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Summers: Regulations actually have made banks less safe

Summers: New laws haven’t made big banks safer

Regulators both have helped stabilize the banking system and cut off ways for institutions to keep themselves afloat should a crisis hit, economist Larry Summers said Thursday.

The dichotomy has left the system overall just as prone to a collapse as it was eight years ago Thursday when Lehman Brothers fell and set off a global panic, the former White House advisor told CNBC's "Closing Bell. "

"If banks were much better capitalized and much less levered than they used to be, you would expect that you would see their equity would become much less volatile," Summers said.

However, that hasn't been the case.

A Harvard paper Summers co-authored and presented Thursday contends that alternative measures that go beyond simple capital ratios show a system that still carries risk. Slapping regulations on banks to prevent them from engaging in certain types of risk practices can only go so far, and to some extent may have harmed the system.

"I don't think that one can simply be complacent and assume that we've now created some kind of system where because we measure less leverage in regulatory context we can assume that the institutions are far safer," Summers said.

"Some parts of regulatory efforts have operated to remove many sources of income for banks, and that has had the perverse effect of when you have reduced future income, your safety declines," he added. "You have to look at the contents of regulation and not just the quantity of regulation."

The paper is co-authored by Natasha Sarin and was scheduled for presentation at a conference Thursday. Summers has served under multiple presidents, including as Treasury secretary under President Bill Clinton and heading the National Economic Council for President Barack Obama.

Lawrence Summers
David Orrell | CNBC

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.

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"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 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."