Identifying Systemically Important Financial Institutions

7/29/2019 Identifying Systemically Important Financial Institutions

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Interna

tionaltopics

Curre

ntIssues

Author

Christian Weistroffer*+49 69 [email protected]

Editor

Bernhard Speyer

Technical Assistant

Sabine Kaiser

Deutsche Bank ResearchFrankfurt am MainGermanyInternet: www.dbresearch.com

E-mail: [email protected]: +49 69 910-31877

Managing Director

Thomas Mayer

As par t o f t he searc h for an adequat e response t o syst em ic r isk ,

policy makers seek to identify financial institutions whose viability is crucial for the

smooth functioning of the financial system. Institutions are viewed as systemically

important if they are large, highly interconnected and unable to exit the marketwithout causing major disruptions.

System-w ide r i sk cannot be eas i l y loca ted a t a smal l g roup o f ind iv idual inst i tu t ions. Systemic interdependencies are an integral part of adifferentiated financial system, where various intermediaries fulfil differentfunctions. Liquidity transformation and the allocation of credit create system-wide

risk that would also be present in a system without SIFIs.

Focuss ing on banks as the p r imary source o f sys temic r i sk may

prove shor t -s ight ed. Hedge funds, insurance companies, other non-bankfinancials, but also market infrastructures, all contribute to the smooth functioning

of the economic and financial system and can become systemically relevant.

The met hodo log ies used to i den t i f y SIFIs are not nec essar i ly su i ted

t o i ncen t i v i se them fo r regu la to ry purposes . In particular, themethodologies used need to be designed to reduce moral hazard and system-

wide risk. Incentivising financial institutions to become merely less significant on

the basis of the criteria currently under discussion, e.g. by lowering cross-borderexposure, could distort the competitive landscape and potentially raise overall

risk for the financial system.

Resolvabi l i ty in c ase of fa i lure should be a key cr i t er ion in the

benchmark ing o f S IF Is. Measures to enhance resolution and bail-in withinresolution regimes can effectively reduce moral hazard associated with the too-

big-to-fail problem. The likelihood that the institution would be resolved or

restructured in an orderly procedure if it were to fail should also be a central

theme in the benchmarking of SIFIs. If that were ensured, all other indicatorswould carry far lower relevance.

*The author would like to thank Hanno Stremmel for excellent research assistance.

August 11, 2011

Ident i fy ing system ic a l ly impor t ant

f inancia l inst i t u t ions (SIFIs)


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Current Issues

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Identifying systemically important financial institutions (SIFIs)

August 11, 2011 3

Indispensable for the financial

system or avoidable evil?

1. I n t roduc t ion

Based on the experience of the recent financial crisis that started in2007, policy makers are working on a new regulatory framework toaddress systemic risk. Their aim is, inter alia, to identify financialinstitutions whose viability is crucial for the smooth functioning of thefinancial system overall. So called SIFIs are systemically importantfinancial institutions that are large, highly interconnected and unableto exit the market without causing major disruptions. Designatedinstitutions are potential candidates for tighter supervision andadditional loss absorbency requirements further down the road.

While new policies are still under discussion, it is clear that theindicators and methodology used to identify systemically importantinstitutions will be key in promoting a more stable financial system.In this context, two different concepts need to be distinguished:1.) The mere identification of systemically relevant institutions andmarket infrastructures and 2.) the benchmarking of banks and non-bank financials for regulatory purposes. The difference between thetwo concepts is most obvious when considering a financialinstitutions global activity. A globally active bank may have a largerfootprint on the global economy than a local institution. However, afinancial system which provides incentives for banks to reducecross-border exposure need not be more stable than one thatfosters cross-border diversification.

In this study we discuss the analytical framework for identifying andbenchmarking systemically important financial institutions. First, welay out the main concepts underlying the SIFI definition. Next, weturn to the methodologies used for measuring systemic importancein academia and for policy purposes. One by one, we go through thedifferent categories as proposed by the Basel Committee onBanking Supervision (BCBS) for identifying global systemicallyimportant banks (G-SIBs). Finally, we give a brief overview on hownon-bank financials and market infrastructures can be included inthe SIFIs framework.

What is a SIFI?

Although there is no commonly accepted SIFI definition, policymakers generally consider institutions as systemically relevant thatcannot exit the market without causing major disruptions to thefinancial system. According to this definition, systemic relevance

depends on the institutions potential for destruction. The moredestructive power an institution has upon failure, the more relevant itis for the system. The alternative view defines systemic relevance asa positive: Financial institutions are systemically relevant if theirviability is crucial for the smooth functioning of the wider financialsystem. This definition stresses the (positive) contribution of aninstitution to a general public good.

Both views represent two sides of the same coin: Are SIFIsnecessary and indispensable for the financial system? Or are theypotentially dangerous, the result of an unguided market process? Inthe second case, the adequate response would be to incentivisefinancial institutions to become less relevant. In the first case, it

would be to ensure survivorship of those institutions deemedindispensable for the financial system. Reflecting on the desiredstructure of the financial system overall will help shape thecorresponding policy response.


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Its participation in a systemic event

An institutions contribution to

systemic risk

Basic concepts to identify SIFIs

To our knowledge, there is no consistent theory of SIFI regulation,but rather a number of methodological and empirical concepts thatcoexist in a loose manner. A counterfactual thought experiment mayhelp to determine whether a particular institution should be regardedas systemically important or not. To this end, a common approachpresupposes that a particular financial institution fails. It thenassesses the possible fallout for the rest of the system.1

The alternative approach assumes that a large shock hits thefinancial system, e.g. the bust of a property market bubble. It thenconsiders to which extent a particular institution participates in asystemic event that follows suit. If losses to a particular institutionare large relative to overall losses such an institution will beviewed as systemically relevant. Participation in a systemic event isdetermined by the expected loss the institution is likely to cause toits non-bank creditors.

Theintuition behind this approach is as follows: When a financialinstitution fails, it defaults on its liabilities and/or triggers asset firesales. The ensuing losses to the rest of the financial system throughfirst, second or third round effects will be regarded as theinstitutions contribution to systemic risk. Third round effects in ourwording refer to spill-over stemming from uncertainty orreassessment of financial risk; whereas first and second roundeffects arise from direct and indirect exposure to the failinginstitution. A financial institutions contribution to systemic risk isgenerally reflected in its liabilities to the rest of the system, i.e. to

other financial institutions, and in its possible impact on asset andcredit markets.

2

1

Borio and Tarashev (2011) refer to this as the bottom-up approach. A top-downapproach would consider the expected loss (or value at risk) of the system withand without a particular institution being part of it. The marginal difference of therisk measure is then interpreted as the institutions contribution to systemic risk.

It thus captures how important an institutionis for the deposit system and how vulnerable it is to a systemicshock. The likelihood of participating in a systemic event is, inter

alia, determined by an institutions credit exposure to other financialinstitutions and its leverage. Table 1 summarises the twoapproaches and relates them to the corresponding risk indicatorsand policy objectives.

