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Regulating SIFIs in the European Union: A Primer from an Economic Point of View

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Regulating and Supervising European Financial Markets

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Abstract

Global financial markets have experienced an unprecedented succession of crises affecting the processes, structures, and rules of said markets. As well as the underlying crises, innovative concepts to regulate and supervise financial institutions are still unfolding, leading to new organizations as well as new rules. While many of the institutional responses are of a general nature, specific institutional change is directed at selected financial intermediaries. While small in number, Systemically Important Financial Institutions (SIFIs) are, by their very nature, of seminal importance. First of all, this analysis puts SIFI regulation into perspective, before identifying two critical pillars of any SIFI rulebook. Based thereon, it is shown that the current European approach seems rather ill-conceived, as it lacks thorough justification, reasoning, and structure, and is thus prone to causing undesirable market processes in the future. This segues into the discussion of alternative approaches to the regulatory treatment of SIFIs that could lead upcoming institutional change in a reasonable direction.

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Notes

  1. 1.

    This distinction is according to the seminal work of Nobel laureate Douglass C. North, who defines institutions as the “rules of the game” and distinguishes them from organizations, see North (1990), pp. 3–6. However, “institutional change” encompasses the evolution of rules and organizations alike.

  2. 2.

    The elaboration of the distinction between spontaneous and designed rules belongs to the seminal achievements of Nobel laureate Friedrich August von Hayek, see extensively v Hayek (1989). See also v Hayek (1963), and, of his earlier works, v Hayek (1933), especially p. 129 on “spontaneous institutions”.

  3. 3.

    Obviously, “financial institutions” goes beyond banks. Regardless of non-banks—like AIG—being treated as SIFIs during or prior to the financial crises, the discussion of systemic importance traditionally focuses on banks, see e.g. Herring (2009), especially p. 178. This primer proceeds analogously. In particular on systemically important insurance institutions, see Harrington (2009). More in general on various financial institutions of systemic relevance, see Billio et al. (2012). Skeptically on the existence of SIFIs that are neither banks nor life insurers, see Elliott (2012).

  4. 4.

    Representing a global view, not going into European details, see Moshirian (2012).

  5. 5.

    As discussed in several contributions to this compilation. As an overview, see also Schoenmaker (2013), especially pp. 365–368.

  6. 6.

    See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111–203, §§ 931–939H, 124 Stat. 1376 (2010). Of the numerous comments on Dodd-Frank in general, see extensively Murdock (2011). With respect to the impact of Dodd-Frank on financial regulation, see also Cooley and Walter (2011).

  7. 7.

    Coffee Jr (2012), p. 342.

  8. 8.

    See the extensive discussion by Schwarcz (2008), especially pp. 196–198.

  9. 9.

    For an overview of different definitions, see Prokopczuk (2009), pp. 2–4.

  10. 10.

    One of the shortest definitions of systemic risk (the “possibility of system wide failures”) has been provided by Kaufman (1996), p. 17. The European Central Bank defines systemic risk as a risk of financial instability “so widespread that it impairs the functioning of a financial system to the point where economic growth and welfare suffer materially”, see European Central Bank (2010), p. 147. During his extensive discussion, Schwarcz (2008), especially p. 204, suggests a rather detailed “working definition of systemic risk: the risk that (1) an economic shock such as market or institutional failure triggers (through a panic or otherwise) either (X) the failure of a chain of markets or institutions or (Y) a chain of significant losses to financial institutions, (2) resulting in increases in the cost of capital or decreases in its availability, often evidenced by substantial financial-market price volatility”. On the ambiguity of the definitions of systemic risk, see Cerutti et al. (2012), with further references.

  11. 11.

    For an empirical study of systemic risk drivers among European banks that shows size to be a minor determinant of SIFIs, see Kleinow and Nell (2015).

  12. 12.

    Adams and Brock (1987), p. 61. Nevertheless, the economic history of the US in particular shows a long tradition of concern about big banks, see Goldstein and Véron (2011), p. 5.

  13. 13.

    See, e.g., Moosa (2010), pp. 319–320.

  14. 14.

    Among the most (in)famous examples are the insolvencies of the railroad company Penn Central, and car manufacturer Chrysler in the 1970s. On the Penn Central case, see Weston (1971), especially p. 311, and the further contributions in that issue, pp. 327–362. On (the loan guarantee programme for) Chrysler, see e.g. Reich and Donahue (1985). On the meaning of Continental Illinois for the TBTF concept, see Goldstein and Véron (2011), pp. 5–6. Besides the subsequent analysis, see also, more briefly, Kleinow et al. (2014), especially pp. 1586–1587.

