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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.


About Chris M Skinner

Chris M Skinner
Chris Skinner is best known as an independent commentator on the financial markets through his blog, the Finanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal’s Financial News. To learn more click here...

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  • Bob Giffords

    In the old days, companies that were too big to fail were deemed unreasonable combinations in restraint of trade and broken up. Now for some reason we want to treasure them and give them the competitive advantages of government guarantees.
    The more we protect them the more we encourage others to join the club, which weakens competition and raises moral hazard and monopoly rents.
    Why should taxpayers encourage and indeed fund such anticompetitive behaviours?
    Moreover, focusing only on systemically important institutions will divert attention from other combinations of smaller institutions that collectively have systemic impact as you rightly point out.
    Robust systems can sustain the loss of any systemically important component or group of components. If bankruptcy law is too inefficient, then we need to improve it, not preempt it.
    Writing a will implies that the owner of the assets has a right to decide how these should be shared out after its own demise. This appears to preempt the rights of creditors, shareholders and other interested parties (government guarantors of retail deposits for example.). Is this really what we want to do? What if a will comes in conflict with the facts on the ground? Companies are very complex and dynamic entities. Will it not create opportunities for poison pills whereby the implications of the will would bring pressure on creditors to keep funding and thus increase systemic instability?
    There seems to be a clear intention to undermine competition in all of this. Before we start to write definitions we need to be clear about the implications of proceeding down this road and have a grown-up political debate about it.
    One last observation: Will there ever be a point beyond which too big to fail is just too big? When a bank has 500 million customers (size of the EU) or 308 million (size of the US) or China’s ICBC with 150 million?. Sooner or later we shall have to decide.

  • Brilliant point Bob: regulators should primarily consider the ‘moral hazard raise and monopoly rents’

  • I am absolutely agree with the subject. This is a huge gap. Because there is no absolute definition even between in the parent companies(banks)’ products. One company(bank) defines a product as”a”, the other company (bank)defines as “b” . As long as there will not be an absolute definition especially in derivatives there will never be an absolute future:)

  • Fritz Thomas Klein

    Yes, the ‘too big to fail’ fact is a matter of definition, but this is not restricted to the financial sector. General Motors was also saved!
    Society will always regard the failure of some large companies as detrimental. Politics as the representative of society must find an ex-ante definition for such companies. Companies and their shareholders must know in advance that they meet the criteria for ‘support by society’ – simply because the disadvantages for society as a whole of their failure are regarded as too large. But the consequences of support must remain as drastic for shareholders as in the case of explicit failure – or even more drastic! This means that shareholders loose everything as son as society has to step in. But shareholders will know in advance that they are investing into such a company and the additinal risk they are taking.