2 Ibid.

Contribution tosystemic risk

Participation insystemic event

Concept Marginal distress of thesystem, conditional on theinstitution failing

Expected participation ofthe bank in a systemicevent; losses to the bankcreditors

Risk indicators Intersystem liabilities Asset correlations

Liquidity and maturitymismatch

Transparency andresolvability

Leverage Risk bearing capacity

Policy objectives Contain systemicimpact upon failure

Ensure survivorshipin systemic event

Avoid moral hazard

The table distinguishes between the contribution and participation approach. Both concepts are reflectedin different policy objectives summarised in the first row. The second row lists possible indicators tomeasure systemic relevance. Of course, policy objectives and indicators are not exclusively linked toeither one of the concepts.

Source: DB Research 1


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August 11, 2011 5

Local institutions, too, can become

relevant for the global system

The case for regulating SIFIs

The case for regulating systemically importantfirms can be rationalised as follows:

Banks and other financial institutions pay apremium for their own default risk but aregenerally not charged for the possibility that

their failure can create problems in other partsof the system. In other words, contagioneffects upon failure i.e. through direct creditlinks, increased uncertainty regarding mutualexposures, or forced asset sales createexternalities that are usually not borne by theinstitution causing them.

Some institutions create more externalitiesthan others. Those institutions cannot exit themarket without causing major disruptions tothe wider financial system. As a consequence,they are viewed as too important to beallowed to fail which, in turn, gives rise tomoral hazard concerns. To the extent that

creditors of SIFIs can expect to be bailed-outin case of failure, debt financing of theseinstitutions enjoys an advantage over equityfinancing.

At least two consequences follow from this:On the one hand, competition is distortedbetween institutions that are regarded as tooimportant to fail and those that are not. On theother hand, institutions that enjoy implicitpublic guarantees not only have an incentiveto lever-up, but also to maintain or raise theirlevel of systemic relevance. Both effects tendto increase fragility of the financial systemoverall.

From an analytical perspective, the contribution approach seems tobe better suited to determine systemic relevance of individualinstitutions. It can be used to identify those institutions that createnegative externalities and contribute more strongly to system-widerisk than others (see box The case for regulating SIFIs). However,depending on the policy objective, it is useful to also consider

participation in a systemic event, because, once a crisis hits, it isparticipation and hence survival of systemically relevant institutionswhich matters to the functioning of the financial system and theeconomy overall. Both views complement each other and should betaken into account when forming policy responses.

The reference system

The failure of a financial institution most likely will have some effecton its owners, creditors, debtors and other market participants. Towhat extent these effects can be judged systemically relevantdepends on the chosen reference system. The distinction betweenlocal and global SIFIs provides an illustrative example of how

different reference systems can lead to different policy conclusionsregarding an institutions systemic relevance. If the chosenreference system is world financial markets, supervisors may view alocal institution, i.e. one which does not operate in foreign marketsand is funded purely domestically such as the J apanese Post Bank,as not systemically relevant, even if the institution is of considerablesize. J udged against the domestic financial system, the sameinstitution might well be considered systemically important.

The same holds true for the identification of the relevant group offirms and individuals that may all be affected if the institution fails. Isit only the banking system, the wider financial or the overalleconomic system that should be considered? The answer to this

question determines not only how systemic relevance of individualinstitutions should be judged, but also which institutions should beincluded in the overall SIFIs universe.

Market environment

Recent crisis episodes have demonstrated that the relevance ofindividual institutions is also a function of the current market andgeneral economic environment. Under adverse external conditions,which are almost always present in a systemic crisis, it is difficult todistinguish SIFIs from institutions that pose no potential threat to thesystem. In particular, the line between local and global can becomeblurred if second and third round effects are taken into account.Third round effects in our wording refer to spill-over stemming

from uncertainty or reassessment of financial risk; whereas first andsecond round effects arise from direct and indirect exposure to thefailing institution.

In light of experiences made during the recent financial crisis, a runon a local institution may well trigger a systemic crisis on a globalscale. Take the case of Northern Rock in the UK, an institution whichby most standards would not be considered a global SIFI. Duringthe crisis, funding difficulties in wholesale markets led to a run onretail deposits which threatened to spill over from Northern Rock toother (domestic) banks. A default of Northern Rock would certainlyhave affected the British banking system overall and thus otherbanks that are active in the British market, including foreign banks.

Policy makers were well-advised to prevent a panic in this situationwhich could easily have spread to other countries.


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The net should be cast

sufficiently wide

Non-bank financials, too, contribute

to systemic risk

A similar case can be made by considering current banking sectorproblems in the smaller, highly indebted euro area countries. In asituation where fears of capital flight are present, the failure of adomestic institution, say in Greece, could have severeconsequences for the European banking system as a whole. Underthese circumstances, rather small events of perceived local

relevance can easily turn into a systemic crisis, making it difficult toidentify systemically important institutions ex ante.

Systemic relevance of non-bank financials

Policy makers are often keen to emphasise that the financial systemhas a primary role in serving the financial needs of the real sector,i.e. corporates and households. From a public policy perspective theobjective is to ensure that the financial system as part of the widereconomic system is able to fulfil its functions. Securities houses,insurance companies, investment funds but also providers of marketinfrastructure, all contribute to the smooth functioning of theeconomic and financial system and can thus become systemically

relevant if certain criteria are met. But also institutions outside corefinancial markets, such as public guarantors or governmentsponsored entities, should be viewed as systemically relevant if theirfailure poses a threat to the stability of the financial system.

Therefore, the net should be cast wide to include every institutionthat poses a potential threat for the functioning of the financialsystem. Take the case of US money market funds. The asset side ofthese institutions consists to a large extent of systemically relevantclaims, i.e. short-term claims on the financial system mainly in theform of commercial papers. To the extent that money market fundspromise to pay their investors at par, they face solvency risk.Although money market funds do not engage in maturity trans-

formation, they are inherently fragile and can become prone tobank-run-like phenomena if the value of securities held falls belowpar (i.e. breaks the buck), as happened in 2008. Hedge fundsprovide another example, which according to the criteria proposedby the BCBS (see below pp. 10-13) show several traits of systemicrelevance. Hedge funds invest to a large extent in assets for whichmarket values cannot be observed and which cannot easily beliquidated if necessary. If a fund faced solvency problems, forced firesales could drive asset prices down, possibly affecting otherinstitutions. Systemic risk can also emerge from the funds liabilitiesside. Often, hedge funds are highly leveraged, exposing the bankingsector to substantial credit risk.

