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Summers: Banks no safer now than they were before the crisis

Lawrence Summers
David Orrell | CNBC
Lawrence Summers

Big banks are no safer now than they were before the financial crisis, according to a new analysis by a Harvard duo that includes former White House economic advisor Larry Summers.

Not only does the paper assert that the possibility of a too-big-to-fail scenario still looms, but they also said the increased regulatory environment actually has played a part in keeping the system endangered.

"We find that a substantial part of the reason banks have become riskier and effectively more leveraged is a decline in their franchise value," the researchers wrote in a white paper for the Brookings Institution. They added that "it appears plausible that a large part of the reason for declines in franchise value is regulatory activity and the prospect of future regulation."

In essence, the paper argues that the regulatory pressure through Dodd-Frank and other measures has made banks a tougher investment.

The paper is co-authored by Natasha Sarin and was scheduled for presentation at a conference Thursday, which happens to be the eighth anniversary of Lehman Brothers' bankruptcy filing, a crucial moment in the crisis. Summers has served under multiple presidents and headed the National Economic Council for President Barack Obama.

The two authors note that heightened regulations and "draconian" stress tests have caused banks to increase their capital levels substantially but also could reduce their ability to raise equity during times of crisis.

That would be pivotal, considering that required capital levels "have historically not had much predictive power for bank failures."

"Bear Stearns, Wachovia, Washington Mutual, Fannie Mae, and Freddie Mac were all seen by their regulators as well-capitalized immediately before their failures. In contrast, the pricing of their equity and debt securities was signaling distress."

The lesson from 2008 should resonate today, though it may not satisfy conventional thinking about what the banking system needs to do in order to guard against another crisis the likes of which nearly toppled the global financial system.

"We find that (market risk) measures are in the same range that they were prior to the financial crisis," Summers and Sarin wrote. "This suggests cause for concern that there is a nontrivial probability of at least a major loss in equity value by a major institution sometime in the next few years."

The paper does not argue specifically against regulation, conceding that by some measures the system would be even more fragile without Dodd-Frank specifically.

Banks have underperformed the market by a wide margin since the policy came online in July 2011. In the period since, the KBW Nasdaq Bank Index is up about 50 percent, while the broader S&P 500 has risen more than 95 percent.

The authors, though, say their research on risk, volatility and expected returns calls "into question the view of many officials and financial sector leaders who believe that large banks are far safer today than they were a decade ago."

"It is certainly possible that markets were unduly complacent before the crisis and are excessively alarmed today," they add. "But given that market risk measures functioned much more effectively as canaries in the coal mine during the 2008 crisis than did regulatory risk measures, we would caution against complacency."