The Financial Stability Board announced that there are 30 systemically important global financial institutions (SGFIs) — 24 banks and six insurance companies — that pose sufficient systemic risk to warrant additional supervision and the establishment of recovery and resolution plans ("living wills"). Global financial regulators intend to set forth an aggressive regulatory regime including wind-down provisions to create orderly dissolution of SGFIs should they fail.
This middle road may be the worst-case approach. It identifies the systemically important institutions and allows them to continue to exist. At the same time, it acknowledges that regulations cannot be successful in averting failure but can, however, avert a global financial catastrophe through an established method of wind-down.
If the existence of SGFIs poses risk to the world's financial system, then rather than try to manage failure, either a strategy to successfully avoid failure should be pursued (which arguably can be done but inflames critics of "too big to fail" and makes regulators' knees tremble under the weight of the task) or SGFIs should not be allowed to exist.
Congressman Maurice Hinchey of New York introduced a bill to require the Treasury to dismantle any U.S. financial institution deemed so big that its collapse would undermine the entire national economy. Under this "Too Big to Fail, Too Big to Exist Act," the FIs that pose systemic risk are identified and then broken up into pieces to eliminate the systemic risk. This approach differs from those that advocate recovery and resolution plans, but it acknowledges the same issue: that regulators cannot be successful in regulating FIs so they don't fail. The best that can be done is to set up living wills or to not allow SGFIs to exist.
If it is possible to identify institutions whose failure could deliver a headshot to the economy, why should they be broken up? The belief that dispersing risk among more, smaller players (think mortgage-backed securitization) will make the economy a safer place is flawed. Because banks tend to have similar asset compositions, this thought suffers from a fallacy of diversification. Breaking up institutions to address systemic risk takes the focus off regulatory responsibility and creates more institutions of substantial size that must be regulated more closely. If SGFIs can be identified, then the focus must be on oversight and regulation rather than on how to manage failure.
By identifying SGFIs, the financial regulators want to name the institutions that have the potential to cause economic damage on a regional or global basis. At the largest banks, cadres of regulators are positioned in-house and oversee all banking activities on a continual basis. With such unfettered access to the business, it is reasonable to believe the regulators should be able to prevent institutions from taking on undue risks, operating with insufficient capital levels and improperly managing asset/liability allocations and liquidity.
In a discussion paper, the Federal Reserve Bank of Cleveland attempts to create a framework to identify systemically important FIs in the U.S. In addition to an FI's size, the paper identifies four other attributes that can make an institution systemically important: contagion; correlation ("too many to fail"); concentration; and conditions/context. Under this framework, dozens of U.S. financial institutions would be classified as systemically important, versus 30 SGFIs across the globe as identified by the Financial Stability Board.
It is perhaps "conditions/context" that is most problematic for creating a regulatory framework to manage systemic risk. "Firms that might be made systemically important by conditions/context are probably the most difficult to identify in advance," the paper states. To borrow a phrase from Donald Rumsfeld, the former secretary of Defense, these are the "known unknowns." That SGFIs lack the intent to cause economic harm is what makes systemic-risk regulation and mitigation so pernicious. There is no business plan that outlines how a financial institution will load up on risk and unleash a financial shock wave.