  15. 15.

    The US (office of the) comptroller of the currency (OCC) is an independent agency of the Department of the Treasury that “charters, regulates, and supervises national banks and federal savings associations (collectively, banks) and licenses and supervises the federal branches and agencies of foreign banks. The OCC’s mission is to ensure that these institutions operate in a safe and sound manner, provide fair access to financial services, treat customers fairly, and comply with applicable laws and regulations”, see OCC (2014), p. 1. As he shows characteristics of a central banking as well as of a supervisory agency, an equivalent to the OCC might not be found in different regulatory architectures.

  16. 16.

    See US Congress—House of Representatives (1984), pp. 194–276. Prior to its failure, Continental Illinois had been the eighth-biggest bank in the US in terms of total deposits.

  17. 17.

    See US Congress – House of Representatives (1984) passim, esp. pp. 220, 278, 299–300.

  18. 18.

    See US Congress – House of Representatives (1984), p. 300.

  19. 19.

    Morgan (2002), p. 880. On the critical reception of the bail-out of Continental Illinois, see Macey and Garrett (1988).

  20. 20.

    See Athavale (2000), especially pp. 124–126.

  21. 21.

    Dowd (1999), p. 10. See also Moosa (2010), especially pp. 320–321, 331–332. Extensively on the LTCM case in general, see Dunbar (2000).

  22. 22.

    Financial institutions that are overtly or covertly categorized as being TBTF gain an additional safety net against insolvency—probably producing distorting effects for several of their stakeholder groups. See O’Hara and Shaw (1990), pp. 1588–1590 and passim. See also Kane (2000). See also, very pointedly, Cochrane (2009), especially p. 34: “As long as some firms are considered too big to fail, those firms will take outsized risks.”

  23. 23.

    See Morrison (2011), pp. 500–501, with further references.

  24. 24.

    See again, very pointedly, Cochrane (2009), especially p. 34: “After the Bear Stearns bailout earlier in the year, markets came to the conclusion that investment banks and bank holding companies were “too big to fail” and would be bailed out. But when the government did not bail out Lehman, and in fact said it lacked the legal authority to do so, everyone reassessed that expectation.”

  25. 25.

    On the seminal importance of the Lehman case, see, very pointedly, Mollenkamp et al. (2008). More extensively, see the economic analysis of Brunnermeier (2009), especially pp. 88–90. For a detailed review, see Estrada (2011), especially pp. 1113–1125.

  26. 26.

    Herring (2009), p. 176.

  27. 27.

    Bernanke (2009) (contains all the citations of this paragraph).

  28. 28.

    The earliest references to SIFIs date back to the early 2000s, see Soussa (2000); Bank for International Settlements (2001); Belaisch et al. (2001); and Worrell (2004). In connection to the recent financial crisis, SIFIs were first mentioned in the Global Financial Stability Report of April 2007, see International Monetary Fund (2007).

  29. 29.

    See Jenkins and Davies (2009).

  30. 30.

    See Financial Stability Board (2011), p. 4. Previously, parts of the assessment methodology and the regulatory measures had been mentioned in a (preliminary) Basel document, see Basel Committee on Banking Supervision (2011). Shortly thereafter, the credit rating firm Moody’s listed 28 banks following a comparable methodology, and published this as part of the Weekly Credit Outlook of 25 Jul 2011, pp. 18–19 (accessible via www.moodys.com).

  31. 31.

    See Financial Stability Board (2012).

  32. 32.

    See Financial Stability Board (2013).

  33. 33.

    See Financial Stability Board (2014); in connection with Basel Committee on Banking Supervision (2014).

  34. 34.

    The ECB supervises about 120 “significant banks” and identifies them based on size, importance for the economy (EU, member state), cross-border activities, and further qualitative criteria; see Council Regulation (EU) No 1024/2013 of 15 October 2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions. Official Journal of the European Union 56:63–89 (L 287/63, 29.10.2013), especially pp. 75–76. National systemically important banks (N-SIBs) in Germany are identified by a comparable selection of quantitative variables, e.g. the balance sheet total, the intensity of interbank connections and cross-border connections, see Deutscher Bundestag (2012); and Deutsche Bundesbank/Bundesanstalt für Finanzdienstleistungsaufsicht (2009), pp. 17–18.

  35. 35.

    Stern and Feldman (2004), p. 12. On the problem of this financial contagion in general, see Kaufman (1994). See also the modeling approach of Allen and Gale (2000).

