Compromiso del Personal

In the recent fi nancial crisis, as in earlier crises, governments in Europe and North America felt compelled to provide support to a number of fi nancial institutions. The cost of this support added up to almost one-quarter of world GDP (Haldane, 2009).10 _{Why did they undertake this effort? This question applies especially to}

the international SIFIs that are the focus of this report, many of which had to turn to their home country national governments for support during the crisis. As aptly put by Bank of England Governor Mervyn King, SIFIs are ‘international in life, but national in death’. Because governments lack resolution tools to resolve the affairs of one of these institutions without creating potentially intolerable ‘systemic’ spillovers to the rest of the fi nancial system, there has been a pronounced increase in improvised bailouts.

The principal channels of contagion include (1) interconnections with other large complex, international fi nancial institutions that are rapidly changing, so

that the collapse of one could lead to the collapse of others;11 _{(2) the inability}

to continue systemically important services during a resolution of non-essential activities;12 _{(3) the inability to resolve an institution with substantial corporate}

complexity. In short, the fear of systemic risk may leave governments little choice but to provide support to systemic fi nancial institutions, even if this means putting substantial public resources at risk.

To be sure, systemic risk is notoriously diffi cult to defi ne. Paul Volcker likened it to Justice Potter Stewart’s defi nition of pornography: You know it when you see it.13 _{This may be true, but it is not a very helpful basis for building a}

coherent supervisory system.14 _{The standard working defi nition of systemic risk}

was provided in the Group of Ten’s Report on Consolidation in the Financial Sector (2001, p. 126):

‘Systemic fi nancial risk is the risk that an event will trigger a loss of economic value or confi dence in, and attendant increases in uncertainty about, a substantial portion of the fi nancial system that is serious enough to quite probably have signifi cant adverse effects on the real economy.’

This defi nition has two important implications. First, to qualify as systemic risk, the shock must be associated with the possibility of a contagious loss of value or confi dence that spreads to other parts of the fi nancial system and may disrupt fi nancial activity well beyond the location of the precipitating shock.15 _Second,

the disruption of the fi nancial system must be so grave that it is likely to cause a substantial decline in real economic activity.

The problem with this defi nition, as Kane (2010) has noted, is that to be useful in controlling systemic risk it must lead to a verifi able metric.16 _{The inclusion of}

terms like ‘quite probably’, ‘possibility of a contagious loss of value’, and ‘likely to cause’, makes it very diffi cult to verify whether an incident is systemic or not.

11 Policy-makers are understandably risk-averse when they think that withholding support may set off a systemic crisis, and so are vulnerable to being pressured by fi nancial markets and large institutions specifi cally (and have an obvious interest in collecting subsidies). The next section describes work underway to reduce such linkages, lower the impact of linkages, increase the transparency, and reduce the information and other disadvantages of the authorities that leave them vulnerable to this kind of uncertainty.

12 Some of these points of vulnerability arise from the parts of the international fi nancial infrastructure that must be kept functioning even during a crisis. The next section notes some international efforts to deal with this problem although we shall focus on these critical parts of the infrastructure that are controlled by particular large complex fi nancial institutions.

13 Some scholars would argue that Volcker has seen systemic risk when it was not there. See, for example, Kaufman’s (2004a) critique of the bailout of Continental Illinois.

14 Peter Wallison (2009a) has argued, ‘While the terms “systemic risk,” or “systemic breakdown” can be defi ned in words, they cannot be used as an effective guide for policy action. We have no way of knowing when or under what circumstances the failure of a particular company will cause something as serious as a systemic breakdown – as distinguished from a simple disruption in the economy.’ 15 This assumes that the fi nancial system is reasonably competitive. If, instead, a fi nancial system is heavily

concentrated, the collapse of a single fi rm may qualify as a systemic event. This may be a problem in particular, small countries, but it is certainly not the case for the international fi nancial system. 16 John Taylor (2010), after reviewing the empirical literature concludes that systemic risk is still not well

defi ned and that ‘reform proposals that rely on systemic risk to determine in advance whether a fi rm should be deemed systemically signifi cant are not ready for prime time. They should be shelved until an operation defi nition is available’. Nonetheless, we believe that it is possible to identify in advance at least some of the institutions that have the greatest potential to cause systemic problems.

