow financial system, a shortcoming that, had it been addressed,
would have made the financial bailout and emergency measures
unnecessary.

In the post-Depression era, the financial system outgrew
protections imposed on banks and “A large parallel financial system
emerged outside of the framework of protections established for
traditional banks,” Geithner said in testimony prepared for delivery
before the Financial Crisis Inquiry Commission on the causes of the
financial crisis and the case for reform.

In other episodes, the failure to exercise regulatory oversight
correctly or completely was found to lie at the root, “But a principal
cause of the crisis was the failure to provide legal authority to
constrain risk in this parallel financial system,” Geithner said.
“Prudential regulations were limited to banks, and did not extend to the
parallel financial system.”

“Moreover, accounting and disclosure requirements and regulatory
capital requirements helped encourage the shift in risk to the parallel
financial system, without adequately capturing the remaining exposure of
banks to those risks,” he said.

Without adequate capital or attention to risk, the shadow financial
system – which despite the name operated in the open and was as large as
the traditional banking system – was more vulnerable to a traditional
bank run.

“The emergency financial response to the run that started in the
parallel financial system was necessary to protect our economy from an
even greater calamity. But if our regulatory and supervisory systems had
had the tools and authorities to prevent risks from accumulating in
unregulated sectors of the financials system in the first place, such a
large emergency response would not have been necessary,” Geithner said.
“That is a key reason why financial reform is so essential.”

He noted that the “long period of relative economic and financial
stability,” contributed to the build up of the parallel system by
encouraging borrowers and investors to take on more risk.

But unlike the troubles faced by the government-sponsored
enterprises “this market grew up without any explicit or implicit
government insurance or any history of government support in a crisis.
This was a pure failure of market discipline,” the Treasury chief said.

Outlining the key features of the financial regulatory reform
proposals before Congress, Geithner said the old system “did not evolve
to keep pace with growth and innovations in our financial services
industry. The constraints imposed by banking regulation were significant
enough to encourage activity to move away from banks in search of
lighter regulation, lower capital requirements, weaker consumer
protections, and better tax and accounting treatment.”

But he warned: “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.”

** Market News International Washington Bureau: 202-371-2121 **

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