American Banker, Tuesday, June 7, 2011

By Karen Shaw Petrou

There will be two turning points this month for the new regulatory framework for systemically important financial institutions. First, global regulators will reveal criteria to define global SIFIs — the biggest of the big. And the U.S. will take yet another stab at our SIFI standards, issuing the third proposal on how to tell a SIFI from a run-of-the-mill big nonbank financial company.

As these standards take shape, there’s growing danger that their sum total will be flat-out silly: global SIFIs judged by just how humongous they are while U.S. SIFI standards slap around bank holding companies with as little as $50 billion in assets and even small foreign-bank operations here if the parent back home crosses the $50 billion threshold.

The stakes here are very high. The global SIFI standards will cost covered firms first a punitive capital surcharge and then additional up-the-ante requirements. U.S. SIFI standards are set by Title I of the Dodd-Frank Act, meaning they are set in law and soon to come. The statute mandates an array of high-impact SIFI standards to be set by final rule no later than Jan. 21, 2012.

To be sure, these SIFI standards result from the manifest lapses that led to the financial crisis. The new rules seem to make sense in the abstract, but piled together, all of them create a crushing burden of complex, untested and cross-cutting rules with unknown implications that may well have unintended consequences. Thus, regulators should carefully calibrate the SIFI standards, with the U.S. taking particular care to require them only of institutions that genuinely pose real risk to the financial system, not just those that cross the arbitrary SIFI thresholds stipulated by Dodd-Frank and sure not to be used by any other nation or by global regulators.

The global rules for SIFIs are in the works at the Basel Committee on Banking Supervision and the Financial Stability Board, the parent organization not just for the Basel Committee, but also for international securities and insurance regulators. SIFI standards have emerged as a top priority, in part because global regulators feared that, if they didn’t finalize them now, the sense of panic that sparked the current regulatory round would fade and, with it, the chance for any global accord on cross-border SIFIs.

As a result, global SIFI standards are set to be released later this month and then finalized in time for the G-20 summit in November. Along the way, the stability board will finally agree not just on what to dictate for SIFIs, but also on who they are so that the standards are — it hopes — uniformly applied in every jurisdiction in which a global SIFI sets up shop.

The first add-on global standard for global SIFIs will be a capital surcharge. Initially, regulators were divided on this, with some instead favoring a tax to reimburse home-country citizens for any future SIFI bailouts. The tax issue has been left to national jurisdiction and the focus — along with at least a preliminary consensus — is on capital.

The global SIFI surcharge here will be some form of higher requirement atop the Basel III capital standards — 3% is the working assumption. This higher capital ratio is designed to ensure that a SIFI has added “loss-absorption” capacity — that is, it can bounce when it falls, with investors — not taxpayers — taking at least a first layer of risk before the government steps in.

Piling on, another global SIFI surcharge is aimed at liquidity. The new Basel III rules address not just capital, but also liquidity, doing this in ways even regulators have yet to understand. Still, this uncertainty has not dissuaded work on a liquidity surcharge. The idea is less developed than the capital proposal, but it currently looks like a third liquidity ratio added to the two in the Basel III rules to ensure that global SIFIs are not so “interconnected” through the payment system or other channels as to pose a new form of risk to global finance.

Finally, global regulators are hard at work on “living wills.” These are documents global SIFIs would need to craft to show their regulators how taxpayers could be put out of a global SIFI’s misery if the firm faltered. Crafting these plans is a challenge for global SIFIs given their size, scope and complexity, but it’s a challenge made still more formidable by the widely differing resolution regimes across the nations in which these SIFIs do business. In some nations, there isn’t even anything like a deposit insurance system, let alone a way to handle nonbanks like broker-dealers or insurance companies. Sometimes, countries haven’t bothered with these resolution regimes because they’ve long acknowledged that all of their SIFIs are too big to fail. Other nations — the U.S. of course among them — have pushed back against the notion of “too big to fail” and begun work on SIFI resolution regimes designed to ensure systemic firms can fail without fallout for the broader financial system.

Here, firms designated as SIFIs are damned twice: first with the Dodd-Frank resolution regime, which imposes new risks on all their creditors, shareholders and investors, and then with the SIFI regulatory requirements. Under U.S. law, a SIFI can’t be bailed out, but it has to be regulated as if it could.

We’ve yet to see the U.S. capital or liquidity surcharges, but a foretaste of the SIFI standards is in the living-will proposal issued earlier this spring by the Federal Deposit Insurance Corp. and the Federal Reserve Board. It’s a very tough proposal requiring far-reaching reports and plans by covered firms. Essentially, each is told how to plan to die even as shareholders continue to ask how the SIFIs hope not just to survive, but also to profit.

Recovery plans are about making it through the tough times; resolution plans are about figuring out how to shut off life support, with U.S. law requiring planning not for orderly liquidation authority, but for even the more painful process of termination under Chapter 11 of the Bankruptcy Code.

These living wills are so stringent that SIFIs may well die at their hands — that is, assuming the rest of the SIFI surcharges don’t get them first.

Karen Shaw Petrou is a managing partner at Federal Financial Analytics Inc.