At the same time, the International Monetary Fund predicted U.S. financial institutions could ultimately lose $2.7 billion from the global credit crisis and said U.S. banks may need $275 billion in new capital.
Geithner told members of a congressional oversight panel that despite the ongoing crisis, the government's financial rescue policies were showing signs of progress, including increases in the number of refinanced mortgages and signs that credit conditions have improved.
"We need a financial system that is not deepening or lengthening the recession," he said. "Meeting this obligation requires actions by the government; it requires the government to take risks."
The stock markets appeared to take a positive view of Geithner's testimony, including his assessment that "the vast majority" of banks could be considered well-capitalized. Bank stocks slid on Monday, but bounced back after Geithner's comments.
His testimony came in the wake of a watchdog agency report that warned Obama administration initiatives could increasingly expose taxpayers to losses and make the government more vulnerable to fraud.
Neil Barofsky, a special inspector general assigned to the bailout program, concluded in a 250-page quarterly report to Congress that a private-public partnership designed to buy up bad assets is tilted in favor of private investors and creates "potential unfairness to the taxpayer."
Geithner said the new plan "strikes the right balance" by letting taxpayers share the risk with the private sector while at the same time letting private industry use competition to set market prices for the assets. The plan is "better than the alternatives," Geithner said.
"That is a better model than having the government itself come in and independently try to value these things," Geithner said.
Geithner reported that "the vast majority of banks" have more capital than they need to be considered well-capitalized. But he said the economic crisis and the bad assets have created uncertainty about the health of individual banks and reduced lending across the system.
"For every dollar that banks are short of the capital they need, they will be forced to shrink their lending by $8 to $12," he said.
While credit conditions have improved in the past few months, "reports on bank lending show significant declines in consumer loans, including credit card loans, and commercial and industrial loans," Geithner said.
The IMF forecasts come as the government is putting banks through "stress tests" to determine their individual capital needs going forward. The IMF's $2.7 trillion figure covers expected losses from 2007 through 2010.
In a letter Tuesday to oversight panel chairwoman Elizabeth Warren, Geithner said that $109.6 billion in resources remain in Treasury's rescue fund. But officials expect the fund will be boosted over the next year by about $25 billion as some institutions pay back money they have received.
Under questioning from panel members, Geithner said that even if banks want to pay back the money, that doesn't mean the government would necessarily accept the payment.
"Ultimately we have to look at two things, one is do the institutions themselves have enough capital to be able to lend and does the system as a whole, is it working for the American people for recovery," Geithner said.
The government's effort to stabilize the financial sector and unclog the credit markets has come under heavy scrutiny. Treasury officials say the Obama administration has been holding participants more accountable. Geithner sent key members of Congress six-page letters last week spelling out his department's measures.
Still, Warren told Geithner: "People want to see action described in terms that make sense to them and want to see that taxpayer funds aren't being used to shield financial institutions from the consequences of their own behavior."
Nobel Prize-winning economist Joseph Stiglitz told a congressional panel that the government should create a "financial products safety commission" to determine which financial products are potentially toxic to the banking system. This should be done in addition to tightening regulations on banks and preventing them from becoming "too big to fail" in the first place, he said.
And Barofksy, using blunt language, offered a series of recommendations to protect the public and took the Treasury to task for not implementing previous advice.
Overall, Barofsky's report said the public-private partnership using Treasury, Federal Reserve and private investor money could total $2 trillion. "The sheer size of the program ... is so large and the leverage being provided to the private equity participants so beneficial, that the taxpayer risk is many times that of the private parties, thereby potentially skewing the economic incentives," the report stated.
In particular, the report cited funds that would be used to purchase troubled real estate-related securities from financial institutions. Under plans unveiled by Treasury, for every $1 of private investment, Treasury would invest $1 and could provide another dollar in a nonrecourse loan. That money could then leverage a loan from another government fund backed mostly by the Federal Reserve, a step that Barofsky said would dilute the incentive for private fund managers to exercise due diligence.
Barofsky recommended that Treasury not allow the use of Fed loans "unless significant mitigating measures are included to address these dangers."