Failure to give regulators enough legal power and the rapid growth of a shadow banking system were behind the eruption of the financial crisis, U.S. Treasury Secretary Timothy Geithner will tell an official inquiry on Thursday.

In testimony prepared for delivery to the commission investigating the causes of the 2008-2009 turmoil, Geithner said loosely-regulated non-bank financial firms had grown to a size nearly equal to the traditional banking system, with $8 trillion in assets.

Financed with short-term funds and with thin cushions of resources, the shadow banking system was particularly vulnerable to a classic run or banking panic, Geithner said.

While all financial forms need to be brought under tougher regulation as part of a broader regulatory overhaul, Geithner

cautioned against preventing banks from engaging in some risk-taking on behalf of customers.

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, he said.


Geithner's predecessor, Henry Paulson, told the panel that when he took over Treasury in mid-2006 he was concerned about the potential for a severe market downturn but conceded the situation was more ominous than he realized.

What wasn't clear to me...was the scale and degree of the problem, the gravel-voiced former Goldman Sachs head said, nor was the former Bush administration prepared for it. There wasn't a plan in place when I arrived, I think we put a plan in place.

Goldman Sachs itself has been sued by the Securities and Exchange Commission over allegations it hid from investors the fact that securities underlying a risky debt transaction were chosen by a hedge fund firm that bet they would lose value.

Paulson said he was surprised at the lack of focus by so many market participants and regulators on the importance of liquidity amid the crisis and said that must be corrected.

The U.S. Senate is in the middle of work on the Obama administration's sweeping reform of the financial sector, with a central issue whether to rein in banks' trading in some financial instruments to curb risk.

Both Geithner and Paulson agreed it was necessary to regulate trading of derivatives more closely, and to put more of the trading on central exchanges.


Geithner said regulators could have stepped in earlier to get some control over the activities of non-bank financial institutions. But a principal cause of the crisis was the failure to provide legal authority to constrain risk in this parallel financial system, Geithner said.

A massive injection of liquidity into the banking system by the Federal Reserve -- made necessary because of the run that started in the shadow banking system -- averted economic calamity.

But if our regulatory and supervisory systems had had the tools and authorities to prevent risks from accumulating in unregulated sectors of the financial system in the first place, such a large emergency response would not have been necessary, Geithner said.

He said financial reform proposals now before Congress, if approved, would stiffen regulation and make the system safer by subjecting all financial firms to stronger capital levels and more conservative leverage requirements.

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, he said.

(additional reporting by David Lawder and Karey Wutkowski)

(Reporting by Glenn Somerville, editing by Patrick Graham)