3

If policies focus too narrowly on the banking sector, it is likely thatsystemic risk builds up in the very sectors excluded fromsupervisory scrutiny. The increase in liabilities of the so-calledshadow banking system in the US whose cumulative assets bynow exceed those of commercial banks can be interpreted in thatway (see chart 2). Also, the rise and fall of AIG (AmericanInternational Group) provides an illustrative example. Backed by asuperior rating and without a systemic risk supervisor in charge, AIGengaged heavily in the CDS market writing protection againstdefault of other financial institutions. AIG thus contributed to thebuild-up of systemic risk and eventually became highly vulnerable toa systemic shock itself. The example of AIG highlights the necessityto include allpotential candidates in the SIFIs universe. Althoughdifferent institutions are subject to different regulatory and

3 Elliot and Litan (2011) provide further examples of how non-bank financials maycontribute to systemic risk.

0

3

6

9

12

15

18

21

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

Shadow banks

Commercial banks

Trad i t iona l vs shadowbank ing sys tem in the US

Total liabilities in USD tr

Sources: Fed, DB Research 2


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August 11, 2011 7

The academic approach to measuringsystemic importance

There are a number of different concepts thataim to attribute systemic risk to individual

institutions. Among the most prominentattempts are the following:

Conditional Value at Risk (CoVaR)

CoVaR is defined as the value at risk (VaR) ofthe financial system conditional on institutionsbeing in distress. Systemic risk contribution isdefined as the difference between CoVaRconditional on the institution being in distressand CoVaR in the median state of theinstitution.

Adrian and Brunnermeier (2010)

Marginal Expected Shortfall (MES)

MES is defined as the expected loss

experienced by each firm when aggregatelosses are large. By also consideringleverage, the Systemic Expected Shortfall(SES) can be estimated, where SESincreases with leverage and MES.

Acharya (2009)

Acharya et al. (2009, 2010)

Brownlees and Engle (2010)

Shapley Value

A game-theoretic instrument, the ShapleyValue assesses how important each player isto the overall system and what payoff theplayer can expect from cooperation. Theproposed measure attributes the overall

(system-wide) risk to each institution on thebasis of its average contribution to the risk ofall the sub-groups in which it participates.

Tarashev et al. (2010)

Gauthier et al. (2010)

Liu and Staum (2010)

Drehmann and Tarashev (2011)

Further approaches

Further approaches include measures derivedfrom network models, the probability that abank fails conditional on other banks failing, orthe calculation of a fair insurance premium forsystemic risk in a portfolio context.

Segoviano and Goodhart (2009)

Huang et al. (2009, 2010, 2011)

Zhou (2009)

Chan-Lau (2010)

supervisory regimes, the concepts to determine systemicimportance in principle apply to banks and non-bank financialinstitutions alike.

Measur ing sys tem ic im por tance

Mainly as a direct response to the current regulatory debate, theliterature on how to measure systemic importance is growing rapidly.Two basic approaches can be distinguished: On the one hand,researchers use regression techniques to extract information frommarket prices sometimes based on rather complex financialmodels. On the other hand, policy makers pursue a more hands-onapproach. For the sake of usability, they tend to prefer an indicator-based approach which does not rest on markets assessment butincorporates bank-level data, i.e. balance sheet data, volume oftransactions etc. The chart below provides a first overview of thedifferent approaches.

Market-based measurement of systemic importance

The academic approach has so far focussed on market-basedmeasures of systemic importance in a portfolio context (see boxThe academic approach to measuring systemic importance). Themodels used are based on asset price correlations and othermarket-based risk measures, such as VaR (Value at Risk) or MES(Marginal Expected Shortfall). In some cases, they also incorporatedata on leverage or interbank claims and liabilities. Two broadstrands can be distinguished: On the one hand, researchers allocatesystemic risk in an additive manner, i.e. by deriving measures ofsystem-wide risks and allocating them to individual institutions

subsequently (e.g. MES and Shapley Value). On the other hand, in anon-additive manner, measures are based on the expected shortfallor Value at Risk of the system, conditional on the default of aparticular bank (see above, chart 3).

SIFIs

ident i f i ca t ion

Market-basedmeasurement

Addit ive

measures

Derive system-wide

risk -> allocate toindividual institutions

e.g. MES,

Shapley Value

Participation in systemic event

Contribution to systemic r isk

Non-additive

measures

Derive systemic

relevance for each

institution

e.g. CoVaR

Indicator-basedmeasurement

BCBS (2011)

Global systemically

important banks

FSOC (2011)

US significant banks

and non-bank

financials

Source: DB Research, 2011

j3


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The supervisory approach tomeasuring systemic importance

Indicators used to identify systemicallyimportant financial institutions for supervisorypurposes are generally derived from on- andoff-balance sheet items, such as total assets,interbank claims or liabilities.

Systemic importance is measured in relativeterms, i.e. relative to the reference system. Tothis end, it is necessary to define a referencegroup against which the value of the systemicrisk indicator can be benchmarked. Thereference group can either be determined bycommon characteristics the institutions share,e.g. size and interconnectedness, or byparticipation in a certain market in which therespective institutions are active.

The resulting indicator is then expressed asthe rank of a particular institution among its

peer group members or as a volume sharerelative to the referenced market or peeraggregate. Composition of the benchmarkgroup is revised on a regular basis andadjusted if necessary.

A joint report issued by the IMF, BIS and FSB(2009) provides guidance to the G20 financeministers of how systemic importance offinancial Institutions, markets and instrumentscan be assessed. In a further document, theFSB (2010) offers recommendations to theauthorities for developing suitable assessmentmethodologies.

Need to d istinguish between

identification and benchmarking

Although market-based measures of systemic importance have theirrole in risk monitoring and supervision, they share a number of traitsthat make them less suitable as supervisory benchmarks. First,market-based indicators are not available for all financial institutions,as only a part of financial institutions is publicly listed and traded ona regular basis. Second, market-based indicators are not stable over

the cycle. During tranquil times, they may understate systemiceffects and overstate them during crisis times. Finally, market-basedmeasures anticipate current or future policy actions to the extentthat systemically important institutions may be viewed as bettersupervised or more likely to be granted public assistance in times ofdistress.

Indicator-based measurement of systemic importance

Supervisory authorities tend to prefer indicator-based approachesand use market-based measures mainly as a cross-check. Indicator-based measures have the advantage that they can be applied moreuniversally across listed and non-listed institutions. They are also

more robust than market-based measures that rely on a limitednumber of rather volatile indicators. An important drawback is theinability of indicator-based measures to differentiate between aninstitutions systemic risk contribution and its participation in asystemic event. Moreover, indicator-based approaches require asomewhat arbitrary choice of the indicators, composition of the peergroup and definition of weighting and threshold schemes.

Indicator-based approaches are also more transparent and thuseasier to trace by the affected institutions. From a policy perspectivethis may be of advantage if the primary goal is to nudge designatedinstitutions into becoming less systemically relevant. To this end, theindicators give clear guidance to the affected institutions in which

areas they can reduce exposure, or change their way of doingbusiness, so that the supervisor will view them as less relevant.However, similar to external solvency ratings there is a trade-offbetween transparency of the methodology and the possibility thatrated institutions start gaming the rules, i.e. by reducing exposurein the areas that feed into the rating, while increasing exposure inothers. This may be one of the reasons why regulators prefer tohave some discretion in the rating process and use a relativebenchmark approach, where systemic relevance is determined notonly by the actions of the institutions themselves but also by theactions of others (see box The supervisory approach to measuringsystemic importance).

Benchmark ing f inanc ia l ins t i tu t ions

In this chapter we discuss indicators used to benchmarksystemically relevant institutions. Conceptually, this is decisivelydifferent from the mere identification of SIFIs. While both conceptsare closely interrelated, the methodology used for benchmarkingfinancial institutions in addition needs to take policy objectives andincentive effects into account.

