Today, the global financial reform agenda is increasingly targeted toward reducing the size, scope and systemic risk posed by large institutions. However, it appears to be the consensus that breaking them up is either politically or economically unwise.
The current policy aim is to apply increasing capital and liquidity charges against systemically important high-risk companies in order to create institutional and structural incentives for financial intermediaries to divest of — or otherwise "de-risk" — non-core banking activities.
This approach is evident in the harsh penalties that can accrue to a firm for failure to produce an approved recovery and resolution plan (i.e., a "living will"), lack of proper enterprise-wide stress-tests and risk appetite frameworks, and the surcharges based on an assessment of systemic importance.
To address the unintended consequences of the extraordinary policy actions that occurred during the heat of the crisis — such as increased moral hazard — the G20, Financial Stability Board and the Basel Committee on Banking Supervision are aggressively attacking the too big to fail doctrine through various regulatory mechanisms.
Perversely, many large, cross-border banks have become bigger and more interconnected since the start of the crisis, an apparent move in the opposite direction of structural health and financial stability. But more is happening to address the TBTF issue than meets the eye.
The additional costs that will begin to accrue to the large financial organizations create a series of institutional incentives, similar in nature to proposals around incentive compensation (e.g., see the Federal Reserve's excellent horizontal review of incentive compensation practice), to assess whether and how to provide the highest return to investors. The result of these assessments ultimately may require material alterations to existing business models and, like proprietary trading, cause big banks to reassess their legal entity, governance, and strategic business objectives.
In combination, the current set of reforms — including Basel III liquidity and capital rules, the Dodd-Frank Act's resolution planning requirements, and the hotly debated systemic risk and loss absorbency requirements –creates a powerful framework of institutional and supervisory policy levers that can be used by regulatory authorities to limit risk-taking, control bank size, and deter banks from increasing their systemic importance.
One of the most compelling and ambitious projects relates to the July 2011 BIS Consultative Document, "G-SIBs: Assessment Methodology and the Additional Loss Absorbency Requirement." Within this framework, the Basel Committee has developed a methodology called the "indicator-based measurement approach" that is used to determine the relative systemic importance of globally systemically important banks.
Under the IBMA, large global banks and financial institutions are classified into one of five buckets, each with a capital add-on factor that increases based on the level of systemic risk a bank represents. These assessments recognize that no institution is loyal to a national flag, but to the melting pot of powerful shareholder interests and executive insiders. Thus, national safety nets are clearly insufficient to handle the cross-border economic risks, a negative externality that is, nonetheless, borne by the taxpayers of the country of incorporation.
Evidence of a firm's lack of loyalty is clearly observed whenever domestic regulation causes a bank executive to threaten to "move to the country of least regulatory resistance," which highlights why the activities of the G20, FSB, and Basel are so important. Coordination of official sector action is, therefore, critical to ensure that broader social-policy objectives can be satisfactorily addressed.
The aim of these regulatory initiatives is directionally correct, but there remain questions. Will the combined panel of policy levers truly reduce systemic risk?
The answer remains unclear. To date, risk has been managed systematically through sovereign actions of forbearance, direct, and indirect support. Consequently, in some cases, the sovereign itself has become a significant source of systemic risk, representing a cross-border exposure that may need additional transparency, enhanced risk management, and new facilities and venues to handle spillover effects and contagion. Some have gone so far as to suggest the creation of country risk officers and more rigorous crisis management groups than currently exist.
More practically, perhaps, are questions related to the impact of new regulations and determining the impact on credit availability. And from the investor side, one can hope that the investment community, and well managed firms, will begin to enhance their disclosure of stress-test results, compensation practice, and economic value-added, as opposed to less risk-focused GAAP-based accrual earnings.
Enhanced prudential standards may be weakened due to special interests and lobbyists, but the international reform program seems to have a good deal of cohesion and, if pursued with continued force and tenacity could be the right recipe for dismantling TBTF once and for all.
Thomas Day is SunGard's in-house expert on risk management solutions and policy across the banking sector. He also serves as the vice chairman of the Professional Risk Managers' International Association.