Treasury Secretary Timothy F. Geithner told the Financial Crisis Inquiry Commission today that the financial crisis of 2007 and 2008 was the result of a poorly regulated parallel banking system that was “particularly vulnerable to a classic run or banking panic.”
This parallel system came in many shapes and sizes. Independent investment banks like Lehman Brothers and Bear Stearns grew in size and financed themselves in the overnight repurchase agreement, or “repo” markets, which rely on assets or securities as collateral. Asset-backed commercial paper (ABCP) conduits and structured investment vehicles (SIVs) were used by banks and a broad range of other financial institutions as funding vehicles for different types of assets. Specialized finance companies expanded into a broad range of consumer and business lending activities.
These institutions and funds were financed by institutional investors and by money market mutual funds, which purchased their short term commercial paper, or lent to them overnight in the repo markets secured by various forms of collateral.
Across this system, longer-term financial assets, which necessarily had some risk of loss, were financed short term, by investors and funds that had the right to withdraw their money or refuse to continue to fund a maturing obligation.
Geithner told the Commission that the reforms being proposed in Congress will bring needed oversight to the parallel banking sytem. About repo, he said:
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.