If the primary goal is to incentivise financial institutions to becomeless systemically relevant, the indicators should be designed tocapture risk contribution. In order to be incentive compatible, the

indictors should be measurable and difficult to manipulate; theyshould be determinable by the financial institutions managementand display relatively low volatility so as to reflect strategic


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Policies to deal wi th SIFIsPolicy makers have a wide range of toolsavailable to address the SIFIs dilemma. As afirst best solution, policy makers can try toeliminate externalities created by SIFIs byensuring a full bail-in of creditors and limitingcontagion effects upon failure. Alternatively,they may opt to charge SIFIs for theexternalities (e.g. through taxes) and increasethe SIFIs likelihood of survival (e.g. throughcapital requirements). As a last resort, theymay choose to restrict SIFIs in their range ofviable activities or abolish them altogether.

Eliminate externalities

Provide for an orderly resolutionmechanism that allows to maintainsystemically important functions of thefailing institution

Provide for bail-in mechanisms so thatcreditors cannot expect to be bailed out

Enhance market infrastructure to reducethe risk of contagion

Charge for externalities

Charge levies according to systemic riskcontribution

Ask for additional capital and liquiditybuffers

Increase likelihood o f survival Increase capital and liquidity requirements

Restrict leverage

Abo lish SIFIs

Limit the size and range of viable activities

Break-up of systemically importantfinancial institutions

Creating a seal of quality for SIFIs

decisions rather than day-to-day market fluctuations. If the primarygoal is to make the system safer, the indicators should in additioncapture how likely an institution is to participate in a systemic event.4

Its the policy objective that matters!

An effective benchmarking of financial institutions makes sure that

the indicators used are in line with the respective policy objectivesand tools to be applied. To illustrate this point consider the followingcase: Imagine a central counterparty (CCP) which is highlyinterconnected and whose failure would disrupt the smoothfunctioning of derivatives markets. Such an institution would bejudged systemically relevant according to the contribution approach.In extremis, a policy maker that merely tries to minimise aninstitutions contribution to systemic risk by looking at its inter-connectedness could decide to abolish the CCP altogether. Forobvious reasons, this would not be a sensible way to deal with thisparticular form of system-wide risk. After all, CCPs are meant toreduce complexity in the OTC market and thereby enhance stability

of the system. In this case, it will be important to know not only towhich extent the CCP contributes to systemic risk but also to whichextent it would be affected by a system-wide shock. The corres-ponding policy objective would be to ensure survivorship of the CCPand would call for sufficient collateralisation and capitalisation of theinstitution (for an overview of different policy options, see boxPolicies to deal with SIFIs).

By contrast, consider an industrial company which engages in theselling of Credit Default Swaps (CDS) and other derivatives on alarge scale but does not have an adequate credit risk managementin place to deal with the resulting risk. In order to enhance stability ofthe system, it may not suffice to look at the institutions viability in a

systemic crisis but also to consider its contribution to systemic riskby looking at its derivatives liabilities. In this case, the policyobjective could be to disincentivise the company to engageexcessively in the selling of derivatives.

The examples show that indicators used to identifysystemicallyrelevant institutions need not necessarily be suited to benchmarkinstitutions for regulatory purposes. Furthermore, the exampleshighlight the fact that systemic relevance is linked to the respectivepolicy objective. In some cases, it may be desirable to haveinstitutions assuming a systemically relevant role as this increasesstability of the system overall, in others, it may not.

Side effects

In addition to the desired effect of incentivising financial institutionsto become less systemically relevant, further (unintended) effectsneed to be considered. For instance, the market may viewdesignated SIFIs as less risky and demand a lower risk premium not necessarily because SIFIs may be required to hold highercapital buffers, and not because investors can expect to be bailed-out, but because SIFIs can be expected to be under closer scrutinyfrom supervisors and the general public. Banks that bear the SIFIslabel might not only pay a lower risk premium on their bonds, they

4

Bluhm and Krahnen (2011) argue that a banks contribution to systemic risk is notnecessarily a sufficient determinant of its optimal level of capitalisation, i.e. thecapitalisation which optimises the systems resistance to shocks. Consequently,using risk contribution as the sole determinant can result in a sub-optimalallocation of capital within the system.


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The Basel criteria

Based on the recommendations by theFinancial Stability Board (FSB) to reducemoral hazard posed by systemically importantfinancial institutions, the Basel Committee on

Banking Supervision (BCBS) has put forwarda preliminary list of criteria according to whichsystemic importance should be identified. Atthe end of July 2011, the proposedmethodology for identifying globally importantbanks (G-SIBs) was released for publicconsultation.

The methodology intends to capture systemicimpact if a bank were to fail, not the probab-ility of failure. Although the methodology hasyet to be finalised, it is clear that indicators willfall into five categories. In addition to size,interconnectedness and substitutability, theBCBS lists complexityand cross-jurisdictional

activityas relevant criteria. Indicators for eachcategory are based on banks on- and off-balance sheet items.

The proposed methodology assigns equalweights to each of the five sub-categories.Indicators are measured as a share of theaggregate value for the entire sample. Morethan 70 banks are included in the sample, 28of which are classified as G-SIBs.

http://www.bis.org/publ/bcbs201.htm

Raising market entry barriers

may also find it easier to attract deposits from corporates andhouseholds, especially in times of market tension.

Moreover, depending on the exact design of the measurementapproach, the SIFIs regime may create effective barriers to entryinto the market for global financial services. In markets where

interconnection is unavoidable and a global network provides for acompetitive advantage, non-SIFIs would face high incremental costsassociated with entering this market and being forced to comply withSIFIs regulation. The existing SIFIs, which do not face the sameentry costs, would be effectively protected from competitivepressures, inter alia depending on the actual regulatory burden.

Identifying globally impor tant banks

In the following paragraphs we discuss the indicator-basedmeasurement as proposed by the BCBS (see box The Baselcriteria). Although the approach is crafted to identify globallyimportant banks, i.e. financial institutions that are subject to bankingregulation under the Basel definitions, the underlying concept can

also be discussed in the context of identifying relevant non-bankfinancial institutions.

One by one, we go through the different criteria used to identifysystemically relevant institutions, i.e. size, interconnectedness,global activity, substitutability and complexity. Indicators are judgedon the basis of how well they measure risk contribution as well aswhich incentive effects they may create.

1. Size

The size of a financial institution is usually measured by the value oftotal assets held or the institutions market capitalisation. The BaselCommittee proposes to measure size by the total exposure as

defined for use in the Basel III leverage ratio. This allows consider-ing non-balance sheet items in addition to on-balance sheet items.However, to use this measure on a comparable basis, distortionsdue to different accounting rules across jurisdictions would have tobe eliminated at first.5

Size is the predominant theme in the measurement approach asproposed by the Basel Committee. Almost all variables aremeasured in absolute values rather than ratios (except for thewholesale funding ratio). The indicator is expressed as theinstitutions share of the samples aggregate value. Thus, eachindicator measures the size of a particular institution relative to itspeers in the designated SIFIs universe. Depending on the actual

regulatory burden, the methodology provides stronger or weakerincentives for financial institutions to reduce business volume atleast to a level where they will no longer be considered too large.

