In all of the demands for preventing too-big-to-fail banking, there’s a common assumption: policy-makers know which banks are so big or otherwise so systemic as to warrant break-up. But, is there in fact any reliable way to tell a systemic bank from the rest of the herd or, at least as important, to distinguish a systemic insurance company like AIG or investment bank like Lehman Brothers from the not-so-bad boys? In a paper to be presented Tuesday, I assess this critical question: is there any methodology by which one can objectively define the systemic in “systemically-important financial institutions”? Scuttling SIFIs is all the rage, but how in fact to do this if we don’t know who’s systemic? Our survey of pending rules and the academic/policy literature found absolutely no consensus on systemic criteria. TBTF cures are thus being built on a “know-it-when-we-see-it” standard that, by virtue of its subjectivity, will surely miss the next round of systemic risk.
Case in point: size as the threshold for radical reform such as that sought in the Brown-Vitter bill. That measure says $500 billion is the asset size at which sanctions are warranted to prevent TBTF. Where does this number come from? It’s an order of magnitude above the $50 billion standard mysteriously set in Dodd-Frank for lots of tough new rules, but another zero doesn’t make it any more meaningful.
When one turns to the research on systemic risk, size is only one possible systemic criterion – several researchers argue that it is in fact counter-productive. Even where findings back a size criterion, this is so far solely for banks and often supported only by vague or different size criteria that provide no meaningful guide to policy-makers.
Our paper goes into considerably more detail on other ways to define “systemic,” noting how many studies support their own criteria by discrediting all the others. There may well be a worthwhile systemic criterion somewhere in this mix – at least for banks – but there’s clearly no consensus on what it is nor any specifics from which policy-makers could take meaningful action.
Does this mean we should sit by and let academics burn still more midnight oil? Of course not. Even if we can’t define “systemic,” we know its ferocious power all too well. So, first we should continue to work through the analytics and come up if we can with sound and simple systemic criteria. Unless or until we have them, we should do two other things vital to curtailing another dance with financial disaster.
First up, build out the orderly-liquidation authority so we know if it can in fact be a credible cure to TBTF. The jury is very much out, in part because the FDIC has kept so much of its OLA methodology under wraps. I understand why no one wants to rush something so complex, but the longer this takes, the less credibility it has.
Second, let’s step away from SIFI designation to use another critical power in Dodd-Frank: the Section 120 power FSOC has to designate systemic “activities or practices.” After almost three years, FSOC girded its loins and did so for MMFs, pushing the SEC to act on a proposal set for release on Wednesday. Regulators are deeply worried by other risky activities – REITS and repos are now at the top of their list. So far, all FSOC has done is quietly fulminate.
But, if real risks are evident – as most regulators believe – then FSOC should quickly issue edicts on risk mitigation, putting primary regulators on notice that they must act quickly or face public scrutiny. The systemic-activity designation process isn’t perfect, but it’s straightforward and – critically – includes a public-comment provision that ensures FSOC’s thinking is guided by industry and advocacy analytics.
Think what might have been avoided had there been an FSOC in 2004 to force the banking agencies’ hands when they couldn’t bring themselves to sanction subprime mortgages – a mandate from on high could have shamed OTS and, I think, pushed all the agencies to act. This ultimately happened after Senate Banking hauled them in to ask hard questions about incomplete rules in 2006, but by then the crisis was embedded in the financial system and the rest, of course, is history.
To cure TBTF, we must know how to diagnose the systemic disease. Until we can reliably do so, policy should focus on other, more robust remedies to resurgent systemic risk.