Fed’s Geithner wants ’shock absorbers’

Federal Reserve Bank of New York President Timothy Geithner said Monday that regulators are working to add "shock absorbers" to the financial system in response to the mortgage mess that nearly brought down Bear Stearns. "This crisis exposed very significant problems in the financial systems of the United States and some other major economies," Geithner said in a lunchtime speech at The Economic Club of New York. "Innovation got too far out in front of the knowledge of risk."

Geithner says the crisis offers an opportunity for comprehensive reform. "Our current system has evolved into a confusing mix of diffused accountability, regulatory competition, an enormously complex web of rules that create perverse incentives and leave huge opportunities for arbitrage and evasion, and creates the risk of large gaps in our knowledge and authority," he said. "This crisis gives us the opportunity to bring about fundamental change in the direction of a more streamlined and consolidated system with more clarity around responsibility for the prudential safeguards in the system."

Geithner and Treasury Secretary Henry Paulson led the mid-March rescue of Bear Stearns, which has come in for criticism from some unusual corners in recent weeks. Last week, two top Fed officials - Richmond Fed President Jeffrey Lacker and Philadelphia Fed President Charles Plosser - questioned the decision to step in to prevent Bear Stearns from collapsing. They said that by doing so, the Fed could feed future bad investments by reassuring investors that they too will be rescued. Geithner says he believes the Bear Stearns rescue answered those concerns by leaving Bear shareholders with heavy losses, though he stresses he views moral risk as a serious question that must be dealt with in any remake of the financial regulatory system.

Geithner's comments come as investors digest the latest sour developments in the financial sector. Lehman Brothers (LEH) plunged as much as 13% Monday after the firm raised $6 billion in new capital and surprised Wall Street with a $2.8 billion second-quarter loss. Finance chief Erin Callan said on a conference call that the firm is done trimming the size of its balance sheet and is ready to turn its focus back to making money. But fairly or otherwise, the specter of Bear Stearns will continue to loom over the brokerage sector for some time.