Saturday, August 22, 2009

Systemically Important Financial Institutions: The Cleveland Federal Reserve Turns To YouTube To Show The Way Forward

What should we do about systemically important financial institutions moving forward? Consider implementing a three-tiered regulatory system. Well, that is the approach recently advanced by James Thomson, a Vice President and Financial Economist at the Cleveland Federal Reserve Bank. In an amusing and simple drawing board presentation on YouTube, Thomson spells out and outlines the regulatory approach he deems best for regulating systemically important financial institutions. Yes, the Federal Reserve Bank of Cleveland is turning to YouTube to show us the way forward!!!

In recent months, the term “systemically important financial institution” has garnered a great deal of media attention and news coverage. What is a systemically important financial institution? It is a financial institution that is so large, or interconnected with other institutions, or unique that it poses the risk of pulling the entire financial system down with it should it fail.
How do you gauge whether an institution is systemically important or not? The Federal Reserve Bank of Cleveland has proposed looking at the institutions size and four additional criteria to determine systemic importance. The Federal Reserve Bank of Cleveland calls these additional requirements the four C’s: contagion, correlation, concentration, and context.

How do the four C’s play themselves out? “Contagion” refers to the “too connected to fail” syndrome. For example, if you have swine flu and go to work, church, or a professional baseball game the “bug” can spread rapidly. The same goes for financial institutions: when one is sick it can spread a “bug” that infects other institutions that are interconnected through loans, deposits, or insurance contracts. “Correlation” refers to the “too many to fail” syndrome. If financial institutions see their peers doing risky things, they decide to join the party. Financial institutions assume if everyone is doing something risky then there is no way the government will let the entire industry fail; regulators will step in to offer a bail-out to all. Under this scenario moral hazard is eroded. “Concentration” refers to the “dominant or essential player” syndrome. If a financial institution dominants a particular business or has a high percentage of money leveraged in a particular area that is risky, this could make the financial institution a systemically important institution. AIG is a prime example of such a firm, in relation to AIG’s dominance of the credit default swap market. The final of the four C’s stands for “context.” This is known as the “conditions matter” syndrome. Let’s assume the financial market is antsy or jittery. The failure of one large firm in the system might be interpreted by investors as a bad omen or sign of things to come, or as a harbinger that underlying market conditions will soon erode. Under such a scenario the financial market collapses. The collapses experienced at Bear Stearns and Lehman Brothers illustrate types of "context" failures.

James Thomson proposes a three-tiered approach to deal with systemically important financial institutions. Tier One would cover high-risk institutions. Potentially, the failure of these institutions would pose the greatest risk to the financial system. Tier One would include complex financial institutions like large interstate banks and multi-state insurance companies. Tier One institutions would be subject to the most stringent regulation.

Tier Two would include moderately complex financial institutions. These institutions would be chosen based on their interconnectivity, involvement in critical market functions and activities, and the affect of stress in the overall economy on their condition. Large regional banks and insurance companies would be the market players regulated under Tier Two. In a sense, Tier Two financial institutions would undergo a more moderate level of regulatory scrutiny.

Finally, Tier Three would cover remaining non-complex financial institutions. Community banks would make up the market participants covered by Tier Three. Tier Three institutions would fall outside the watchful eyes of systemic institutional regulators like the Federal Reserve. The notion is that if a Tier Three institution failed it would be unlikely to cause any widespread ripples in economic markets.

The goal of the three-tiered system Thomson proposes is to equate oversight and regulatory activity with the degree of risk involved with the type of financial institution. Thomson hopes that the risk of being a systemically important financial institution may be mitigated. We shall see. YouTube and the Federal Reserve Bank: what a combination we have unleashed!!!

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