BANKTHINK

No Financial Institutions Are Systemically Important

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The postmodern regulatory approach to banking relies on the idea of systemically important financial institutions.

The Financial Stability Board defines these creatures as financial institutions whose "disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity."

The FSB lists a few dozen global systemically important financial institutions. Disagreement in this new postmodern world seems to center on better working definitions of systemically important, questions of process and authority as to who shall make the final determination, and quibbles about specific entities and their designations. Only a few bother to ask whether this entire approach is useful or not. And essentially nobody considers the possibility of complete deregulation of the banking sector, including allowing competing currencies.

Let's take a heterodox tack on this issue and consider the hypothesis that no financial institutions are systemically important.

The standard definition above of SIFIs is essentially useless – just like the modern interpretation of the Commerce Clause of the Constitution is useless as a limit on power. What was intended to be a limited Congressional power has expanded into a blank check to act in any case where there is an aggregate effect on economic activity. Congress doesn't even need to explain how the effect aggregates, which would be a low enough hurdle; there only needs to be a "rational basis" for thinking there could be such an effect. In other words, as the Institute for Justice, a libertarian public-interest law firm, argues, as long as the judge's imagination is creative enough, virtually any law can be authorized under the prevailing interpretation of the Commerce Clause.

Similarly, just about any institution can be deemed systemically important under the standard definition. Economic activity in the free market naturally encourages complexity and interconnectedness. That is how the magic of mutual benefit and prosperity spreads throughout the world.

But what is the wider financial system that we are so worried about? People invest in assets and securities with the understanding that they could lose all their money. That's why they don't usually put all their eggs in one basket. People trade with counterparties with full knowledge that in the event of distress or default, some of the money may not be recoverable. That's why they insist on collateral.

To be sure, there are critically important companies and industries in America. If the power goes out, we expect the electric company to be working round the clock. Other critical crews such as firefighters, ambulances, hospitals, and police are also available every hour of every day in the year.

But other businesses that are useful but not critical are not always open. The post office is closed on Sundays. Many museums are closed on Mondays. Most regular office businesses are closed all weekends.

On the other hand, many seemingly "unimportant" businesses are also open every day, often 24 hours a day: fast food restaurants, bookstores, supermarkets, and pharmacies. So it's not necessarily the case that every round-the-clock establishment is in some political sense important, but it does seem reasonable that any establishment that is in some political sense important better be open round-the-clock.

Are banks open round-the-clock? Famously, no. They are closed for every federal holiday observed by the Federal Reserve: Ten holidays a year including Labor Day, Columbus Day, Veterans Day, Martin Luther King Jr.'s birthday, Washington's birthday, and five more. By and large, banks are closed Sundays. They are closed at night. And when they are open, they work, by definition, banker's hours. (The seven-days, open-late model of a handful of community and regional banks is the exception that proves the rule.)

Yet economic activity continues to function even when banks are closed. Credit cards still work. ATMs dispense cash. Checks are accepted. The markets that people are willing to pay to be open are open.

If a crazy calendar somehow had several federal holidays in a row, and banks were closed for a full week, would anybody even notice?

We in the banking and finance community like to think of ourselves as central and critically important to an economy, but perhaps banks are not that important after all. Their major function of clearing and moving money can obviously be postponed indefinitely without major ramifications. And of course that entire functionality can be replaced with electronic services such as PayPal or electronic currencies such as Bitcoin. Is PayPal a systemically important financial institution? Is Bitcoin, or Visa, or MasterCard? Not according to the FSB.

No financial institution is truly systemically important. I worked at Long Term Capital Management when the Federal Reserve twisted arms to orchestrate a private rescue. Would the world have been so much worse if LTCM had simply been allowed to fail or find its own solution? Perhaps it would have been better, given the implied sanction the event gave to future moral hazard.

The only times in history when the collapse of a company threatened an entire nation's economy were when the nation was intricately tied up with the company: The South Sea Company of the 18th century, a public-private partnership closely supported by the British government; the Mississippi Company, established under the auspices of King Louis XV by economist John Law; Fannie Mae and Freddie Mac. What else needs to be said?

