A question of definition

There’s a whole load of things we’re grappling with today, and not many people seem to know how to grapple with them well. There’s a challenge for example regarding definitions.

Defining what is “systemically important” versus what is not.

Defining what is “commercial trade” versus speculative.

Defining appropriate levels of capital versus required levels of capital.

Defining what trust means and how to regain it.

Defining appropriate levels of security and privacy.

And more.

To take a couple of these points that have been bothering me: what is “systemically important”?

This came up because global regulators are claiming a need to protect “systemically important financial institutions” (SIFI), as these are the ones they view as too big to fail.

So, a systemically important institution is one that a country defines as being capable of bringing the down the country.

This means that BNP Paribas is systemically important to France, as it controls around 40% of all transactions that take place in the country. By the same token, Lloyds-HBOS and RBS are systemically important to the UK and Citi, BoA and JPMorgan Chase to the USA. AIB and Bank of Ireland are systemically important to Ireland and Icesave to Iceland.

Then it gets tricky, because I am asking what is systemically unimportant.

Northern Rock?

Bear Stearns?

Lehman Brothers?

In truth, the SIFI discussion is exactly that: Sci-Fi!

The reason being that every SIFI is linked to a lesser SIFI which, in turn, is linked to a smaller SIFI, and so the discussion of what is systemically important is purely a matter of scale and economy.

What this really means is that for the most globally interconnected SIFIs, we need living wills – a method of letting such an institution fail in a matter of days, without bringing down the whole financial system as Lehmans did.

To be honest, I would like to see living wills for every bank, taking the view that systemically important is purely relative. However, for the truly cross-border banks that are systemically important, rather than national banks, this should extend further to have an unravelling plan that can be achieved without disrupting their interconnected counterparties.

That’s darned difficult, but will be something the regulators will and are tackling.

Second point: commercial activity versus speculative.

Another tough call.

Is investing in an OTC derivative to hedge US dollars against Chinese remnimbi in a three month forward swap is commercially sensible, but could also be just as easily a speculative hedge. How do you decide?

The regulator says that it’s down to whether the investment can (a) be shown to be related to a commercial reason and (b) is it systemically important, as in major investing versus minor.

Again, all difficult to determine.

Major versus minor, commercially justified versus unjustified, is all very much shady guesswork but, even though it’s darned difficult, the regulators are tackling this one too.

I think these are all questions that regulators are trying to tackle actually, and will struggle with: levels of capital, liquidity risk, collateral and assets required, deposit to loan ratios, leverage ratios ... you name it.

In fact, it all reminds me of the original discussions of the Markets in Financial Instruments Directive (MiFID) where the European Commission originally said a systematic internaliser is a business that trades 15% of its annual volume off its own book.

Then folks asked how they would measure that?

Volume or value?

Equities only or all instruments?

Europe only, Eurozone only or general book of business?

And, as most banks do not report these figures, how would they find out anyway?

All in all, no matter how much the Regulator wants to be the Enforcer, they will struggle until they can come up with some sensible definitions that they and the industry can implement.