Failures in market discipline, regulation led to financial crisis: Top official

Problematic areas included a “shadow” banking system which sprung up beyond the legal reaches of financial regulators.

“Low interest rates encouraged consumer borrowing and excessive leverage in the shadow banking sector,” said Federal Deposit Insurance Company Chairman Sheila Bair in a prepared remarks. Bair was in Washington today before a special panel of lawmakers known as the Financial Crisis Inquiry Commission.

She also said the financial regulatory system collectively did not limit many risky financial activities that led to the crisis.

“In retrospect, it is clear that supervisors were not sufficiently forward looking in identifying and correcting imprudent risks,” she said.

She was appearing in Washington before a special panel of lawmakers known as the Financial Crisis Inquiry Commission.

She also said market discipline failed when most investors came to rely exclusively on assessments of financial products by credit ratings agencies.

“The growth of private-label securitizations created an abundance of AAA-rated securities out of poor quality collateral and allowed poorly underwritten loans to be originated and sold into structured debt vehicles,” she said.

She also blamed compensation for employees that was not properly linked to risk management.

“Formula-driven compensation allows high short-term profits to be translated into generous bonus payments, without regard to any longer-term risks,” she added.

Among the financial reforms the FDIC and some other regulators seek are: the authority break up companies considered ‘too-big-to-fail’; introduction of incentives to reduce the size and complexity of certain companies; creation a ‘systemic risk council’ to monitor risks affecting the overall financial system; greater regulation of financial products known as derivatives; and the creation of a government agency to protect consumers of financial products