TEXT-US Treasury Sec Geithner's testimony on derivatives

WASHINGTON, July 10 (Reuters) - The following is the full text of prepared
remarks of U.S. Treasury Secretary Timothy Geithner to a joint hearing on
Friday of the House Financial Services and Agricultural Committees on
regulation of over-the-counter derivatives.
Chairman Frank, Ranking Member Bachus, Chairman Peterson, Ranking Member Lucas,
members of the Financial Services and Agriculture Committees, thank you for the
opportunity to testify today about a key element of our financial regulatory
reform package - a comprehensive regulatory framework for the over-the-counter
(OTC) derivatives markets.
Over the past two years, we have faced the most severe financial crisis in
generations. Some of our largest financial institutions failed. Many of the
securities markets that are critical to the flow of credit in our financial
system broke down. Banks came under extraordinary pressure. And these forces
magnified the overall downturn in the housing market and the broader economy.
President Obama, working with the Congress, has taken extraordinary steps to
stabilize the economy and to repair the damage to the financial system. As we
continue to put in place conditions for economic recovery, we need to lay the
foundation for a safer, more stable financial system in the future.
This financial crisis has exposed a set of core problems with our financial
system. The system permitted an excessive build-up of leverage, both outside
the banking system and within the banking system.
The shock absorbers that are critical to preserving the stability of the
financial system - capital, margin, and liquidity cushions in particular - were
inadequate to withstand the force of the global recession, and they left the
system too weak to withstand the failure of major financial institutions.
In addition, millions of Americans were left without adequate protection
against financial predation, particularly in the mortgage and consumer finance
areas. Many were unable to evaluate the risks associated with borrowing to
support the purchase of a home or to sustain a higher level of consumption.
The United States entered this crisis without an adequate set of tools to
contain the risk of broader damage to the economy and to manage the failure of
large, complex financial institutions.
Many forces contributed to these problems. Household debt rose dramatically as
a share of total income, financed by a willing supply of savings from around
the world. Risk management practices at financial firms failed to keep abreast
of the rising complexity of financial instruments. Compensation rose to
exceptionally high levels in the financial sector, with rewards for executives
unmoored from an assessment of long-term risk for the firm, thus misaligning
the incentive structures in the system. Our framework of financial supervision
and regulation, designed in a different era for a more simple bank-centered
financial system, failed in its most basic responsibility to produce a stable
and resilient system for providing credit and protecting consumers and
investors.
The Administration proposed in June a comprehensive set of reforms to address
the problems in our financial system that were at the core of this crisis and
to reduce the risk of future crises.
We proposed to establish a new Consumer Financial Protection Agency with the
power to establish and enforce protections for consumers on a wide array of
financial products.
We proposed to put in place more conservative constraints on risk taking and
leverage through higher capital requirements for financial institutions and
stronger cushions in the core market infrastructure.
We proposed to extend the scope of regulation beyond the traditional banking
sector to cover all firms who play a critical role in market functioning and
the stability of the financial system.
We proposed to put in place stronger tools for managing the failure of large,
complex financial institutions by adapting the resolution process that now
exists for banks and thrifts.
We proposed to reduce the substantial opportunities for regulatory arbitrage
that our system permitted by consolidating safety and soundness supervision for
federal depository institutions, eliminating loopholes in the Bank Holding
Company Act, moving toward convergence of the regulatory frameworks that apply
to securities and futures markets, and establishing more uniform standards and
enforcement of standards for financial products and activities across the
system.
And we proposed to work with other countries to establish strong international
standards, so the reforms we put in place here are matched and informed by
similarly effective reforms elsewhere.
Any regulatory reform of magnitude requires deciding how to strike the right
balance between financial innovation and efficiency, on the one hand, and
stability and protection, on the other. We failed to get this balance right in
the past. The reforms that we propose seek to shift the balance by creating a
more resilient financial system that is less prone to periodic crises and
credit and asset price bubbles, and better able to manage the risks that are
inherent in innovation in a market-oriented financial system.
We consulted widely with members of Congress, consumer advocates, academic
experts, and former regulators in shaping our recommendations. And we look
forward to refining these recommendations through the legislative process.
One of the most significant developments in our financial system during recent
decades has been the substantial growth and innovation in the markets for
derivatives, especially OTC derivatives.
Because of their enormous scale and the critical role they play in our
financial markets, establishing a comprehensive framework of oversight for the
OTC derivative markets is crucial to laying the foundation for a safer, more
stable financial system.
A derivative is a financial instrument whose value is based on the value of an
underlying "reference" asset. The reference asset could be a Treasury bond or a
stock, a foreign currency or a commodity such as oil or copper or corn, a
corporate loan or a mortgage-backed security. Derivatives are traded on
regulated exchanges, and they are traded off exchanges or over the counter.
The OTC derivative markets grew explosively in the decade leading up to the
financial crisis, with the notional amount or face value of the outstanding
transactions rising more than six-fold to almost $700 trillion at the market
peak in 2008. Over this same period, the gross market value of OTC derivatives
rose to more than $20 trillion.