By Mojmír Hampl (The Wall Street Journal 21.6.2012)
Defining and identifying systemically important institutions should mean that the others will be allowed to fail. Experience suggests otherwise.
One unfortunate side effect of the escalating euro-zone crisis has been to sideline discussion on financial regulatory topics that aren't relevant to the day-to-day of the debt crisis. The debate about the definition and role of systemically important financial institutions (SIFIs) has been going on in international political and technocratic forums for several years now, but its interim conclusions are raising many questions and concerns. To create yet another half-baked concept in this area is riskier than it may seem.
The story of the SIFI debate is a simple one. Since the 2008 financial crisis we have discovered (yet again) that there are institutions that the public sector is unwilling or unable—without incurring prohibitive costs—to let fail. As those institutions would not survive a crisis in normal market conditions, the state helps them by giving them either direct support or guarantees at taxpayers' expense.
The conclusion that has been drawn from this in developed countries is that if SIFIs exist, let's define them in advance and not wait for the next crisis. And let's be harder on them than on the rest. That way we'll reduce the risk that they'll engage in moral hazard.
This approach has led the Financial Stability Board to create a list of "globally systemically important institutions," with similar European Union- and country-level lists likely to be added in time. These institutions would likely be subject to higher capital requirements and stronger supervision, with intensive preparations for their potential failure and detailed guidelines on what to do if they do fail.
But there's a clear contradiction here: If the banks on this list are "too important" and hence are unlikely to be allowed to fail, why should they have to be better-prepared for failure than their competitors that can fail? Why should they have more capital when their owners will be guaranteed against losses anyway? Shouldn't it be the other way around?
The same paradox applies to the idea that banks with SIFI status should contribute more to the deposit insurance system. As with capital requirements, this is meant to be some sort of penalty or charge for the state guarantee. But an institution that is too important to fail surely doesn't need deposit insurance. Such insurance should serve to protect deposits in institutions that can fail.
The idea of creating lists of SIFIs is based on the rather arrogant assumption that we officials in state agencies, central banks and international institutions are capable of recognizing SIFIs in advance and amending the lists in good time—and that our approach, definition and methodology for doing so will always be right.
Yet the crisis demonstrated that many competent authorities failed to recognize the systemic importance of certain financial companies until the very last moment. The definition of systemic importance changed, not without reason, almost week to week as the 2008 crisis spread and deepened. What was unimportant at the start of 2008 was important by year-end.
Why should things be any different in the future? Given the rapid pace of growth of the financial market, the next few decades may see the emergence of globally significant institutions from emerging nations that are not even part of Western governments' attempts to define SIFIs.
Bank of England Governor Mervyn King once said that a bank that is too big to fail is too big, period. But this bon mot does not answer the question of what is "big" or "too big" from the perspective of the next crisis. Nor does it answer the question of whether breaking up a SIFI wouldn't ultimately mean that instead of rescuing one large institution, a government would have to rescue 20 small institutions instead.
This objection applies all the more if large institutions merely pretend to "voluntarily downsize" in order to avoid the costs of additional regulatory requirements. Most financial institutions would not want to be on such a SIFI list, as it would mean higher costs and greater regulatory uncertainty. The ideal situation is to avoid being a listed SIFI, but nevertheless to be treated as one when bad times come.
The European example shows that political decisions made in the heat of a crisis usually diverge from pre-prepared solutions, treaties and agreements. The Brussels-based think tank Bruegel has noted that, with a few minor exceptions, no bank in the European Union has been allowed to fail during this crisis. In other words, European politicians have declared that virtually every financial institution is systemically important. It hardly seems realistic to claim that defining and listing SIFIs would convince governments to let non-SIFI institutions fail during the next crisis.
If we accept the concept of "systemic importance" at all, an institution's SIFI status ought to be determined by the scale and intensity of the particular fire it faces during a financial crisis, and by the particular means, constraints and resolve of those trying to put the blaze out. This would be fairer and have more of a disciplining effect on the entire financial sector. In an uncertain market, why should any institution feel certain that it will live forever?