Approaches in dealing with systemically important financial institution SIFI

Table of contents

I. Introduction

II. Facing systemic relevance
II.1 Defining systemic relevance
II.2 Defining the leading actors
II.3 Benefits of being systemic relevant
III. Design of an efficient framework to contain systemic risk
III.1 Elements of an efficient framework
III.2 Basel III - A step into the right direction?
III.3 Proposals to reduce the TSTF problem
III.3.1 Quantity reduction based approaches
III.3.2 Prize regulation based approaches

IV Conclusion

V. Appendix

VI. References I

List of tables

Table 1: The value of the TSTF subsidy

Table 2: Evaluation of selected approaches to solve the TSTF problem

List of figures

Figure 1: Average assets relative to GDP of US commercial banks

Figure 2: Systemic Levy taxing schemes

Figure 3: Systemic Levy and Systemic Risk Fund

List of abbreviations

illustration not visible in this excerpt

I. Introduction

As a result of the worldwide financial crisis which occurred in 2007, an intensive discussion about preventing possible future crisis like that has arisen. One of the key points in these de- bates is the necessity to protect the economy from negative effects of failing financial institu- tions.

These can be dramatic what you can see by reflecting the facts of the recent crisis that is characterized by big bank failures and so caused domino effects. Thus it is very important to reduce the so called systemic relevance of financial institutions. But the design of a framework that contains systemic risk effectively is not just a simple task, because you have to consider a couple of factors in view of creating an effective solution.

This paper presents a short overview of the issue of hazard that is caused by systemic relevant institutions (SIFI) and the content of the actual debate by illustrating the costs the institutions cause and the presentation and evaluation of several approaches of economic experts with regard to the topic of reducing systemic relevance. Finally the paper tries to draw a conclu- sion.

II. Facing systemic relevance

To face systemic relevance it is important to know about the meaning of this term and furthermore to analyze the elements of this subject first. In a next step we have to look closer at the regarded institutions and finally examine the reasons why a firm has the incentives to grow “too systemic to fail”.

II.1 Defining systemic relevance

“Systemic relevant” or “too big to fail” is the expression for systemic institutions which play such an important role in economy which makes it quite difficult to accept their insolvency. As a consequence of the decay of a systemic important institution, the government has only two options: let the institution go down and hope that the induced extend on economy is man- ageable or bail the SIFI out. In other words: “Let a systemic institution fail and bear the chaot- ic fallout or pump in enough public support to keep it alive” (Cottarelli 2010, p.2). The latter alternative is quite likely, if you look at the failure of Lehman Brothers in September 2008 and the drastic effects on the economy that shifted the whole world into the financial crisis.

This illustrates why systemic relevance is a kind of negative externality and thus offers the failure of the market. Due to this fact A. Haldane compares the TBTF problem with environ- mental pollution and calls it “systemic pollution” (Haldane, 2010, p.6). The previously mentioned term “too big to fail” (TBTF), which is an official expression that is used in many working papers, leads to a common misconception. Systemic relevance does not only depend on the size of the institution, but also on other dimensions. Altogether the most important attributes are the size, the interconnectedness with other institutions, the insti- tution’s complexity and also the market position. Thus it is necessary to give a short definition of these attributes that lead to systemic relevance and the “too systemic to fail” (TSTF) prob- lem¹: “too big to fail” (TBTF), “too interconnected to fail” (TITF), “too complex to fail” (TCTF) and “too unique to fail” (TUTF).

“Too big to fail” refers to the size of the institution’s balance sheet in combination with the fiscal capacity of the firm’s home country (GCEE, 2009, p.141).

“Too interconnected to fail” means that an institution has a high degree of national and/or international interconnectivity with the whole system. If such an institution fails, a dramatic domino effect could occur, which may cause great damage all over the economy. The third fundamental factor of the TSTF subject is an institution’s degree of complexity. The higher the latter, the higher is the raise in uncertainty in economy when a “too complex to fail” institution fails.

The last factor is the “too unique to fail” problem. In this context it is also important to have a look at the market position of the regarded firm (CEP, 2010, p.4). If it operates like a mo- nopolist or if there are no substitution possibilities, an individual player can also be systemic relevant.

These key facts describe the “too systemic to fail” problem and furthermore are the starting points of the debate about reducing this matter.

II.2 Defining the leading actors

After this definition of systemic relevance it is necessary to take a look at the main actors of this play. Systemically important financial institutions do not only appear in the banking sec- tor, but also non banks, e.g. hedge funds and insurance companies, can be systemic relevant. Those can be very interconnected with the banking system as well and lead to financial dis- tress. They can also be too complex to fail and cause fire sales (Weder di Mauro, 2010).

II.3 Benefits of being systemic relevant

Being systemic relevant offers many advantages to the institution thus there are strong incentives to grow to a SIFI in any direction described above, because “such institutions gain lower funding costs, yield higher revenues and face a higher probability of being bailed out in a crisis event” (Doluca et al, 2010, p.2). This causes the government’s time inconsistency problem. The government may threat a no bail out policy and strict sanctions to the institutions, but if this happens in a non credible way and there is a precedence of protecting failing institutions, the threats cause no impact on the institution’s behavior. In fact the government would have no other option but to bail the weak institution out. This leads to an implicit guarantee which generates a moral hazard scenario where financial institutions have strong incentives to become systemic relevant. The results of the above mentioned time inconsistency problem are enormous emergency packages and bank aid.

