What to do about Systemically Important Financial Institutions

The term “systemically important financial institution” is all over the news these days. It refers to financial institutions that are so big, or interconnected, or unique that they pose a risk of taking down the entire financial system should they fail.

If we can identify these institutions and why they’re risky—then mitigate those risks—we might be able to prevent the next big financial meltdown.

The first trick is to determine just what makes a financial institution systemically important.

The Federal Reserve Bank of Cleveland proposes using an institution’s size and four additional criteria—the four C’s we’ll call them: contagion, correlation, concentration, and context.

Let’s start with contagion. This is the “too connected to fail” syndrome.

Something bad happens within an institution. It catches the equivalent of a really potent virus and becomes so sick that it doesn’t look like it’s going to make it. That’s obviously bad for the institution. But if the institution is connected to a lot of other institutions and firms (through loans, deposits, insurance contracts, etc.), they all might get pulled down.

Next, is correlation.

This is the “too many to let fail” syndrome. What happens here is firms look around and they see a whole bunch of their peers doing something they’re pretty sure is risky—say getting into mortgage-backed securities in a big way.

What they decide, though, is that if everyone’s doing this risky thing, there’s no way the people regulating affairs are going to let any one institution fail because if one institution fails, every institution like it would also fail and that could lead to a disaster that regulators would likely step in to prevent.

Next up—concentration.

This is the “dominant or essential player” syndrome. If a firm has a high percentage of its money or business concentrated in an area that turns out to be particularly risky, this too could make the firm systemically important.

Our final C is context.

This is the “conditions matter” syndrome. Let’s say the market is doing great. It’s humming along. If a big firm looks as though it might fail, no one worries too much because the overall market is sound. But if the market is jittery, the failure of the big company might be interpreted as a sign of worse things to come, or that underlying conditions in the marketplace are eroding. So the conditions, in this case, could influence whether a particular institution is deemed systemically important.

Even using an institution’s size and these four C’s—it’s not easy to tell whether a particular financial institution is systemically important. Complicating matters further, some institutions may be more systemically important than others.

That’s why a researcher at the Federal Reserve Bank of Cleveland is proposing a three-tiered system for categorizing systemically important financial institutions.

Tier One

Tier one would include high-risk institutions—those whose failure would pose the greatest risk to the system. These would be large, highly complex financial institutions such as large, interstate banks and multi-state insurance companies, and they’d be under the most stringent requirements.

Regulators would keep a close watch on their business, and there would be stricter reporting guidelines. They’d have to undergo regular stress tests and might have to maintain additional capital to make sure they have enough cash on hand to absorb stresses on their business. They might also be required to keep executive compensation appropriately aligned with the long-term viability of the firm and the safety and soundness of the financial system.

Tier Two

Tier two would include moderately complex financial institutions that may create some systemic risk based on how connected they are, or their involvement in critical market activities, or how their condition may be affected by stress in the economy.

Large regional banks and insurance companies would be examples of tier-two institutions, and they would undergo periodic stress tests, have additional reporting requirements and undergo more rigorous supervision than they do today . They might be required to develop contingency plans to address what they’d do if they didn’t have enough cash flow to pay their obligations. There might be limitations on what they can have in their portfolio and some additional requirements for how much money they need to set aside for emergencies. They might also have certain limits on exposure to counterparties.

Tier Three

The third tier would include non-complex financial institutions. These institutions—community banks, for example—would fall outside of the systemic institution watchdogs’ purview because of the low probability that a failure or stress would cause any widespread ripples throughout the financial system.

The goal of this three-tiered system is to match the level of oversight and regulation appropriately to the risk of different kinds of institutions.

While there’s no guarantee this will prevent the next crisis, if the playing field for financial institutions is leveled—meaning we regulate institutions in different tiers with varying degrees of oversight to put them on equal footing—and the advantages of being systemically important are minimized, it should lead to a stronger, more stable financial system that will serve all of us better in the future.