5 Ways Regulators Are Killing ‘Too Big To Fail’

Too Big To FailThe term “systemically important financial institution” — or SIFI — fell into common use in the wake of the 2008 financial crisis. According to the Financial Stability Board, “SIFIs are financial institutions whose distress or disorderly failure, because of their size, complexity, and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.”

In other words: SIFIs are too big to fail, a term which itself has become so commonly used its acronym (TBTF) has pretty much replaced it in day-to-day use. In 2012, the FSB published a list of global SIFIs (or G-SIFIs), identifying by name the financial institutions that it believed were so large their failure would cause significant national or even global economic damage. Some of the institutions included on the list are: Bank of America (NYSE:BAC), Barclays (NYSE:BCS), Citigroup (NYSE:C), HSBC (NYSE:HBC), and JPMorgan (NYSE:JPM).

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Killing too big to fail means doing two things: reducing the likelihood that a bank will fail in the first place, and ensuring that — should a collapse occur — the bank can either absorb its own loss, or be wound down in such a way that does not impose harm on the public. New regulations are focused on containing the burden of failure to shareholders and creditors, not taxpayers. In short, regulators can’t guarantee that a bank will never fail, but they can reduce the likelihood, and they can reduce the damage done to the public.

Let’s take a look at the various ways regulators are approaching too big to fail, and how new policy will affect the world’s largest financial institutions.

Getting back to the basics

As Vice Chair of the Federal Reserve, Janet Yellen’s voice has been at the forefront of the regulatory chorus. Delivering a speech before the International Monetary Conference in Shanghai at the beginning of June, Yellen cut right to the chase: “The financial crisis revealed that banking firms around the world did not have enough high-quality capital to absorb losses during periods of severe stress.”

At a fundamental level, a bank is only as stable as its capital base. As Yellen and countless other observers have pointed out, it is inexcusable that the fallout from the collapse of a bank can spread like contagion and negatively impact the public. Increased capital requirements — both in quality and quantity — translate into an increased capacity to absorb losses. The latest set of rules, known as Basel III, is currently being digested by the markets, but there is of course some disagreement between regulators and industry participants on the best way to move forward.

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The Tier I common capital ratio at any given bank is often used as a snapshot of capital strength. Here’s an overview of how banks have been beefing up in preparation for Basel III:

Q2’12 Q3’12 Q4’12 Q1’13
Bank of America 7.95% 8.97% 9.25% 9.42%
Citigroup 7.91% 8.64% 8.74% 9.34%
JPMorgan 7.94% 8.38% 8.75% 8.86%
Wells Fargo 7.78% 8.01% 8.18% 8.39%
U.S. Bancorp 7.87% 8.18% 8.09% 8.22%

Liquidity standardsMoney

Banking regulation is anything but straightforward. The financial crisis was loaded with many lessons, and as Fed Vice Chair Yellen pointed out, one of them was the fact that some banking firms, particularly those with significant amounts of short-term wholesale funding, can become illiquid before becoming insolvent. This is usually the result of an outflow of creditors caused by fears over the bank’s stability, something akin to a run on deposits.

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To combat this, the Basel Committee has formulated two separate liquidity standards. The first is the Liquidity Coverage Ratio, which has a time horizon of 30 days; the second is the Net Stable Funding Ratio, which has a one-year time horizon. Proposals on how to adapt to new requirements gauged against these ratios are still being worked through.

Capital surcharges

As Yellen pointed out, the Fed and the global regulatory community have two primary goals: “(1) producing stronger regulations to reduce the probability of default of such firms to levels that are meaningfully below those for less systemically important financial firms, and (2) creating a resolution regime to reduce the losses to the broader financial system and economy upon the failure of a SIFI. The goal has been to compel SIFIs to internalize the costs their failure would impose on society and to offset any implicit subsidy that such firms may enjoy due to market perceptions that they are too-big-to-fail.”

One way that the FSB and the Dodd-Frank Wall Street Reform and Consumer Protection Act have gone about trying to address these challenges is to impose a loss-absorption capacity at SIFIs scaled to the estimated impact of their collapse. This capacity ranges between 1 percent and 2.5 percent of risk-weighted assets, and is to be met with common equity.

Here are some of the loss-absorbency buckets, as outlined by the FSB:

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Source: Financial Stability Board

New bankruptcy mechanisms

The previous three regulatory initiatives have all been aimed at reducing the likelihood of failure, but no one can guarantee financial immortality. Regulators have argued that new bankruptcy mechanisms should be put in place — proactively and with foresight — to mitigate damage in the event of failure.

Mechanisms like the orderly liquidation authority (or OLA), which is outlined in Title II of the Dodd-Frank Act, provide a means for recapitalization and restructuring of banks that imposes losses on shareholders and creditors, and not the general public. The idea of regulations like this is to make a bailout a zero-probability event. However, Title II has its critics, including Philadelphia Fed President Charles Plosser.

In a speech addressing too big to fail, Plosser argued that “While Title II improves our ability to wind down SIFIs, it is ultimately biased toward bailouts. Remember that Title II resolution is available only when there are concerns about systemic risk. Just imagine the highly political issue of determining whether a firm is systemically important, especially if it has not been designated so by the Financial Stability Oversight Committee beforehand. The delay in making this determination will make the firm harder to resolve and likely lead to some sort of bailout.”

Plosser suggests that a new mechanism could be added under Chapter 14 of the Bankruptcy Code to deal specifically with bankruptcy at large financial institutions.

Strengthening the environmentMan Measuring Money

“Reducing the likelihood of a severe financial crisis also requires strengthening the capacity of our financial markets and infrastructure to absorb shocks,” Yellen commented.

Specifically, Yellen indicates that short-term securities financing transactions are a major unaddressed financial risk. To date, most regulatory reform has glossed over these transactions, because, Yellen suspects, they appear safe.

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“Toward that end, U.S. and global regulators have worked to improve the transparency and stability of the over-the-counter derivatives markets and to strengthen the oversight of financial market utilities and other critical financial infrastructure. In particular, U.S. agencies are working together to address structural weaknesses in the triparty repo market and in money market mutual funds.”

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