Undoubtedly, size plays an important role in determining systemicrelevance. If a large institution failed, the fallout for the rest of thesystem would likely be larger than it would be if a small institutionwere to fail. The larger an institution, the stronger, ceteris paribus, isits impact on the stability of the financial system overall. It is lessobvious, however, whether the stability of the system can beincreased by limiting the size of individual institutions. In fact,empirical evidence is mixed as to whether the costs of having largeinstitutions outweigh the benefits. Maturity and liquidity trans-

5 Moreover, the measure does not take account of the fact that exchange rate

fluctuations affect the institutions ranking, even if the institutions underlyingnotional exposures have not changed.
http://www.bis.org/publ/bcbs201.htmhttp://www.bis.org/publ/bcbs201.htm


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Assessing resolvabil it y of financialinstitutions

Resolvability of a financial institution isdetermined by internal as well as externalfactors. Internal factors relate to the type ofbusiness, the funding and organisationalstructures of the institution. External factorsinclude domestic resolution regimes thatsupport the authorities in maintaining thecritical functions of a failing institution. Forinternationally operation institutions, cross-border coordination and sharing of informationplays also an important role.

In J uly 2011, the FSB released for consult-ation recommendations for an effectiveresolution of systemically important financialinstitutions. Although the document primarilydiscusses how resolution regimes can bemade more effective, it also contains somevaluable thoughts on resolvability assess-ment.

Including resolvability as an overridingcriterion in the assessment methodologywould minimise competitive and otherdistortions and help align incentives with theaim of reducing moral hazard and increasingsystemic stability overall. To this end,qualitative and quantitative factors should

be considered which determine the likelihoodthat the institution would be resolved orrestructured in an orderly procedure if it wereto fail. Based on the FSBs proposedresolvability assessment, the firms structureand operations, its management informationsystems as well as national resolutionregimes and tools should be considered.

http://www.financialstabilityboard.org/publications/r_

110719.pdf

formation as well as the allocation of credit risk create systemicinterdependencies that cannot be easily allocated to individualinstitutions. Systemic risk can also be present in ahighlydecentralised system with many small institutions.6

In a systemic crisis, it can be even more difficult to deal with the

failure of small and medium-sized institutions than it is to stabilise alimited number of rather large institutions. Crisis management in ahighly fragmented banking system may bind more capacities thanthe rescue of a single institution. Moreover, medium-sizedinstitutions create significant uncertainty regarding their systemicrelevance, as in the case of Lehman Brothers. Exceptional circum-stances are almost certainly warranted in a crisis situation, whichmakes it nearly impossible to distinguish between systemicallyrelevant and non-relevant institutions.

In order to align incentive effects of the measurement approach withthe overall goal of reducing moral hazard greater emphasis shouldbe given to resolvability as an overriding criterion (see box

Assessing resolvability of financial institutions). Size is animportant determinant of systemic relevance ex ante; however, it isthe likelihood of an institution failing without causing systemicdisruptions which should matter for policy purposes. Includingresolvability as an overriding criterion in the assessmentmethodology would minimise competitive and other distortions andhelp align incentives with the aim of reducing moral hazard andincreasing systemic stability overall.

2. Interconnectedness

Interconnectedness of a financial institution is generally measuredby the volume of its intra-financial system assets and/or intra-financial system liabilities. The former reflects an institutions credit

exposure to the rest of the system and determines its participation ina systemic event. The latter captures credit risk to the rest of thesystem and thus an institutions potential contribution to a systemicevent. The Basel Committee proposes, in addition, to use thewholesale funding ratio, i.e. the share of funding raised from sourcesother than retail deposits in total liabilities.

Intra-system claims and liabilities are not a bad thing per se. Theyare an integral feature of a vertically differentiated financial system,where different financial intermediaries fulfil different functions. Intra-system claims and liabilities arise to the extent that some institutionsspecialise in the collection of funds from outside the system, e.g.deposit-taking institutions, money market funds etc., while others

depend on whole-sale funding (e.g. investment banks). They alsoreflect claims and liabilities in the interbank funding markets and thesharing of credit risk between financial institutions. To a certaindegree, interconnectedness and the risk of contagion go hand inhand with the benefit of having a differentiated financial system inwhich the allocation of risk and liquidity is organized by privatemarkets.

To achieve the optimal level of intra-system dependencies it will benecessary to determine which claims and liabilities are classified assystemically relevant and which not. To this end, the definitions usedshould be as narrow as possible but as broad as necessary. Theresulting incentive effects need to be considered. For instance, if

6 The US savings and loan crisis provides a case in point. Here, correlatedexposures among many smaller institutions created systemic threats even withoutan explicit role for large institutions.

Bank fa i lu res and bank s ize

Number offailed banks1960-2009

Depositsaffected(USD bn)

Large banks 13 127*

(assets >USD10 bn)

Medium-sizedbanks

166 354

(assets USD1-10 bn)

Small banks 2,523 260

(assets


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Symbiosis o f bank and state finances

In some highly indebted European countries,domestic banks have increased theirexposure to the sovereign over the pastyears. This development has led to asymbiosis of bank and state finances, where

states provide guarantee for their banks, whilebanks provide funding to states.

In Greece, Portugal and Ireland systemicrelevance has increased not only of banks butalso of the sovereign. As a consequence, theclose links between banks and states haslimited political options to restructure govern-ment debt outstanding without causing majordisruptions to the financial system. Thequestion arises whether banks should bediscouraged to invest in domestic governmentbonds ex ante.

As long as state finances are sound, govern-ment bonds provide a rather safe and liquid

asset. Banks use these assets mainly tomanage their balance sheet position. How-ever, in times of distress there is a moralhazard problem with having systemicallyrelevant institutions fund sovereign debt. Iflocal institutions enjoy (implicit or explicit)backing on a transnational scale, e.g. throughthe Eurosystem, they may be induced toprovide political lending to their homesovereign. Even in the absence of politicalpressure, the fact that banks can fundthemselves more easily and at lower cost thanthe sovereign creates incentive for banks toprovide financing to the sovereign. Theincrease in sovereign exposures of banks in

some highly indebted European countries canbe interpreted in this way.

liabilities vis--vis insurers and pension funds were not included inthe definition, incentives would be set to obtain funding from thoseinstitutions rather than from other banks. To prevent systemic riskbuilding up outside the official banking sector, in particular, exposureto non-bank financials should be included in the definitions. Againstthe backdrop of debt sustainability issues in some highly indebted

European countries, special consideration should also be given toclaims and liabilities vis--vis the home country sovereign (see boxSymbiosis of bank and state finances).

3. Global activity

A financial institutions global activity is generally measured by itscross-border claims and liabilities. The Basel Committee proposesto use cross-jurisdictional claims and liabilities as a core measureand non-domestic revenues as an ancillary measure.

The general presumption is that globally active banks are aparticular threat to the stability of the global financial system,whereas banks which are active only in their home market are not.

