Wednesday, April 13, 2016


What does "systemically important" mean? How can an institution, per se, be "systemically important?"  The WSJ coverage of Judge Rosemary Collyer’s decision rescinding MetLife’s designation as a "systemically important financial institution:" gives an interesting clue to how our regulators' thinking is evolving on this issue:
The [Financial Stability Oversight] council argued — bromide alert — that “contagion can result when relatively modest direct, individual losses cause financial institutions with widely dispersed exposures to actively manage their balance sheets in a way that destabilizes markets.”
It's not a bromide. It is a revealing capsule of how the FSOC headed by Treasury thinks about this issue.

"Actively manage balance sheets" is a fancy word for "sell assets." So there you have it. "Systemically important" now just means that an institution might sell assets, because selling assets might lower asset prices. "Contagion" and "systemically important" are no longer about runs; you see one bank in trouble and go take your money out of a different one. "Contagion" and "systemically important"  is no longer the (false, but plausible) domino theory, that if I default and owe you money, you default.

Policy is no longer just about stopping runs. Policy is not just about stopping any large bank from failing, or ever just losing money. Policy is about  stopping asset prices from falling, and stopping even the small marginal additional fall in prices that might accompany one  large institution's sales.  (Except that leverage and capital ratios now force institutions to sell even if they don't want to, a delicious case of contradictory regulatory commands.)

Owen Lamont's classic characterizatiion of policy-maker's attitude toward selling short, now applies to selling at all.
 Policymakers and the general public seem to have an instinctive reaction that short selling is morally wrong. Short selling has been characterized as inhuman, un-American, and against God
The journal nails the basic problem
For eight years, federal regulators have failed to define precisely the “systemic risks” they claim they can identify across the financial landscape.
But no definition makes it easy to endlessly expand the word's meaning.


  1. Couldn't have analyzed it better.

  2. How the FSOC thinks about systemic risk is spelled out in the 300+ Basis for designation:

    What is surprising though is how investigative journalists don't seem to read beyond press releases.

  3. Perhaps the broader question is not about systemically important 'institutions' but systemically important 'industries'. We may find that only splitting larger institutions into more smaller institutions may actually make the problem worse. This sounds counter-intuitive but remember that in times of crisis, the fate of all of these institutions within an industry tends to become highly correlated. This is true whether they are larger or smaller. So, from that perspective it shouldn't matter if you have 20 SIFIs or 2000 institutions each a hundredth of the size or a former SIFI. Now, on top of that larger institutions tend to have more diverse and balanced portfolios. These are more likely to weather the storm than smaller portfolios.

    Another way of saying the same thing is to look at the SP500 index tracking ETF SPY. Imagine 500 investors each have a holding in this. They are concerned about risks. Ask yourself the question is it better to have 500 people invested in this ETF, or each of the 500 people to hold one (one only one) of the constituent stock? Most would feel safer with the diversified choice.

    The fuss should not be over systemically important 'institutions' but systemically important 'industries'. The answer is more about ring-fencing speculative areas of a business from their core offerings (eg separating investment and retail banking operations).

    Beyond systemically important ‘institutions’ and ‘industries’, we should also consider systemically important ‘markets’ and ‘systems’. While central bankers are pushing investors into riskier assets, there is a belief that creditors should always be made good. These two ideas are at odds. This is destroying the function of lending (and free markets). Central bankers should think very carefully about exactly what ‘risky’ assets are and if pushing investors into them is really a good idea. If central bankers really feel that pushing investors into risky assets is a good idea, let them do it, but when the system blows up, let them publicly take blame for the pain and suffering they have created with their arm-chair theories.

  4. A perspective on too big to fail. It wasn't that one or two of the top twenty banks over-concentrated risks in subprime loans and subprime loan securitizations/CDL's/CDO's that massively defaulted. It was that each and every one, to varying degrees, invested in the toxic assets.

    And, right, that "managing balance sheets" is a big lie. Financial asset losses are incurred regardless of whether the assets are sold at losses (based on credit impairment) not entirely related to market liquidity. Financial assets are impaired (which many banks refused to recognize) when they stop paying according to contractual terms. At that point, both GAAP and FFIEC regulatory reporting conventions require that the asset be measured for impairment (estimate realistic cash flow recovery and discount it at the contract interest rate; or, if collateral dependent, at the FV of collateral less cost to sell). Then, either a direct write-down is recorded or an addition to a loss reserve recorded - operating expenses increase, too. Many banks refused these accounting actions.

    Apparently, it was too difficult, and too damning, for the Congress and regulators to honestly identify the causes of the recent Great Recession. So, they produced distractions like the SIFI concept. The causes were right in front of them. It was so easy. All they needed were mirrors.

    1. "Produced the sifi concept"? Really? Don't give the Feds so much credit. The last insurer to fail (without bailout) was a 35 billion dollar firm. How informative Is it when the largest insurer is close to a trillion dollar? Not much. And what kind of liabilities does this trillion dollar firm originate? Retail insurance? Not exactly...


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