1. Dealing with complexity: Systemic Risk and SIFIs
The financial crisis in late 2008 starkly exposed the vulnerability of the global financial system to unexpected shocks in banks’ funding sources, together with high volatility state across different asset classes.
Systemic Risk indeed refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system. A more general definition for Systemic risk is: The risk that the financial system or a major part of it – either in an individual country, region or globally – is put in real and immediate danger of collapse or serious damage with the likelihood of material damage to the real economy.
Systemic risk, while it may be triggered by other risks such as Credit risk or Liquidity risk, is different from such risks. It is identified not by its source but by its effects. Moreover this type of risk, highly dynamic and evolving, is usually associated with tail risk.
2. SIFIs’ externalities and Macro-prudential Supervision
The first reason to regulate systemic risk is the presence of externalities between institutions. By its very nature, a financial firm’s contribution to systemic risk is a negative externality imposed by each firm to the system. Each individual firm is clearly motivated to prevent its own demise, not instead the collapse of the system as a whole. Therefore, regulators should act to correct this system-wide imbalance.
Previous financial regulations such as the Basel capital requirements, are micro-prudential in nature, in that they seek to limit each institution’s risk at bank level. However, unless the external costs of systemic risk are internalized by each financial institution, the institution will have the incentive to take risks that are borne by others in the economy. Thus, financial regulation should be macro-prudential in nature and focused on limiting systemic risk.
For instance, the Expected Impact approach, outlined by the FSB and BCBS in November 2011, determines how much additional capital would be needed to reduce probability of failure for a SIFI, so as to equalize the expected impact on the financial system of a SIFI’s failure with non-SIFI’s ones.
We have that social risk posed by the failure of a financial institution can be approximated by:
Given that Exposure at Default (EAD) in $ is normally higher for SIFIs and assuming that the Loss given default (LGD) rate in % is the same for both, we have that, in order to satisfy the equality, PDSIFI shall be proportionally lower than PDnonSIFI.
According to the above-mentioned framework, SIFIs must hold a “surcharge” in the form of capital or contingent capital or insurance protection, based on the marginal contribution of each financial institution to the overall systemic risk.
In the chart below, some key points related to the Global-SIFIs policy framework.
Recovery Plan describes measures providing for the recovery of a firm or parts of that firm in a phase where the institution is under distress, but still a “going concern”. In this phase, the firm remains under control of the management, although authorities may have the regulatory powers to order or enforce the implementation of the recovery measures by the firm’s management. Recovery measures tend to stabilize the situation of the individual institution.
On the contrary the Resolution Plan describes measures providing for the resolution of the bank on a “gone concern” basis, identifying actions to achieve an orderly resolution or wind-down should recovery measures not be feasible, fair or prove insufficient to the firm as a going concern. It should assure that the bank has the capability to generate the information that Authorities would require at the point of intervention.
Finally, benefits of macro-prudential Supervision outweigh its costs. The SIFIs rules proposed by FSB and endorsed by G20 Leaders are a key condition over the short term to increase Global Financial Stability, and might be complemented subsequently with other supervisory tools aimed at further reducing negative externalities of Systemically Important Financial Institutions.
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