Globally active banks are often larger than domestic banks andthrough their foreign funding exposure provide a further channel forcontagion across national borders.

Global activity is a typical example of how the measurement ofsystemic relevance is not necessarily suited to benchmark financialinstitutions for regulatory purposes. Tying regulatory burden tocross-border claims and liabilities entails the risk of creatingunintended side-effects. If, due to SIFIs regulation, banks facedhigher marginal costs in their cross-border activities than their localcompetitors, global banks would easily be priced out of the market.Especially in the European context, this would counteract the idea ofa single market for financial services. But also in the global context,

it is not so clear why a system that provides incentives to reducecross-border business should be more stable than one that fostersdiversification across countries.7

On the contrary, globally active banks may be part of the solutionrather than part of the problem. In light of the sovereign debt crisis insome EMU member states, large cross-border institutions can helpform a more resilient banking system within the euro zone.

8 Globallyactive banks are not only able to better diversify country-specificcredit risk but also to maintain a stable funding base, especially intimes of distress. In so doing, they can continue to provide creditwhen local institutions are no longer able to meet corporate andprivate funding needs.9

7 Cihk et al. (2011) argue that systemic resilience increases with cross-border

interlinkages, at least up to a certain point. Past this point, resilience decreasesagain, until the financial network becomes close to complete and the systembecomes even more resilient.

Recent experience in Spain has

demonstrated that global banks can have a stabilising effect also onhome markets. In Spain, globally acting banks were able to step inand continue to provide credit in a situation where national Cajaswere hit hard by recession and the bust in Spanish propertymarkets.

8 Mayer et al. (2011) argue that a defragmented banking system within the euro-area has created a situation where local shocks can readily lead to intra-eurocapital flight.

9

Navaretti et al. (2010) find that lending of EU banks foreign affiliates has beenstable and even increasing between 2007 and 2009. For an in-depth discussion ofthe costs and benefits of cross-border banking within the EU, see also Allen et al.(2011). For a discussion of how cross-border banking has fared before, during andafter the financial crisis, see Schildbach (2011).


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August 11, 2011 13

Important to consider resolvability

Strong market position not to be

mistaken for lack of substitutability

Based on the arguments listed above, global activity may be usedas an indicator to determine participation in the overall sample ofglobal SIFI candidates, i.e. by distinguishing between local andglobal SIFIs. However, we doubt that incentivising financialinstitutions to become less globally active is suited to establish amore stable financial system.

4. Substitutability

Substitutability of a particular financial institution is particularly hardto measure. The Basel Committee proposes to use assets undercustody, value of payments cleared and settled through paymentsystems, as well as values of underwritten transactions in debt andequity markets to measure substitutability. The measurement ofsubstitutability in that way requires (a) a consistent definition of whatconstitutes a systemically relevant market and (b) the definition of asystemically relevant market share. In this respect, it is very similarto the concepts used in competition law.

However, with the aim of ensuring a stable financial system,

substitutability should not be misunderstood as a measure of marketdominance. Even if a financial institutions market share or the valueof transactions it processes is large, the institution may not beindispensible for the functioning of the system. The likelihood thatthe institution can exit the market without causing major disruptionsshould be assessed, rather than the mere volume of assets held ortransactions processed. This requires a counterfactual analysis ofwhat were to happen if a particular institution was no longer offeringits services, not the mere assessment of market shares.

5. Complexity

Complexity generally relates to the corporate structure of an

institution. It can also refer to the asset side of a financial institutionsbalance sheet with more complex assets adding to the complexityof the financial institution. The Basel Committee takes this latterview and measures complexity by the notional value of OTCderivatives, level 3 assets for which no market value can beobserved, as well as the value of assets held on the trading book oravailable for sale.

The use of complexity as a measure of systemic relevance rests onthe notion that more complex financial institutions are more difficultto dissolve if they fail. More complex assets are harder to sell andmore complex corporate structures more difficult to disentangle. Inboth cases, it is rather difficult to find adequate indicators.

Complexity seems to be only one of the factors that determine thelikelihood that a financial institution can be resolved without causingsystemic problems.

With respect to the corporate structure, it would be important toconsiderresolvability as an overriding criterion to judge aninstitutions contribution to systemic risk. Besides other bank-specificinternal and external factors that determine resolvability, complexitymay be just one of the factors that need to be assessed. If aninstitution fails, it will be necessary that those parts of the businesswhich are deemed systemically relevant on the asset- as well asliability-side can be isolated from the rest of the business on agoing-concern basis.

On the asset side of bank balance sheets, it may be useful toconsider excessive engagement in overly complex products.However, a certain degree of complexity of bank balance sheets isnecessary for instance in the market for bespoke OTC derivatives.


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14 August 11, 2011

Dodd Frank SIFI designation

In the US, the Dodd-Frank Act designated allcommercial banking groups with USD 50billion or more in consolidated assets asSIFIs, but leaves the designation ofsystemically important non-bank financialinstitutions and bank holding companies withthe Financial Stability Oversight Council(FSOC).

According to Dodd-Frank, the FSOC candesignate a non-bank financial company forenhanced supervision if material financialdistress at such a firm, or the nature, scope,size, scale, concentration, interconnected-ness, or mix of the activities of the firm, couldpose a threat to the financial stability of theUnited States. Currently, the FSOC is in theprocess of formulating a methodology toidentify systemically important non-bankfinancial institutions.

Besides hedge funds, money market funds

and securities houses, the rules targetfinancial subsidiaries of large (industrial)corporate, which have become quite large inthe US and in some cases have threatenedthe existence of their parent companies.

A notice of proposed rulemaking fromFebruary 2011 defines a company as a non-bank financial institution, if either 85 % ofgross revenues or 85% of gross assets arerelated to financial activities. As for bankholding companies, a threshold of USD 50billion in total consolidated assets applies. Theproposed definitions apply to domestic as wellas foreign institutions. The Fed may designate

further companies as non-bank financialinstitutions on a case-by-case basis.

http://www.federalregister.gov/articles/2011/02/11/2011-2978/definitions-of-predominantly-engaged-in-financial-activities-and-significant-nonbank-financial

Internationally Acti ve InsuranceGroups (IAIGs)

Following the FSBs recommendation onreducing moral hazard posed by SIFIs, theInternational Association of InsuranceSupervisors (IAIS) has released a conceptpaper in J uly 2011, which lays out theframework for the supervision of

Internationally Active Insurance Groups(IAIGs).

Internationally operating financial institutionsthat hold assets and/or insurance liabilities ofmore than USD 20 bn or gross writtenpremiums of more than USD 10 bn will besubject to heightened supervisory scrutiny.

There will be closer coordination andinteraction between supervisors for theseinstitutions and IAIGs will be required to meetadditional requirements concerning riskmanagement and contingency planning.

The final framework is scheduled to be inplace by mid-2013. It is expected that the

initial number of IAIGs will be limited to about40 to 50 and increased thereafter.

http://www.iaisweb.org/__temp/ComFrame_Concept_Paper_Final.pdf

After all, it is the very role of financial intermediaries to assess andbear the risks that cannot easily be grasped and are nottraded inpublic markets. The resulting complexity of assets held by banks is anatural consequence of this very function. It should be addressed byaccounting and disclosure rules rather than SIFIs regulation.

