NEW YORK (CNNMoney.com) -- Henry Paulson and Timothy Geithner, two key players in the government's bailout of the financial system, said Thursday that steps should be taken to shed light on the darker corners of Wall Street in order to prevent another crisis from happening.
Paulson, who was Treasury Secretary at the height of the 2008 financial meltdown, and his successor, Geithner, who was president of the Federal Reserve Bank of New York at the time, both testified before the Financial Crisis Inquiry Commission in Washington.
The commission, which is holding a series of hearings this year to investigate the causes of the crisis, is probing unconventional and lightly regulated lending practices known as "the shadow banking system."
"The lesson of this crisis, and of the parallel financial system, is that 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," " Geithner said in prepared remarks.
Geithner said the parallel, or shadow, banking system grew rapidly over the last few decades, reaching about $8 trillion in assets at its peak and rivaling the traditional banking system.
But the nation's regulatory framework, which is designed to limit excessive-risk taking in a traditional setting, did not keep pace with the innovations in the shadow banking system, he said.
As the crisis intensified, Geithner added, the system became instable and investors panicked. In response, the government implemented "aggressive policy measures" to avert a second Great Depression, he said.
"This was a pure failure of market discipline," said Geithner, referring to the rapid buildup of risk in the shadow banking system. If regulators had broader authority to curb risky bank behavior, "such a large emergency response would not have been necessary."
"That is a key reason why financial reform is necessary," he said.
The Senate on Wednesday took a major step forward in the push to create a Wall Street reform package by approving a bipartisan deal to unwind big financial firms that are considered too big to fail. But lawmakers are still debating a number of other proposals, including new rules for the derivatives market and new consumer protections.
While Paulson's testimony echoed many of Geithner's comments, the former Treasury Secretary and Goldman Sachs alum cautioned against over-regulating the non-traditional banking system.
The shadow banking system, which he described as large credit and capital markets, helps provide short and long-term funding for municipal governments, corporations and individuals. These credit markets "have greatly benefited our nation, spurring growth and prosperity at all levels of our economy," he said.
Paulson acknowledged that the system was marred by "global excesses and regulatory flaws," but he said lawmakers should not throw the baby out with the bathwater.
"In our haste to deal with the flaws in the non-bank financial system, we should not move ourselves back to a system of consolidated, monolithic commercial banks," said Paulson.
Still, Paulson identified four areas where tighter regulation is needed, including securitization, commercial paper, derivatives and money market mutual funds.
Paulson also took the opportunity to offer his explanation of the factors that led up to the crisis. He said the housing bubble, at the heart of the problem, was exacerbated by government policy and irresponsibility on the part of both borrowers and lenders, namely Fannie Mae and Freddie Mac.
But the crisis was also rooted in imbalances in global capital flows, over-leveraged financial institutions, poor consumer protection and "an archaic and outmoded financial regulatory system," he said.
"Many mistakes were made by all market participants, including financial institutions, investors, regulators, and the rating agencies, as well as by policy makers," said Paulson.
He supported the steps policy makers have taken to safeguard the system, but added that risks remain. "A number of the root causes are not being addressed and remain sources of danger to our country," Paulson said.
The testimony came one day after the commission heard from former Bear Stearns executives, including the former chief executive, James Cayne, who argued that the failure of the Wall Street bank was due to market volatility, spurred by unfounded speculation, and not risky behavior.
In his comments Thursday, Geithner said Bear Stearns and Lehman Brothers, two of the main casualties of the crisis, were among the main players in the market for overnight repurchase, or "repo," agreements, asset-backed commercial paper and other structured investment vehicles that make up the shadow banking system.
Bear Stearns was crippled in March 2008 as investors and creditors fled the bank amid fears about its exposure to risky mortgage-backed securities. The investment bank was bought by JPMorgan for about $2.2 billion, or $10 a share, in a fire sale orchestrated by the government.
More than 5% of DACA recipients have started their own businesses since enrolling the program, according to a recent survey. More
New York Governor Andrew Cuomo urged state lawmakers to thwart the new federal cap on state and local tax deductions by restructuring New York's tax code in two ways. More
The fight for the cloud is taking place under the ocean. More
In 1998, Ntsiki Biyela won a scholarship to study wine making. Now she's about to launch her own brand. More
The average cost of a wedding has increased again this year to $35,000. Meanwhile, asking for cash as a gift is fine. More