Alert August 18, 2009

The Federal Reserve Bank of Cleveland Issues Policy Paper on Criteria for Systemically Important Financial Institutions

The Federal Reserve Bank of Cleveland has issued a policy discussion paper that proposes a set of criteria to identify systemically important financial institutions (“SIFIs”) and recommends the development of a regulatory infrastructure based on the nature and source of their importance.  The paper, entitled “On Systemically Important Financial Institutions and Progressive Systemic Mitigation” (“the SIFI Paper”), states that the regulation of SIFIs is one of the most important regulatory reform issues.  The Obama Administration has proposed legislation regarding the consolidated supervision and regulation of SIFIs.  For more on the Obama Administration’s proposed legislation, please see the July 28, 2009 Alert.  The SIFI Paper asserts that establishing a financial stability supervisor alone will not achieve stability, it is also crucial to deal proactively with systemically important financial institution and have a workable definition of “systemically important.”  The resolution of SIFIs is not discussed in the SIFI Paper, but will be the subject of a forthcoming companion paper.

Size.  According to the SIFI Paper, institutional size is not an adequate criterion for determining whether an institution is systemically significant and the “too big to fail” designation an oversimplification.  Any size threshold could also capture large numbers of smaller, non-systemically significant institutions and potentially result in such smaller institutions becoming subject to unwarranted regulatory burdens.  However, the SIFI Paper states that as a starting point for a sized-based definition for systemic importance, a financial institution would be considered systemically important if it accounts for at least 10 percent of the activities or assets of a principal financial sector or financial market or 5 percent of total financial market activities or assets. 

Four C’s.  As an alternative to a size-based definition of systemic importance, the SIFI Paper identifies four risk factors that would make institutions of varying sizes potentially systemically important, the so-called “four C’s” of systemic importance: contagion, correlation, concentration, and conditions/context: 

  • Contagion:  A financial institution would be considered systemically important if its failure could result in (i) substantial capital impairment of financial institutions accounting for a combined 30 percent of the assets of the financial system, (ii) the locking up or material impairment of essential payments systems (domestic or international), and (iii) the collapse or freezing up of one or more important financial markets.
  • Correlation:  In some cases, a single institution alone would not pose a systemic risk, but a group of institutions, acting in lockstep, would. The SIFI Paper refers to this as “too many to fail” and associates it with observed “herding behavior” in the financial system.  There are two important aspects of correlation risk.  First are the incentives for institutions to take on risks that are highly correlated with other institutions because policymakers are less likely to close an institution if many other institutions would become decapitalized at the same time.  Second is the potential for largely uncorrelated risk exposures to become highly correlated in periods of financial stress.  The SIFI Paper identifies correlated risks arising from financial or economic shocks that would make groups of financial institutions systemically important. 
  • Concentration:  A financial institution would be considered systemically important if its failure could materially disrupt a financial market or payments system, causing economically significant spillover effects that impede the functioning of broader financial markets and/or the real economy.  Thresholds for concentration that would render a financial institution systemically important would include any firm (on a consolidated basis) that (i) clears and settles more than 25 percent of trades in a key financial market, (ii) processes more than 25 percent of the daily volume of an essential payments system, or (iii) is responsible for more than 30 percent of an important credit activity.
  • Conditions/Context: In certain circumstances, financial institutions would become systemically important due to macro-economic conditions.  The SIFI Paper proposes two sets of criteria to classify firms that are systemically important due to context.  The first is the probability that economic or financial conditions will materialize that produce the macro-economic conditions under which an institution or group of institutions becomes systemically important.  The second are the thresholds for systemic importance, which would be based on those used to classify SIFIs according to contagion, concentration, and correlation during normal market conditions; which thresholds are applied would depend on which type of systemic importance the conditions produce.  The SIFI Paper states that conditional or contextual risk is the most difficult of the four risk categories to identify in advance.

SIFI Categories.  The SIFI Paper outlines five categories of financial institutions, of which only the first three would contain SIFIs:

  • Category 1:  Financial institutions that would be considered systemically important on the basis of size or concentration.
  • Category 2:  Financial institutions that would be considered systemically important because of contagion.
  • Category 3:  Financial institutions that would be considered systemically important as a group because of correlated risk exposures.  Also included in this category would be financial institutions that are systemically important because of conditions or context.
  • Category 4:  Large financial institutions that would not be considered systemically important, but whose failure could have economically significant implications for regional economies.  This category would include large regional banking companies and large insurance companies.
  • Category 5:  Financial institutions not included in the other categories, consisting primarily of community financial institutions.
Regulation and Reporting.  In order to identify institutions in one or more risk categories, the SIFI Paper states that banking supervisors should be required to conduct periodic systemic risk analyses, stress tests, and other simulations as part of a contingency planning process.  The SIFI Paper proposes that SIFIs be subject to additional regulatory requirements such as increased capital requirements, portfolio restrictions, increased loss reserves, limits on counterparty exposure and mandatory debt-structure requirements.  Such regulatory requirements would become more robust for, or would only apply to, SIFIs in higher SIFI categories.  The SIFI Paper notes that transparency and information disclosure will be a major issue that must be vetted when new regulatory and supervisory architecture is put in place, and recommends full transparency in the determination of SIFIs, including publishing the full list of SIFIs, the criteria for inclusion in a SIFI category, and a “watch list” of financial institutions whose systemic risk status was likely to change in the near future.