Identification of non-bank SIFIsWe have already argued that the principles used to determinesystemic relevance should be applied universally to all financialinstitutions in order to prevent systemic risk building up in sectorsthat are excluded from the SIFIs universe. However, any approachto measuring systemic relevance of individual institutions needs totake into account that different groups of financial institutions fulfildifferent functions within the financial system. Availability of certainbalance sheet items or market information can furthermore varybetween the different groups. It will be necessary therefore to tailorthe measurement approach to the distinct characteristics of eachgroup of financial institutions. In so doing, resolvability of a financial

institution could serve as a central theme and an important criterionfor designation of bank and non-bank financials alike. The likelihoodof the institution being resolved or restructured in an orderlyprocedure if it were to fail, i.e. without causing systemic disruptions,should be considered as a central theme (see also box Assessingresolvability of financial institutions on page 11).

At the moment, regulators are developing methodologies to identifysystemically relevant non-bank financials. The methodologies arestill in the process of consultation. In the US, Dodd Frank has madespecific reference to non-bank financials who can be designated assystemically important on the basis that material financial distress atsuch a firm would pose a threat to financial stability (see box Dodd

Frank SIFI designation). In so doing, Dodd Frank inter aliaaddresses systemic risk in the shadow banking system whosecumulative assets exceed those of commercial banks (see chart 2on page 6).

In a similar vein, the FSB (2010) has assigned supervisors todevelop methodologies for assessing systemic relevance of non-bank financials. In addition to banks and market infrastructures,special attention is given to insurance companies (see below andbox Internationally Active Insurance Groups (IAIGs)).

Insurers

Insurance companies view their core business as largely non-

relevant for financial stability due to relatively low levels ofinterconnectedness with the rest of the financial system. In fact,direct intra-system claims and liabilities are limited, as insurers holdonly a small fraction of their assets in bank debt and equitysecurities. Moreover, insurers are largely independent from bankfinancing. Only in recent years have they started to tap capitalmarkets to fund their operations or transfer insurance risk to capitalinvestors via insurance-linked securities (ILS). Overall volumes arestill manageable, though.

10

Insurers therefore aim to separate potentially systemically riskyactivities from their core business, arguing that only the formershould fall under heightened supervisory scrutiny. Measured by total

asset volume, however, the worlds largest insurers play in the sameleague as the worlds largest banks. Thus, resolvability of large

10 For an overview of the ILS market, see Weistroffer (2010).
http://www.federalregister.gov/articles/2011/02/11/2011-2978/definitions-of-predominantly-engaged-in-financial-activities-and-significant-nonbank-financialhttp://www.federalregister.gov/articles/2011/02/11/2011-2978/definitions-of-predominantly-engaged-in-financial-activities-and-significant-nonbank-financialhttp://www.federalregister.gov/articles/2011/02/11/2011-2978/definitions-of-predominantly-engaged-in-financial-activities-and-significant-nonbank-financialhttp://www.iaisweb.org/__temp/ComFrame_Concept_Paper_Final.pdfhttp://www.iaisweb.org/__temp/ComFrame_Concept_Paper_Final.pdfhttp://www.iaisweb.org/__temp/ComFrame_Concept_Paper_Final.pdfhttp://www.iaisweb.org/__temp/ComFrame_Concept_Paper_Final.pdfhttp://www.iaisweb.org/__temp/ComFrame_Concept_Paper_Final.pdfhttp://www.federalregister.gov/articles/2011/02/11/2011-2978/definitions-of-predominantly-engaged-in-financial-activities-and-significant-nonbank-financialhttp://www.federalregister.gov/articles/2011/02/11/2011-2978/definitions-of-predominantly-engaged-in-financial-activities-and-significant-nonbank-financialhttp://www.federalregister.gov/articles/2011/02/11/2011-2978/definitions-of-predominantly-engaged-in-financial-activities-and-significant-nonbank-financial


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August 11, 2011 15

Systemically important marketinfrastructures

At present, there are three sets ofinternational standards by the CPSS andCPSS-IOSCO, i.e. the Core principles forsystemically important payment systems(2001), the Recommendations for securitiessettlement systems (2001), and theRecommendations for central counterparties(2004). The standard setting bodies arecurrently working on a new set of principlesthat will replace the three existing sets. Thenew set is believed to provide greaterconsistency in the oversight and regulation ofmarket infrastructures worldwide.

http://www.bis.org/publ/cpss94.htm

In the US, the FSOC designates financial

market utilities as systemically relevantaccording to the following criteria:

Aggregate monetary value of transactionsprocessed by a financial marketinfrastructure

Exposure to its counterparties

Interdependencies with other financialmarket infrastructure or payment, clearingor settlement activities

The effects that the failure would have onthe broader financial system

A corresponding rule will come into effect bythe end of August 2011.

http://www.federalregister.gov/articles/2011/07/27/2011-18948/authority-to-designate-financial-market-utilities-as-systemically-important

insurance companies cannot be taken for granted. The sameprinciples used to identify systemically important banks should beapplied also to identify systemically important insurers, i.e.assessing the systemic impact of an insurance companys failure,not the probability of failure.

Would it be possible from a systemic risk perspective to allow largeinsurers to default on their liabilities, leaving policy holders ofcasualty and property insurance but also of life and pensioninsurance without adequate coverage? How would financial marketsreact and what would be the effect on asset prices if a largeinsurance company were forced to exit the market? The answer tothese and related questions should guide the methodology todetermine systemic relevance of insurance companies.

Market infrastructures

Payment systems, securities settlement systems and centralcounterparties are all structures that connect individual marketplayers in order to facilitate their mutual dealings. They provide intra-

system channels for the transfer of money, securities and collateral.They are natural SIFI candidates, as a failure of one of the sub-systems simultaneously affects a large number of players in themarket. Systemic problems can arise if the functions of the failingsystem are not transferred to another platform in a timely manner.

The critical role of market infrastructures has led policy makers torecognise the specific relevance of market infrastructures alreadybefore systemic risk regulation for banks and other non-bankfinancials became an issue. The principles set out by internationalstandard setting bodies for systemically important payment systemsand systemically important securities settlement systems date backto several years before the recent crisis period (see box

Systemically important market infrastructures).Following the experience made during the recent financial crisis,prudential policies explicitly advocate centralisation in marketinfrastructures forcing more contracts to be cleared and inter-mediated by the platforms. Central collateralisation and centralclearing of OTC derivatives has thus become one of the main pillarsof the new regulatory framework, which aims to reduce systemic riskin financial markets overall. Such a policy tends to increase thesystemic importance of market infrastructures. The net gain inoverall stability of the financial system is believed to be positive,though.

In case of market infrastructures, systemic relevance needs to beaccompanied by measures that ensure viability in a crisis event. Tothis end, it will be important to refer not only to loss-given-default,but also probability of default in the benchmark framework.Exposure to counterparties can be used to identify systemicallyimportant infrastructures, but benchmarking should rather be basedon viability and resolvability issues.