Designating certain companies as systemically important accomplishes nothing more than putting them into a closer relationship with the government, making the designation itself a self-fulfilling prophecy. Without the excessive government interference that forces innocent people to be responsible for the failures of others, no financial institution would be systemically important.

Philip Maymin is an assistant professor of finance and risk engineering at NYU-Polytechnic Institute.

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Comments (6)
SIFI=Too Big To Fail. Neither term should exist in a free market financial system and economy - but sadly, as the crisis proved, they do. It really doesn't matter what you call an institution that will receive unlimited government support in times of crisis - the fact is that there are a handful of institutions that WILL receive unlimited government backing in times of deep economic or financial stress. Our system has become so concentrated in such few hands that the government has no choice but to prop up those institutions when failure is imminent to protect the national economy and millions of consumers. When one firm like Well Fargo controls 40% of the nation's mortgages, what other course of action can the government take but to prop them up? So maybe accronyms like "SIFI" or "TBTF" should not exist, but the sad fact is that they do. And they aren't going to get better, but worse.
Posted by commobanker | Wednesday, September 05 2012 at 1:47PM ET
This is all true, but the designation does accomplish several other things: bailing out such institutions saves regulators from having to explain why they let things get that bad in the first place, and politicians get to protect the politically connected.
Posted by kvillani | Wednesday, September 05 2012 at 1:57PM ET
The author states the obvious with one exception -- the consequences of entertwining any corporate entity more with the Federal largess is to stifle competition in that industry in the long run. Designating any bank or financial company as a Systemically Important Financial Institution solves what is actually a short run problem of market inefficiency with a long run solution by bestowing special powers on SIFI companies backed by government authority and taxpayer funds. This power essentially reduces the long run cost to these companies giving them a substanial long run competitive advantage that can't be taxed or regulated away. The next administration ought to dedicate itself to ridding us of the Financial Stability Board and SIFIs.
Posted by Gerald Hanweck | Wednesday, September 05 2012 at 4:41PM ET
Excellent point that the definition of a SIFI is bounded only by the imagination of the regulator. In fact, it is hard to find genuine SIFIs, and I would agree that, at least in the U.S., it is hard to find any banks that are genuinely too big to fail. TBTF is demonstrably found in the minds and actions of regulators. LTCM is an excellent example. It was by no means TBTF, but regulators got nervous about having to deal with the messy financial problems that might have occurred had it failed. An easier solution for regulators was to twist a lot of arms to prop up LTCM.

LTCM is also a good example of why "busting up the big banks" will not solve the TBTF problem. No one is suggesting that banks should be shrunken down to the size of LTCM, and yet LTCM still spooked regulators into taking action to keep it going. Instead of focusing on SIFIs we should focus on regulatory discretion to choose to bail out failing firms rather than deal with the messy problems--or hits to regulatory reputation--of a failing institution.

One correction I would offer to the author: there is never a time in the U.S. when all of the banks are closed. Their front offices may close after certain hours, but many banks are in operation 24/7 providing banking services, such as clearing payments, operating credit card systems, allowing cash to be withdrawn from ATMs, combating fraud, managing assets, protecting the integrity of the payments system. And look at the structure of alternatives like PayPal. They cannot operate without banks. Money goes into PayPal via a bank, and it comes out of PayPal via a bank. As an industry, banking is irreplaceable. But no member of the industry, no single bank, is too big to fail, and no regulator should be allowed to bail out any failing bank.
Posted by WayneAbernathy | Wednesday, September 05 2012 at 5:18PM ET
"...disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity."

Congress fits the definition perfectly; unless the definition only includes "disorderly failure" of a financial institution. As a earlier commented, how about AMTRAC, or the USPS, or Tele-Comms, or computer manufacturers etc.

This is about getting some legislation to get by this roadblock. TBTF cuts across all industry sectors. There is plenty to really argue about so why play with words rather than meanings. If economists w/ Doctorates cannot agree on basic terminology ( or punctuation) it's time to get new consultants, and probably a new Congress

Richard Isacoff
isacofflaw@msn.com
Posted by richard isacoff | Wednesday, September 05 2012 at 6:57PM ET
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