By Félix Villatoro, Ph.D., Assistant Professor, Universidad Adolfo Ibáñez Business School, Chile
In 2011, after the subprime mortgage crisis of 2007-10 and following a series of analyses and proposals, the Basel Committee on Banking Supervision (BCBS) published a methodology to determine which institutions should be considered Global Systemically Important Banks (G-SIBs). The objective of this regulation is to decide which banks should be subject to higher capital requirements. In turn, thanks to having a larger loss-absorbency capacity (LAC), it is expected that such institutions will have a lower probability of becoming insolvent. While it may be too early to fully and properly evaluate in what ways the current BCBS methodology could be improved, this article points out two aspects worth noting about it.
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Throughout the history of financial crises, it has not been uncommon to find cases of financial institutions that have been deemed “too big to fail” or “too interconnected to fail”, posing a complex dilemma for regulators: Should these institutions be allowed to fail in cases in which they are perceived to lack solvency? Or should they be somehow supported, even if this means putting taxpayers on the line? There are no easy answers to these questions, as one has to choose between making inefficient use of public resources and possibly encouraging reckless behavior down the road versus dealing with potentially catastrophic consequences for the rest of the financial system and the economy if such institutions go down. While the protagonists’ names change between crises (for example, Long-Term Capital Management [LTCM] during the years of the Asian financial crisis and Lehman Brothers Inc. during the subprime mortgage crisis), the dilemma remains more or less the same, as there is no easy way to address the main elements behind this phenomenon.
Enter Basel III. After the subprime mortgage crisis and following a series of analyses and proposals, the Basel Committee on Banking Supervision (the Basel Committee) published its methodology in 2011 to determine which institutions should be considered Global Systemically Important Banks (G-SIBs) and, therefore, subject to higher capital requirements that would, in turn, result in their having larger loss-absorbency capacities. The expectation was that such institutions would then experience lower probabilities of becoming insolvent and causing widespread disruption to the financial system.
Such capital requirements have been the first of their kind to be adopted at an international level. They aim to make it less likely that regulators will find themselves, once again, between a rock and a hard place, dealing with insolvent and too-big-to-fail financial institutions.
The task of defining an appropriate methodology to classify banks as more or less systemically important is not an easy one. Currently, the Basel Committee focuses on five key areas to tackle this issue: size, interconnectedness, complexity, lack of substitutability and global scope. In turn, all areas except size are further divided into more components. In the case of interconnectedness, it is measured by three elements: intra-financial system assets and liabilities and securities outstanding. Complexity is also measured by three elements: the notional amount of over-the-counter derivatives, level 3 assets (for example, assets for which there are no observable market prices) and the amount of trading and available-for-sale securities. The degree of substitutability is measured by four elements: assets under custody, payment activity, underwritten transactions in debt and equity markets, and trading volume. Global scope is measured by the number of cross-jurisdictional claims and liabilities. Finally, size is ascertained by the total exposure measure for the Basel III leverage ratio.
Part of the complexity in assessing systemic importance stems from measuring the appropriate banks’ characteristics and giving each one just the “right” influence in the overall measure. While it may be too early to fully and properly evaluate the ways in which the current methodology can be improved, it is nonetheless interesting to focus on two aspects of the ways in which the Basel Committee determines a bank’s degree of systemic importance.
First, presently, each of the institutions undergoing evaluation is assigned an overall score, estimated by summing five individual sub-scores (one for each of the five key areas mentioned above). Implicitly, this assumes there is some type of substitutability among each aspect under evaluation: size, interconnectedness, complexity, lack of substitutability and global scope. For instance, suppose that a bank is currently assigned to bucket 2, which implies an additional 1.5-percent capital requirement. This bank experiences an increase in its score associated with its interconnectedness. Further, let’s assume that the new score would make the bank jump to bucket 3, thus being subject to a 2-percent additional capital requirement. However, during the same period, the bank’s score for complexity drops in such a way that it perfectly offsets the increase in its interconnectedness score. Therefore, the bank’s final score is such that it remains in bucket 2. Would this be a reasonable outcome? Would it be wise not to require additional capital, even though the bank is more interconnected than before? Does a lower level of complexity really justify leaving the bank in its current bucket? What if we are told that the lower level of complexity is associated with changes in the bank’s retail operations, but the intra-financial business remains as complex as before?
As an example, let’s consider Wells Fargo.1 Since the first time the Basel Committee evaluated systemic importance in 2013, this bank has been in bucket 1 most of the time. Between 2016 and 2019, Wells Fargo was moved to bucket 2. Then, for the last two years, it has been back in bucket 1. A quick look at this bank’s scores shows a mixed evolution for different areas. For instance, its level 3 assets (a proxy for complexity) have had a clear downward trend since 2013, while its cross-jurisdictional liabilities (a proxy for global scope) peaked in 2016 and have been going markedly down ever since. However, other areas, such as total payments, assets under custody (both proxies for substitutability) and the notional amount of over-the-counter derivatives (a proxy for complexity), experienced an upward trend, suggesting that systemic importance has been on the rise. Which one should be the most appropriate bucket for Wells Fargo? It is not my objective to provide answers to these difficult questions but rather to point out that the current way the methodology operates may lead to unintended developments. Since systemic importance is a multidimensional characteristic, it is not obvious which way is the most appropriate one to use to consider its many facets.
My second comment regarding the Basel Committee’s methodology is related to the fact that scores for all the aspects under evaluation are relative to the characteristics of the banks that are assessed. That is, the score that a bank obtains for its size, for instance, is obtained by dividing the bank’s exposure by the total exposure of all reporting banks and multiplying this number by a predefined factor. Therefore, if the bank’s assets increase over time in absolute value but the ratio of its assets over the total group of banks’ assets remains constant, its score would remain more or less the same. Is this a desirable feature of how capital surcharges are calculated? The underlying purpose of this regulation is to reduce the probability that a systemically important financial institution reaches the point of insolvency. The more systemically important it is, the higher the capital requirement should be, presumably because of the even higher costs (including those imposed on the rest of the financial system and the economy) associated with the failure of such an institution. Therefore, an important question here would be whether the costs of a too-big-to-fail event depend on the absolute size of a financial institution or, rather, on its relative size (or ranking) among financial institutions. If we believe that the latter is the relevant factor, then estimating the banks’ scores relative to their peer group seems appropriate. However, if the former factor is also deemed relevant, then perhaps a mixed type of score, which considers both absolute and relative values, would be more desirable.
The Basel Committee took a bold step in its search for a way to end the incentive problems faced by insolvent and large financial institutions. We have been aware of this weakness in our financial systems for decades. However, there had been no previous attempts to tackle the issue, at least in an internationally coordinated way. Using the current regulation as a starting point, we must remain observant and keep a critical eye on how the existing methodology is being applied and the results that it has produced so far, while also trying to anticipate scenarios in which the methodology may fall short or produce unintended or undesirable results. If we do this, it may be possible that too-big-to-fail events are eventually part of our past financial history.
Reference
1 The data used by the Basel Committee to evaluate Wells Fargo, as well as other internationally active banks, is available at: Bank for International Settlements (BIS)/Basel Committee for Banking Supervision (BCBS): GSIB Framework Denominators Excel Spreadsheet