Paulson: Financial System Still Threatened

Updated at 9:46 a.m. ET

Former Treasury Secretary Henry Paulson says the causes of the financial crisis still threaten the financial system. But he warns that Congress could stifle the economic recovery if it overreaches and tightens regulation too much.

Treasury Secretary Timothy Geithner says a root cause of the financial crisis was Congress' failure to give regulators enough power to rein in risk-taking by financial firms operating outside traditional rules.

Complete Coverage: Wall Street Under Fire

Geithner and Paulson are testifying at a hearing Thursday of a special panel investigating the crisis and a so-called "shadow" banking system.

As president of the New York Federal Reserve in 2008, Geithner was one of the key architects of the government's response to the crisis and the federal bailout.

Geithner says in his prepared testimony that the financial overhaul legislation now before Congress would close the gaps to give regulators needed powers to restrain risk in the "shadow" system.

"The history of this crisis is full of examples where regulators did not use the authority they had early enough or strongly enough to contain risks in the system," Geithner says in his testimony. "But a principal cause of the crisis was the failure to provide legal authority to constrain risk in this parallel financial system."

The overhaul legislation, which is backed by the Obama administration, has "been crafted to address these and other failures," Geithner says.

Paulson, who was Treasury secretary when the financial crisis began and crafted the Wall Street bailout, says regulators need stronger tools to prevent future crises. But he says lawmakers should be careful not to tighten regulations too much. In his prepared testimony, Paulson says the lightly regulated "shadow banking system" needs better oversight but is necessary for economic prosperity.

He also says that mortgage giants Fannie Mae and Freddie Mac must be restructured.

The panel is investigating the roots of the crisis that plunged the country into the most severe recession since the 1930s and brought losses of jobs and homes for millions of Americans.

In earlier testimony before the House Committee on Oversight and Government Reform, Paulson defended his response to the economic crisis as an imperfect, but necessary rescue that spared the U.S. financial market from total collapse.

"Many more Americans would be without their homes, their jobs, their businesses, their savings and their way of life," he said in testimony prepared for that hearing.

While losses have been staggering, "that suffering would have been far more profound and disturbing" had the government not intervened, Paulson said.

In addition to Geithner and Paulson, the meltdown probe will hear Thursday from leaders of key players in the shadow banking system including senior executives from GE Capital and asset managers PIMCO and State Street.