The Federal Reserve's bank stress test results showed banks are stronger but didn't detail all the risks to investors, Sheila Bair told CNBC Wednesday.
"It's good for the market to have that information" about individual banks and their ability to withstand a financial downturn but "analysts and investors should do their own due diligence. Our regulators are not infallible," said the former head of the Federal Deposit Insurance Corp.
All but four of the banks that were tested passed. The test covered a worst-case financial scenario that would include a 13 percent jobless rate, a 50-percent drop in stock prices and a 21-percent decline in housing prices. The passing banks had to have capital ratios of at least 5 percent.
Bair said the Fed's assumptions on housing-related losses should be looked at very carefully, and that certain risks were not factored in such as liquidity risk and interest-rate risk — what would happen if the Federal Reserve raises interest rates again?
"I still think we need to be somewhat cautious here, especially with banks. They are stronger but in terms of capital distribution, the Fed and the regulators seem to be very cautious to insure the capital cushions remain strong," she added.
She still favors breaking up the big banks to "unlock better shareholder value" by creating "easier to understand pieces."
"I don't sense Washington will force them to break up but I do think the Fed and the FDIC have the legal authority to require them to simplify and rationalize their legal structures," she said. "That would at least make them easier to understand and easier to resolve if they do at some point fail down the road."
She doesn't think banks should be treated like heavily-regulated utilities, "but they need to be allowed to fail, and people who invest in them need to know their money is at risk when they do get into trouble."
She favors higher capital requirements along the line of the Basel III global requirements.
"I think hard and fast capital rules applied to everyone along the line of Basel III... [are] very important to reduce a risk of a failure and help protect us all down the road if we get into another down cycle," Bair said.