07 May 2010

Geithner says root cause of crisis was failure to give regulators enough power

Geithner said the lack of authority for regulators to restrain financial risk was a fundamental cause of the 2008 crisis. Regulators didn't know before the crisis hit how that "shadow" banking system could shake the foundations of the economy.

"I do not believe we were powerless," Geithner 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."

 

"We have to create a strong set of rules that no institution can escape," he said.

 

"The history of this crisis is full of examples where regulators did not use the authority they had early enough or strongly enough to contain risks in the system," Geithner said in his prepared testimony. "But a principal cause of the crisis was the failure to provide legal authority to constrain risk in this parallel financial system."

 

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, US Secretary Geithner concluded.

 

The financial reform proposals now being considered by the Congress have been crafted to address these and other failures and they are being complemented by enhanced regulatory oversight of key aspects of the shadow banking system.   

 

Comprehensive Constraints on Risk Taking.  The proposed reforms will require the enforcement of more conservative capital and leverage requirements on the activities, whether on or off balance sheet, of all major financial institutions.  A company like AIG or Lehman Brothers will not be able to escape consolidated supervision by virtue of its corporate form, and will have to operate on a level playing field with large commercial banks and traditionally regulated financial institutions. 

 

Repo Markets.  These reforms will give the Federal Reserve the authority to build a more stable funding system, take action to address the unstable aspects of the short-term repo markets, and ensure that these markets are used much more conservatively in the future.  These steps will give clear authority to set risk management requirements for these markets, including capital standards, set standards for collateral requirements, and to help ensure that settlement procedures are robust.  They will also create enforcement authority to compel corrective actions as risks build up, or when risk-management is inadequate.  These authorities will also reinforce stability and liquidity even in times of market stress such as a terrorist attack or acute financial crisis.  

 

Higher Standards for Money Market Mutual Funds.  The SEC recently enacted new rules to strengthen liquidity, credit standards and disclosure in the money fund industry.  More work remains to be done in this area, and the President's Working Group on Financial Markets is preparing a report setting forth options to reduce the susceptibility of money funds to runs.

 

Rating Agencies, Disclosure, and Accounting.  These reforms will provide the SEC with authority to limit conflicts of interest, require greater disclosure to ensure more diversity in ratings, and require regulators to reduce the overall reliance on ratings throughout the supervisory system.  The SEC will require more extensive disclosure, including loan-level data for asset-back securities, to ensure that investors have the information they need to make informed decisions.  Changes underway to accounting standards will result in greater transparency for a firm's off-balance sheet commitments, improve standards, and move forward international accounting convergence.

 

Derivatives. These reforms will bring comprehensive oversight and transparency to the OTC derivatives markets.  These markets have proved to be a major source of uncertainty and risk during periods of financial disruption.  The proposed reforms will bring the bulk of these trades into central clearing arrangements, ensuring full transparency and reducing the degree to which financial contagion can spread due to real or perceived counterparty credit exposures.  All dealers and major market participants will be subject to tough prudential standards, including margin and capital requirements.  And the SEC and CFTC will have full enforcement authority to set position limits and address fraud, manipulation, and abuse.

 

Resolution Authority.  These reforms will establish a resolution regime that will give the government the necessary tools to safely put failing financial institutions out of existence without causing a panic or destabilizing credit markets, and without exposing the tax payer to the risk of loss.  

 

Full testimony

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