Another point is the implicit subsidy to TSTF institutions. Like stated out before, the institu- tions get an (unfair) advantage in funding costs and a better rating than smaller firms, caused by the government’s implicit guarantee. This subsidy is ultimately paid by the taxpayer and this represents another fact why it is important to get rid of the TSTF matter. Therefore it is essential to get an idea of the value of this subsidy respectively the fiscal costs for the taxpay- er.

For this purpose a couple of economic experts have done researches with the aim of project- ing the financial support. The next section shows the derivation of the value of the subsidy. Therefore it mainly refers to the studies of Baker and McArthur and Ueda and Weder di Mau- ro but compares these to the results of other economists. In these papers, the authors describe several approaches to estimate the “Too-Big-to-Fail” respectively the TSTF subsidy to finan- cial institutions.

Baker and McArthur (2009) compare the average cost of funds for smaller banks and the funding costs of SIFIs. They define SIFIs as financial institutions with assets in excess of $100 billion and use a population of 18 bank holding companies in the United States. As a result of this comparison they found out that the spread of funding costs between small and (too) big banks was about 29 bp in the period from the first quarter of 2000 to the fourth quar- ter of 2007. This is the last quarter before an important milestone of the financial crisis, the collapse of Bear Stearns. After this period, the U.S. Government was forced to bail the institu- tions out and focus on a TBTF policy with the establishment of TARP².

From the fourth quarter of 2008 through the second quarter of 2009, the funding cost gap mentioned above rose to an average of 78 bp. This is a very sharp increase of 49 bp and an indicator of the SIFI’s advantage to borrow at much lower costs, because the credit worthiness increases as a result of the government’s respectively the taxpayer’s subsidy. Expressed in monetary units, the 49 bp represent a sum of $34.1 billion a year.

Due to the fact, that the widening of the funding spread could have been also caused by other externalities, Baker and McArthur also present a “low scenario”. Therefore the authors use historical data of the last recession in 2002 as base instead of the whole period from 2000 till 2007. Here, the raise in funding costs is from 69 bp to 78 bp which implies an increase of 9 bp. This increase symbolizes a subsidy of almost $6.3 billion a year.

In another working paper, Ueda and Weder di Mauro (2010) also estimate the value of the TBTF subsidy. The authors criticize the method of Baker and McArthur, because their study does not check for other factors that may affect the funding differences and they only use quarterly averages of funding rates. To achieve more valid data, the authors designed two approaches: a ratings study and an event study.

In the rating study approach, the authors use rating information by Fitch Ratings to estimate the impact of the implicit state guarantees on the rating of an SIFI. Therefore they use the data of the ten largest banks of the G20 countries as well as Spain and Switzerland and analyze the value of the institution’s overall ratings³in the time span from the end of 2007 till the end of 2009. By using a regression analysis they found out that the value of the subsidy reaches from 5 bp (for A rated institutions) to 128 bp (for banks with a B rating). This rating bonus of three notches leads to an average subsidy of 65 bp that causes a funding distortion. A similar result was already brought to light by Sironi in 2002 and Rime in 2005, who estimated a subsidy of 20 - 80 bp that results out of the rating bonus of 1-3 notches. Those 1-3 notches are also observed by Haldane (2010) who compared the data of UK banks.

In a second approach Ueda and Weder di Mauro analyze the impact of some events, which happened in the course of the financial crisis. These events are e.g. the bailout of Bear Stearns, the bankruptcy of Lehman Brothers, the nationalization of the IKB etc.. The back- ground of studying the aftermath of these events is the induced change in expectations and the consequences of implicit and/or explicit state guarantees. Thus the authors analyze the impact of several events on the subsidy to share and debt holders by observing the effects of the above mentioned events on the CDS market and the stock market. After comparing their ob- servations, Ueda and Weder di Mauro draw the conclusion that the effect caused by expecta- tions leads to an advantage to TBTF institutions of 20-40 bp in comparison to non systemic relevant institutions.

Abbildung in dieser Leseprobe nicht enthalten

Table 1 sums up the results of the previously shown approaches to estimate the TBTF subsi- dy. Assuming that you can utilize the values Baker and McArthur calculated in general, the subsidy found out by Ueda and Weder di Mauro and Rime can also be expressed in money terms. Thus you can say that the value, estimated of Baker and McArthur in their high scenar- io, is comparable to the average value calculated by the others. Comparing these results it can be observed, that the average value of the calculations of Ueda and Weder di Mauro and Rime on the one hand and the estimated value in the high scenario of Baker and McArthur on the other hand show a mean TSTF subsidy value of 50bp that represents an amount of at least $34,8 billion. This result is confirmed by analogue studies. By taking a look at these massive implicit subsidy you now are able to understand why institutions have strong incentives to become systemic relevant. But these facts also demonstrate an acute need for action to focus and internalize these expenses more than the current regulatory framework claims. This will be the starting point of the next chapter which tries to design an effective, efficient tool to bail economy out of the TSTF trouble.

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¹Because of these elucidations in the following this paper uses the term TSTF to describe the too systemic to fail problem instead of TBTF.

² TARP = Troubled Asset Relief Program of the U.S. Government.

³ Overall ratings are composed of the institution’s financial strength and the expected support rating.