SIFIs: is there a need for a specific regulation on systematically important financial institutions?

Introductory remarks of Stefan Ingves, Chairman of the Basel Committee on Banking Supervision and Governor of Sveriges Riksbank, for the roundtable discussion at the European Ideas Network Seminar on "Long-term growth: organizing the stability and attractiveness of European Financial Markets", Berlin (Deutsche Bank), 19-20 January 2012.

Good morning and thank you for inviting me to share some thoughts with you on the question of whether a specific treatment is warranted for systemically important financial institutions, or "SIFIs". In the few minutes I have to introduce this topic, I will set out the basis for the Basel Committee's response to this question, which is an unqualified "yes". I will say a few words about the Committee's view and the actions we have taken on SIFIs that have been strongly influenced by recent experience. I will then review how our response will help to address the "too-big-to-fail" issue. Our work on this issue is ongoing and I will then say a few words about the Committee's current efforts. I will conclude by sharing with you my thoughts on the direction of future work related to global systemically important banks - or G-SIBs.

Experiences from the banking system - focus on G-SIBs

The Basel Committee's motivation for policy measures for G-SIBs that supplement the Basel III framework is based on the "negative externalities" that these firms create and which current regulatory policies do not fully address. These adverse side effects can become amplified by the global reach of these firms - a problem in any one G-SIB could trigger problems for other financial institutions around the world and even disrupt the global economy (eg Lehman Brothers).

The impact caused by the failure of large, complex, interconnected, global financial institutions can send shocks through the financial system which, in turn, can harm the real economy. This scenario played out in the recent crisis during which authorities had limited options other than the provision of public support as a means for avoiding the transmission of such shocks.

Such rescues have had obvious implications for fiscal budgets and taxpayers. In addition, the moral hazard arising from public sector interventions and implicit government guarantees can also have longer term adverse consequences. These include inappropriate risk-taking, reduced market discipline, competitive distortions, and increased probability of distress in the future.

The Basel Committee's response

What has the Committee done in response to the G-SIB issue? As a starting point, we recognised that there is no single solution for dealing with the negative externalities posed by G-SIBs. Basel III will help improve the resilience of banks and banking systems in a number of ways. These include better quality and higher levels of capital; improving risk coverage; introducing a leverage ratio to serve as a backstop to the risk-based framework; introducing capital buffers as well as a global standard for liquidity risk. These measures are significant but are not sufficient to address the negative externalities posed by G-SIBs nor are they adequate to protect the system from the wider spillover risks of G-SIBs.

To specifically address the G-SIBs issue, the Committee's approach is to reduce the probability of a G-SIB's failure and the impact of a potential failure by increasing its loss absorbency in the form of a common equity capital surcharge. Based on a methodology for assessing systemic importance of G-SIBs, this additional loss absorbency will complement the measures adopted by the Financial Stability Board (FSB) to establish robust national resolution and recovery regimes and to improve cross-border harmonisation and coordination. But even with improved resolution capacity, the failure of the largest and most complex international banks will continue to pose disproportionate risks to the global economy.

Our empirical analysis indicates that the costs of requiring additional loss absorbency for G-SIBs are outweighed by the associated benefits of reducing the probability of a systemic financial crisis. We have also introduced transitional arrangements to implement the capital surcharge that help ensure that the banking sector can meet the higher capital standards through reasonable earnings retention and capital raising, while still supporting lending to the economy. The Committee's analysis points to additional loss absorbency generally in the range of around 1% to 8% of risk-weighted assets. Our agreed calibration from 1% to 2.5% is in the lower half of this estimated range. As a means to discourage banks from becoming even more systemically important, there is a potential surcharge of 3.5%.

Looking ahead

The Committee's approach to dealing with G-SIBs was endorsed by the G20 Leaders at their November 2011 summit. At that time, an initial list of 29 banks that were deemed globally systemically important was published. This is not a fixed list and it will be updated annually and published each November. Transparency is a very high priority and we expect market discipline to play an important role. As such, the methodology and the data used to assess systemic importance will be publicly available so that markets and institutions can replicate the Committee's determination. The requirements will be phased in starting January 2016 with full implementation by January 2019.

The basis for adopting specific requirements to address externalities posed by G-SIBs is not exclusive for the global banking system. Measures should be developed for all institutions whose disorderly distress or failure, because of their size, complexity and systemic interconnectedness would cause significant disruption to the wider financial system and economic activity. These could include financial market infrastructures, insurance companies, other non-bank financial institutions and domestic systemically important banks. The Committee is now in the process of determining whether there are elements of the G-SIBs assessment methodology that could be applied to domestic SIBs.

A number of countries, notably Switzerland, the United Kingdom and Sweden have already taken action to implement higher capital requirements for banks that are deemed systemically important at the national level.

The Swiss too-big-to-fail package, which was approved by the Swiss Parliament in September 2011, is due to come into force on 1 March 2012. The package, which is particularly demanding with respect to capital requirements, consists of the following:

  • A capital buffer of 8.5% of risk-weighted assets. This is in addition to the Basel III minimum requirement of 10.5%.
  • Of this 8.5%, at least 5.5% must be in the form of common equity while up to 3% may be held in the form of convertible capital (CoCos). The CoCos would convert when a bank's common equity falls below 7%.
  • The two big Swiss banks, Credit Swiss and UBS will have to hold a total of 10% common equity tier 1 capital. This exceeds both Basel III and the internationally agreed capital surcharge for G-SIBs.
  • The package also includes a so-called "progressive component" equal to 6% of RWA consisting entirely of CoCos. Unlike the CoCos under the buffer, the Cocos under the progressive component will convert when capital levels falls below 5% common equity.

In the United Kingdom, Sir John Vickers, chair of the Independent Commission on Banking, recommended in September 2011 that systemically important retail banks defined as retail banks with RWA exceeding 3% of GDP should have primary loss-absorbing capacity of at least 17-20% of RWA. At least 10% must be covered by equity capital while the remaining 7-10% may consist of long-term unsecured debt that regulators could require to bear losses in resolution. These are the so called bail-in bonds. The proposed changes related to loss absorbency are intended to be fully completed by the beginning of 2019.

In Sweden, authorities (the Swedish Financial Supervisory Authority, the Ministry of Finance and the Riksbank) announced in November 2011 that capital ratios for the four major banks will be advocated to at least 10% common equity to RWA from 1 January 2013, and 12% from 1 January 2015. The requirements follow the Basel III definitions and include, like Basel III, a capital conservation buffer of 2.5%, but no countercyclical buffer. The Swedish proposal goes further than Basel III, both with regard to the levels and in terms of timing

Conclusion

Basel III will improve the resilience of banks and banking systems but by itself is not sufficient to fully address the negative externalities arising from global systemically important banks. These adverse side effects, which include an increased risk of contagion and moral hazard, have serious implications for fiscal budgets and taxpayers. In response, the Basel Committee has developed assessment methodology to identify G-SIBs and has adopted an additional loss absorbency requirement for such banks that must be met through higher common equity. This is meant to reduce the probability of a G-SIB's failure by increasing its loss absorbency in the form of a common equity capital surcharge. Empirical analysis shows that the reduced probability of a G-SIB's failure will lead to a reduced probability of a systemic financial crisis, which more than offsets the higher capital requirement.