WASHINGTON — A big unanswered question of the Obama administration's proposed regulatory revamp — how to define systemically important institutions — is tackled in a study the Federal Reserve Bank of Cleveland released Tuesday.
The administration's plan leaves vague which firms pose such a risk to the financial system that they require tighter oversight, but the Cleveland Fed is proposing a host of benchmarks to separate companies into three tiers of importance.
The study's author, James Thomson, a vice president in the Cleveland Fed's Office of Policy Analysis, is advocating a continuum of systemically important firms.
"If you're going to think of this definition, the binary distinction doesn't get at the heart of why an institution may or may not be systemically important," Thomson said in an interview. "If you think of it in a binary state, you're not thinking about the causes or why one institution is significant but another institution isn't."
Beyond size, regulators would look at whether a company controls more than 10% of the activities or assets in a particular financial sector or 5% of total market activities. Other benchmarks include whether an institution holds more than 5% of banking assets nationwide or 15% or more of the nation's loans.
If an institution holds 10% or more of the nation's banking assets once its off-balance-sheet holdings are added in, then it too would be considered systemically important.
Thomson's plan considers four other concerns — contagion, correlation, concentration and conditions — that regulators would consider before deeming an institution systemically significant. Again, these ideas echo aspects of the Obama plan but offer far more details.
To avoid a repeat of the government having to help JPMorgan Chase & Co. take over Bear Stearns & Co. out of fear that the investment bank's failure would lead to other problems, Thomson suggests that an institution be treated as systemically significant if its failure would reduce the financial system's assets by 30% or lock up the payments system.
When looking at correlation, Thomson argues, regulators should prepare for the consequences of financial institutions all chasing the same trend, as they did with subprime mortgages.
"This means that a group of institutions that would not typically pose a systemic threat might, in certain economic or financial-market conditions, become systemically important," Thomson wrote in the study.
Institutions that play big roles in certain market functions would be deemed systemically significant. If a firm clears or settles more than 25% of the trades in a market, handles more than 25% of the daily volume of a payments system or controls more than 30% of a particular credit activity, it would meet that definition.
Finally, Thomson said regulators need to acknowledge that some firms are worth rescuing in certain periods when firms of the same size or bigger are allowed to fail during other periods. He compares the Bear Stearns rescue with the collapse of Drexel Burnham Lambert in 1990.
Thomson estimated that 15 to 20 firms would satisfy at least one of these benchmarks and be classified as systemically important. Once that happens, the institutions would be placed into one of three categories, with each category carrying a different level of regulation.
Institutions that alone would not be systemically significant but could cause problems if they failed as a group would be placed into Category 3.
Regulators would conduct routine stress tests and could establish portfolio limits, additional capital requirements and tie loss reserves more closely to whatever is causing the risk.
If an institution's importance is a product of its connections to other firms, it would go into Category 2. Regulators could require additional reporting from this class of institutions so their exposures to other firms could be better monitored. The firm's activities with certain counterparties could also be curbed.
Category 1 institutions would be those that alone present steep risks to the overall economy. Thomson said he believed at least four institutions would find themselves in this classification today, where they would be subject to the most intensive tracking. Regulators could create a mandatory requirement for subordinated debt, which would have the effect of building a cushion between the company and traditional debtholders. Firms could also be forced to hold debt that could be converted into equity if more capital is needed.
"If this doesn't eliminate systemically risky institutions, it would reduce to a large degree the incentive to become systemically important," Thomson said.
If the additional requirements were not enough to discourage companies from landing in one of the three categories, Thomson said the list of systemically important firms could be made public and a watch list could be created to alert the public when an institution is on the verge of being moved into a tougher category.
"If you have a Category 2 institution and they're going to have this much more capital and pay this special assessment, a lot of that is observable," he said. "Why not just make this stuff transparent?"
A representative from the Fed in Washington did not comment on Thomson's proposal.
Thomson acknowledged that his prescription for one of the biggest problems to emerge from the financial crisis is complex but held out hope that it would interest members of Congress.
"The appeal of this is that rather than putting down a blanket set of new restrictions or throwing up your hands and simply saying these institutions are 'too big to fail,' you say we're going to put in place a system that's going to create incentive that will give us a more stable financial system," he said.