How Do We Kill ‘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 replaced it in vernacular. In 2011, the FSB published a list of global SIFIs (or G-SIFIs) alongside a series of proposed policy measures to address them in the event of a collapse. 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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Financial industry participants and regulators have debated the issue of TBTF for years, and have made only modest progress toward a fully fleshed-out solution. In 2011, G20 leaders asked the FSB to “develop a policy framework to address the systemic and moral hazard risks associated with [SIFIs].” One of the key requirements the group outlined was an additional 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.

Speaking at a conference sponsored by the International Monetary Fund in Washington, D.C., on Wednesday, Jeremy Stein, a member of the Board of Governors of the Federal Reserve, explored the logic behind this requirement, and why it may be the best method to address TBTF currently on the table.

“I should note at the outset that solving the TBTF problem has two distinct aspects,” Stein said early in the speech. “First, and most obviously, one goal is to get to the point where all market participants understand with certainty that if a large SIFI were to fail, the losses would fall on its shareholders and creditors, and taxpayers would have no exposure.”

That is, the post-crisis bailout mania that has characterized the past few years is far from ideal. “However,” he continues, “this is only a necessary condition for success, but not a sufficient one.” Using the United States as an example, Uncle Sam intervened with taxpayer dollars because the collapse of major financial institutions would have ultimately been more detrimental to the public. In such a scenario — in which collapse would cause significant systemic damage — many governments may feel obligated (perhaps rightfully so) to intervene.

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So it only makes sense to assume that taxpayers will have no exposure if a SIFI can absorb the damage caused by its own collapse. Stein continues, “A second aim is that the failure of a SIFI must not impose significant spillovers on the rest of the financial system, in the form of contagion effects, fire sales, widespread credit crunches, and the like. Clearly, these two goals are closely related. If policy does a better job of mitigating spillovers, it becomes more credible to claim that a SIFI will be allowed to fail without government bailout.”

With these two vectors in mind, Stein proposes that regulators and the financial community have made progress towards a sustainable system, but that there is still a long way to go.

As it stands, some of the positive steps forward include larger and more robust capital and liquidity testing, backed up by revitalized stress testing. Not only should this help identify weakness earlier on, but it expands the buffer available to each SIFI to absorb losses should disaster strike.

What’s more, 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 this regulation is to make a bailout a zero-probability event.

That said, the FSB and its scaling loss-absorption capacity scheme has its critics. Getting to the point, Stein’s speech addresses these critics and walks through the logic of why he thinks the scheme makes more sense than the alternatives. “Some have argued that the current policy path is not working, and that we need to take a fundamentally different approach,” he said. “Such an alternative approach might include, for example, outright caps on the size of individual banks, or a return to Glass-Steagall-type activity limits.”

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To sum up a long argument (see the speech if you want to run through it), Stein states that: “While I agree that we have a long way to go, I believe that the way to get there is not by abandoning the current reform agenda, but rather by sticking to its broad contours and ratcheting up its forcefulness on a number of dimensions.”

To this point, Stein identifies two primary ideas that warrant attention. The first is that the capital-surcharge schedule outlined for SIFIs (the scaling 1.0 to 2.5 percent of risk-weighted assets that is to be met with common equity) should be increased. The second is the imposition of “a substantial senior debt requirement” that would resolve losses in line with Title II of the Dodd-Frank Act.

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