Thursday, February 14, 2013

Maybe Too Big To Fail, but Not Too Big to Suffer

Which financial institutions are "too big to fail"? According to a report from the international Financial Stability Board, a working group of governments and central banks that tries to facilitate international cooperation on these issues, here's the list as of November 2012.

 Ready for a nice bowl of acronym soup? This list is actually the "global systemically important banks," known as the G-SIBs, which are a subcategory of the "global systemically important financial institutions," or G-SIFIs.  Already finalized, as the Financial Stability Board (FSB) explains, are guidelines for the "domestic systemically important banks," the D-SIBs, which national governments are expected to implement by 2016. Meanwhile, the International Association of Insurance Supervisors (IAIS) has proposed a method of deciding who is a "global systemically important insurers," the G-SIIs. The Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO) are now working on a method to idenfity the systemically important non-bank non-insurance financial institutions (no acronym yet available).

Meanwhile, the Financial Stability Oversight Council (FSOC) within the U.S. Department of the Treasury is working on its own lists. In its 2012 annual report, it designated eight systemically important "financial market utilities"--that is, firms that are intimately involved in carrying out various financial transactions. Here's the list: the Clearing House Payments Company, CLS Bank International, the Chicago Mercantile Exchange, the Depository Trust Company, Fixed Income Clearing Corporation, ICE Clear Credit, National Securities Clearing Corporation, and the Options Clearing Corporation. (And I freely  admit that I have only a fuzzy idea of what several of those companies actually do.)

In addition, the Dodd-Frank legislation presumes that U.S. banks are systemically important if their h holdings exceed $50 billion in consolidated assets. David Luttrell, Harvey Rosenblum, and Jackson Thies explain these points, along with a nice overview of many broader issues, in their Staff paper on "Understanding the Risks Inherent in Shadow Banking: a Primer and Practical Lessons Learned," written for the Dallas Fed. For perspective, they offer a list of the largest U.S. bank holding companies, all of which comfortably exceed the $50 billion benchmark for consolidated assets.

This litany of who is "systemically important" feels disturbingly long, and it's only getting longer. But ultimately, it's a good thing to have such lists--at least if they lead to policy changes. Once you have admitted that a number of financial institutions are too big to fail, because their failure would lead to too great a disruption in financial markets, and once you have then made a commitment that government should not bail out such institutions, what policy prescription follows?

The proposal from the Financial Stability Board is that the G-SIBs (global systemically important banks, of course) should face a different set of regulatory rules. As the Dallas Fed economists explain, these could include "higher capital requirements, supervisory expectations for risk management functions, data aggregation capabilities, risk governance, and internal controls." There are two difficulties with this approach. First, it may not work. After all, a considerable regulatory apparatus in the U.S. did not prevent the financial crashes from 2007-2009. And second, it may work with undesired side effects. In particular, if there are heavy rules on one set of regulated financial institutions, then there will be a tendency for financial activities to flow to less-regulated financial institutions. "If regulation constrains commercial banks’ risk taking, many questionable assets may simply migrate to less-regulated entities."

I don't oppose regulating the SIFIs (that would be "systemically important financial institutions") more heavily. But it's important to be clear on the limits of this approach. After all, it's not that these institutions are big, but rather that they are so tightly interconnected with other institutions. As Luttrell, Rosenblum, and Thies explain: "TBTF [that would be "too big to fail] is not just about bigness; it also includes “too many to fail” and “too opaque to regulate."”

It seems to me that the key here is to remember that maybe some institutions are too big to fail, but they aren't too big to suffer! In particular, they aren't too big to have their top managers booted out--without bonuses. They aren't too big to have their shareholders wiped out, and the company handed over to bondholders--who are then likely to end up taking losses as well. One task of financial regulators should be to design and pre-plan an "orderly resolution" as they call it. The trick is to devise ways so that if these systemically important firms run into financial difficulties, the tasks and external obligations of certain large financial firms will not be much disrupted, for the sake of financial stability,but those who invest in those firms and who manage them will face costs.