Conc lus ions

Mainly as a direct response to the recent financial crisis that startedin 2007, policy-makers are developing a framework to deal with the

too-big-to-fail problem in financial markets. A main building block ofthe new regime will be enhanced regulatory and supervisoryrequirements to be met by systemically important financialinstitutions. Currently, academics and policy makers are working on
http://www.bis.org/publ/cpss94.htmhttp://www.federalregister.gov/articles/2011/07/27/2011-18948/authority-to-designate-financial-market-utilities-as-systemically-importanthttp://www.federalregister.gov/articles/2011/07/27/2011-18948/authority-to-designate-financial-market-utilities-as-systemically-importanthttp://www.federalregister.gov/articles/2011/07/27/2011-18948/authority-to-designate-financial-market-utilities-as-systemically-importanthttp://www.federalregister.gov/articles/2011/07/27/2011-18948/authority-to-designate-financial-market-utilities-as-systemically-importanthttp://www.federalregister.gov/articles/2011/07/27/2011-18948/authority-to-designate-financial-market-utilities-as-systemically-importanthttp://www.federalregister.gov/articles/2011/07/27/2011-18948/authority-to-designate-financial-market-utilities-as-systemically-importanthttp://www.bis.org/publ/cpss94.htm


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methodologies to identify those institutions which deserve specialattention in the new framework.

This study discusses the underlying concepts and indicatorsproposed to measure systemic importance. It argues that system-wide risk cannot be easily allocated to individual institutions, as

systemic interdependencies are an integral part of a differentiatedfinancial system. In particular, non-bank financials should not beexcluded as potential SIFI candidates ex ante. Banks, insurers,investment funds and other non-bank financials all contribute to thesmooth functioning of the financial and wider economic system andshould be benchmarked according to their potential impact uponfailure.

The relevance of individual institutions is also a function of theprevailing economic and market environment. Once more, thecurrent handling of the European debt crisis has demonstrated thatrather small events of perceived local relevance can easily turn intoa crisis on a global scale if second and third round effects are not

properly taken into account. The fact that systemic risk does notevolve in a linear way makes it difficult to identify systemicallyimportant institutions ex ante.

The study also highlights the difference between the aim ofidentifying systemically important institutions and the benchmarkingof those institutions for regulatory purposes. It argues that indicatorsused to benchmark financial institutions need to fulfil additionalcriteria, which are not yet fully reflected in the current regulatoryproposals. Policy makers need to take into account the response ofmarket participants. For instance, judging systemic relevance byglobal activity provides incentives for banks to reduce cross-borderdiversification of credit and funding risk, which does not necessarilylead to a more stable system. Especially in the European but also inthe global context, globally active banks may be part of the solutionrather than part of the problem.

Finally, this study argues that greater weight should be given toqualitative factors which determine the likelihood that an institutionwould be resolved or restructured in an orderly procedure if it wereto fail. Doing so would be in line with the aim to reduce moral hazardand help make the system more stable. If resolvability of marketparticipants were established as a central theme in SIFI designation,competitive and other distortions could be minimised.

Christian Weistroffer (+49 69 910-31881, [email protected])


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References

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prudential bank regulation. J ournal of Financial Stability 5. 224-255.

Acharya, Viral. V., Lasse H. Pedersen, Thomas Philippon andMatthew Richardson (2009). Regulating systemic risk. Chapter13 in Acharya, Viral. V, and Matthew Richardson, RestoringFinancial Stability: How to repair a failed system. J ohn Wiley &Sons.

Acharya, Viral. V., Lasse H. Pedersen, Thomas Philippon andMatthew Richardson (2010). Measuring systemic risk. Mimeo.May 2010.

Allen, Franklin; Thorsten Beck, Elena Carletti, Philip R. Lane, Dirk

Schoenmaker and Wolf Wagner (2011). Cross-Border Bankingin Europe: Implications for Financial Stability andMacroeconomic Policies. CEPR Report. J une 2011.

Bluhm, Marcel and J an P. Krahnen (2011). Default Risk in anInterconnected Banking System with Endogeneous AssetMarkets. Mimeo. January 2011.

Brownlees, Christian T. and Robert Engle (2010). Volatility,Correlation and Tails for Systemic Risk Management. WorkingPaper. NYU Stern School of Business.

Chan-Lau, J orge A. (2009). Regulatory Capital Charges for Too-Connected-to-Fail Institutions: A Practical Proposal. IMFWorking Paper No. 10/98.

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Cihk, Martin; Snia Muoz and Ryan Scuzzarella (2011). TheBright and the Dark Side of Cross-Border Banking Linkages.IMF Working Paper No. 11/186.

Drehmann, Mathias and Nikola Tarashev (2011). Measuring theSystemic Importance of Interconnected Banks. BIS WorkingPaper No 34.

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important financial institutions. FSB Recommendations andTime Lines. October 2010.

Huang, Xin; Hao Zhou and Haibin Zhu (2009). A Framework forAssessing the Systemic Risk of Major Financial Institutions.J ournal of Banking and Finance vol. 33, 20362049.

Huang, Xin; Hao Zhou and Haibin Zhu (2010). Assessing theSystemic Risk of a Heterogeneous Portfolio of Banks During theRecent Financial Crisis. BIS Working Paper No. 296.

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Considerations. Report to the G20 Finance Ministers andGovernors. October 2009.

Mayer, Thomas, J ochen Mbert and Christian Weistroffer (2010).Macroeconomic imbalances and the Eurosystem. GlobalEconomic Perspectives. Deutsche Bank. J une 2011.

Navaretti, Giorgio B., Giacomo Calzolari, Alberto F. Pozzolo andMicol Levi (2010). Multinational banking in Europe financialstability and regulatory implications: lessons from the financialcrisis. Economic Policy. Vol. 25(64), pp. 703-753.

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market expanding. Deutsche Bank Research. Current Issues.October 2010. Frankfurt am Main.


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Copyright 2011. Deutsche Bank AG, DB Research, D-60262 Frankfurt am Main, Germany. All rights reserved. When quoting please cite Deutsche BankResearch.The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the author, which donot necessarily correspond to the opinions of Deutsche Bank AG or its affiliates. Opinions expressed may change without notice. Opinions expressed may differfrom views set out in other documents, including research, published by Deutsche Bank. The above information is provided for informational purposes onlyand without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of theinformation given or the assessments made.In Germany this information is approved and/or communicated by Deutsche Bank AG Frankfurt, authorised by Bundesanstalt fr Finanzdienstleistungsaufsicht.In the United Kingdom this information is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange regulated bythe Financial Services Authority for the conduct of investment business in the UK. This information is distributed in Hong Kong by Deutsche Bank AG, Hong KongBranch, in Korea by Deutsche Securities Korea Co. and in Singapore by Deutsche Bank AG, Singapore Branch. In J apan this information is approved and/ordistributed by Deutsche Securities Limited, Tokyo Branch.In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to anyfinancial product referred to in this report and consider the PDS before making any decision about whether to acquire the product.Printed by: HST Offsetdruck Schadt & Tetzlaff GbR, Dieburg

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