On Tuesday, global regulators released the methodology that will pin the scarlet “S” of systemic importance on banks then forced to bear the burden of the new capital surcharge. As we read it, the new methodology – complex and clearly carefully constructed by hard-working teams of diligent quants – comes back to a simple, wrong-headed conclusion: capital at banks is the cure for all that ails the global financial system.

How so? Simply put, the new assessment methodology is based on five criteria: size, inter-connectedness, complexity, “substitutability” and global scope. Each of these criteria is then broken into indicators of these systemic factors and banks are then ranked on each exposure measured according to the new methodology. Essentially, this is an “as-compared-to-what” methodology, since banks are scored in comparison to each other, not against any objective thresholds. Banks would get scored on each indicator for each criterion and then lined up against the wall with other systemic suspects to compare scores. Those with the biggest systemic totals are then booked as global systemically-important banks (G-SIBs) and told to pay up.

But, does this make sense? Not so much when one pulls the indicators apart and looks at them to see if capital is in fact the cure. Take the inter-connectedness criterion. This is designed to ensure that banks that are too deeply intertwined with others are charged for the risk they run. The driving indicators here are intra-financial system assets/liabilities and wholesale funding (judged by a new ratio). But, is scoring big on these measures the real risk or is the lack of liquidity to honor claims presented by counterparties under stress? Just holding a really big pile of any of these indicators doesn’t per se present risk, it’s whether or not the risk is covered. That’s what the Basel III liquidity rules are aimed at. We’ve argued in the past that the liquidity rules don’t do this all that well, but that’s the goal. If, now, the Basel Committee doesn’t think the rules are worth the bother for systemic institutions, then it should either drop the whole idea or fix it. To lard a capital surcharge atop the new liquidity rule is a punishing burden for big banks – especially when one recalls another critical missing piece, the omission from the new regime of all the colossi that constitute the shadow-banking system.

Now, let’s look at another of these systemic criteria: substitutability. We put it in quotes above because we still aren’t sure this is a word in English, but bear with us. The term is supposed to cover the extent to which financial markets can soldier on if a G-SIB bites the dust due to the ready availability of other service providers. One indicator for substitutability that scores the scarlet S is being big in custody services. Why? This isn’t even a per se banking service; rather, it’s a safekeeping one done in conjunction with other activities that might pose real risk. Custody services present risk, but it’s operational risk that Basel penalizes through a capital charge. That’s not enough? Why not? Regulators don’t answer and, again, fail here to look at the sum total of the rules they’ve amassed to address specific risks and total them up to see if the corpus of costly rulemakings makes combined sense.

Complexity as a criterion? Again, we don’t get it, because several key indicators – size in complex businesses like securities finance, for example – aren’t designated as indicators. Instead, pure capital-markets operations are fingered with a particular eye on OTC derivatives. But, the Basel III rules whack the dickens out of derivatives with new capital charges, and global regulators are also hard at work demanding central counterparties, freestanding capital/margin requirements and other prudential standards in this area. Does the sum of all of these make sense? Who knows?

And, there’s a concluding, final inconsistency in the G-SIB rules. They are premised in the Basel paper on grounds that the “negative externalities” of G-SIBs – that is, their ability to visit their sins on others – warrant the surcharge stigmata. But, on the same day the surcharge proposal was loosed, so too was a new global proposal to end too big to fail. If that works, then why do we need a surcharge? Is it just because regulators don’t trust themselves to craft anything credible on systemic resolution, especially days after the EU bailed out many of its banks all over again? If so, it’s regulators that should wear a scarlet letter, not G-SIBs.

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