The Rise of Multinational Financial Institutions

Faced with lack of information and limited understanding of what might happen tends to make the authorities understandably risk averse. Uncertainty is inherent in policy-making, but it can mean that authorities intervene to support insolvent institutions that may not be systemic because they cannot determine who is a systemic risk.

Some experts have argued that it is impossible to defi ne SIFIs because no one can provide an operational defi nition of systemic risk. They argue that the reason it is impossible to defi ne a SIFI is because so much depends on the particular circumstances.17 _{Still others contend that even if SIFIs can be identifi ed, this}

information should not be made public because it would exacerbate moral hazard.18 _{If SIFIs were to be identifi ed and subjected to heavier compliance costs}

or harsher regulations, some institutions would be tempted to game the system by shrinking just below the threshold or withdrawing from some systemically important activity.

While recognizing that no defi nition will be perfect, we think that it is possible to identify such institutions by their characteristics. Indeed, much work is underway to defi ne the attributes of SIFIs in order to help pinpoint which institutions are most likely to cause signifi cant spillovers in the fi nancial system (see IMF, 2010 for further analysis on how to defi ne and measure the systemicness of fi nancial institutions).

What are the key characteristics of a fi nancial group that may give rise to signifi cant, damaging spillovers? The IMF/FSB/BCBS (2009) paper on systemically important fi nancial institutions provides a good starting-point, and we will expand on that list to address some specifi c issues related to the cross- border context. The merit of the following list of characteristics is that they are generally accepted and fairly easily quantifi able, which means that cross-country comparisons can be made with comparative ease.19

1. Size relative to the economy in which it is headquartered. 2. Complexity as measured in terms of the number of affi liates.

3. Complexity as measured in terms of operational and fi nancial interdependencies among affi liates and between the parent and affi liates.

17 The examples that are often mentioned to support this view, however, are usually examples of weaknesses in the offi cial framework for dealing with institutions – e.g., Northern Rock would not have been a systemic problem except that it exposed a fatal weakness in the British deposit insurance system – or because the authorities have intervened in an unexpected way – e.g., Herstatt would not have been a systemic problem if the German authorities had waited until the end of the clearing and settlement day in New York before closing the bank. The other category that is diffi cult to capture is multiple smaller fi rms that all take the same position as in the US S&L crisis, but this too was a regulatory enforced vulnerability to a real estate shock.

18 It also implies that information from debt markets is not very useful to the extent it refl ects the expectation of a government bailout. In the recent crisis all of a troubled bank’s counterparties and debt holders have been bailed out, except in the case of Lehman Brothers. On the other hand, shareholders were almost always given a substantial haircut or wiped out.

19 As we note in Chapter 4, it leads to a slightly different list of institutions than the Financial Times identifi ed as ‘systemic’. Nor should this list be considered exclusive as some institutions may be systemic for other reasons or circumstances.

4. Performance of functions which are systemically important to the maintenance of the international fi nancial infrastructure, such as being a major factor in the custody business or in clearing and settlement. 5. The number of regulatory agencies and/or courts that would have to

approve a resolution of the group. This is a function of the number of countries in which offi ces are located and the number of regulated businesses in each country.

Each institution could be scored along each of the fi ve dimensions (which are also important components of the resolution planning advocated in Chapter 4). The institutions that receive the highest scores on these characteristics would be termed potential SIFIs and would be distinguished from other fi nancial institutions. Most of these will also have a large international presence.

This process should not only prove helpful in defi ning the individual institutions that are most likely to create damaging spillovers, it should also help in allocating supervisory resources more rationally since these institutions should receive the greatest supervisory scrutiny.