Summers Surprised That Markets See Just as Much Risk in Banksby
More regulation ‘could actually increase systemic risk’
Not an attack on Dodd-Frank, says former Obama adviser
Stricter U.S. regulation since the financial crisis has failed to make banks significantly safer in the eyes of investors, and may even have made them more vulnerable to failure, according to a new paper co-authored by Lawrence Summers.
Summers, who served as President Barack Obama’s National Economic Council director during the passage of the Dodd-Frank overhaul of U.S. financial regulations, found measures of stability related to bank security prices don’t reveal an expected drop in risk. The paper, written with Summers’ Harvard University colleague, Natasha Sarin, is scheduled to be presented Thursday at a conference hosted by the Brookings Institution in Washington.
“To our surprise, we find that financial market information provides little support for the view that major institutions are significantly safer than they were before the crisis and some support for the notion that risks have actually increased,” the pair wrote, adding that “further regulatory actions could actually increase systemic risk.”
The Summers paper comes amid continued debate over the impact of the 2010 Dodd-Frank Act and other regulations imposed since the financial crisis. The new rules raised required capital and liquidity levels, reduced leverage and subjected banks to so-called stress tests to measure their ability to weather shocks. They were aimed at preventing a re-run of the 2008-09 episode that pushed some of the world’s largest financial institutions to the brink of collapse and triggered the worst recession since the Great Depression.
Some Republicans in Congress, convinced regulation has overburdened U.S. banks and stifled economic growth, are advocating measures designed to repeal portions of Dodd-Frank.
Sarin and Summers insisted their findings don’t support the roll-back of the regulatory response to the crisis.
“None of this suggests to us that the broad approach taken by the regulatory community in the wake of the 2008 financial crisis of increasing capital and seeking to contain risk taking was inappropriate,” they wrote. “Indeed we have no doubt that but for Dodd-Frank and regulatory actions, the financial system today would be much more fragile.”
Still, Summers and Sarin didn’t hesitate to implicate regulation in the increased vulnerability of banks.
“A substantial part of the reason banks have become riskier and effectively more leveraged is a decline in their franchise value,” they wrote. “And while we do not study the question in any depth, it appears plausible that a large part of the reason for declines in franchise value is regulatory activity and the prospect of future regulation.”
Summers and Sarin examined a range of market-based barometers of risk associated with a number of U.S. and foreign banks, including equity volatility, derivatives that capture estimates of future volatility, securities that provide insurance against credit default, earnings-to-price ratios and preferred stock yields. They found little evidence that investors considered banks safer today than before 2008.
“If anything, measures of volatility appear to be higher post-crisis than they were pre-crisis, and measures of expected return are higher as well,” they said.
That may partly be explained if investors badly underestimated the risk attached to banks before the crisis, the authors wrote. But more likely, the positive impact of regulation has been countered by the negative consequences of battering their market valuations.
“Critically, a lower ratio of market value of equity to total assets means that the proportional losses on assets sufficient to cause the bank to fail have decreased,” they said. By further eroding market value, additional new rules could make that worse, they added.
The authors concluded by recommending a 2015 paper by Paul Klemperer of the University of Oxford and Jeremy Bulow of American Century Investment Management that calls for counter-cyclical incentives for banks to raise equity capital.
The “unmet challenge in financial regulation and supervision is ensuring that institutions raise equity capital when necessary,” Summers and Sarin said.