  36. 36.

    See, extensively, Benston (1998), pp. 27–85 passim. See also, more briefly, Hanson et al. (2011), especially pp. 4–7.

  37. 37.

    Elliot and Litan (2011), p. 6.

  38. 38.

    See Rudolph (2014), especially pp. 76–77.

  39. 39.

    See also the discussion of “over-inclusion” vs. “under-inclusion” of Elliot and Litan (2011), pp. 10–14. Briefly on “over-designation” vs. “under-designation”, see Elliott (2012).

  40. 40.

    As with the shadow banking system that had evolved prior to the recent crises, see e.g. de la Torre and Ize (2010), especially pp. 122–124.

  41. 41.

    See Kleinow et al. (2014), p. 1585–1586.

  42. 42.

    For a study of implicit funding subsidies of large banks, see Kleinow and Horsch (2014).

  43. 43.

    See Kleinow et al. (2014), especially pp. 1585–1588 and passim. See also later Bongini et al. (2015).

  44. 44.

    For a seminal work on selective perception, see Dearborn and Simon (1958). In a general management context, see Beyer et al. (1997), with further references. In a behavioural finance context, see, extensively, Oehler (1992).

  45. 45.

    On the absence of “straightforward quantitative methods to find the answers here”, see Elliott (2012).

  46. 46.

    See the revised version of the Basel Committee’s G-SIB surcharge proposal, i.e. Basel Committee on Banking Supervision (2013); and the SIFI article (Art. 131) of the CRD IV, i.e. Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013, on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC. Official Journal of the European Union 56:338–436 (L 176/338, 27.06.2013).

  47. 47.

    Commenting on an earlier, quite similar list, the NY Times wrote of “the usual suspects”, see Cox and Larsen (2011).

  48. 48.

    For example, the significance of the Lehman insolvency has been attached to the institution’s 158-year-long history. Based thereon, Judge J M Peck in presiding over Lehman’s filing for Chap. 11 coined the oft-cited declaration of Lehman Brothers as being “the only true icon to fall” during the crisis processes of 2008, see e.g. Denman (2012), p. 271. On this “death of a titan of America’s financial system”, see also Estrada (2011), p. 1113.

  49. 49.

    The problem of (non)subadditivity is a vital part of the discussion of Value-at-Risk measures: A combination of risk positions would represent a total risk that is equal to or smaller than the sum of the single risk positions it consists of. As a seminal contribution, see Artzner et al. (1999), especially pp. 209, 216–217.

  50. 50.

    See Basel Committee on Banking Supervision (2012), subsequently elaborating higher loss absorbency (HLA) as a principal countermeasure.

  51. 51.

    In detail, see Adrian and Brunnermeier (2011); International Monetary Fund (2009); Billio et al. (2012); Acharya et al. (2010); Brownlees and Engle (2012); Jobst and Gray (2013); Weiß et al. (2014). For a comprehensive synopsis, see Bisias et al. (2012).

  52. 52.

    See, e.g., Financial Stability Board (2010).

  53. 53.

    See Avgouleas et al. (2013), especially pp. 210–211; see also Rudolph (2014), especially pp. 79–81.

  54. 54.

    For a general overview on EL calculation, see Bluhm et al. (2010), pp. 2–21.

  55. 55.

    The LGD can be mitigated by collateral, as in the following example: If an outstanding loan (EAD = initial loan minus repayments) amounts to 150, and the lender benefits from a mortgage of 120, the recovery rate would be 120/150 = 0.8, while the LGD would be 1–120/150 = 0.2. For a detailed discussion of the problem of LGD, see Schuermann (2004).

  56. 56.

    See Basel Committee on Banking Supervision (2013), pp. 12, 16–19.

  57. 57.

    For a rather positive evaluation, see Hanson et al. (2011), especially pp. 24–25.

  58. 58.

    Unsurprisingly, rule makers support this correlation, see e.g. Basel Committee on Banking Supervision (2010); however, economic analysis leads to mixed results at best—see e.g. Blum (1999).

  59. 59.

    In comparison to the above-cited study of the Basel Committee, see e.g. Macroeconomic Assessment Group (2010).

  60. 60.

    See the in-depth analysis of Maes and Schoutens (2012), especially p. 63: “Conceptually, contingent capital instruments are debt instruments in ‘good’ states of the world, but convert into common equity at prespecified trigger levels in ‘bad’ states of the world. In principle, the triggers can be tied to the deterioration in the condition of the specific banking institution and/or to the banking system as a whole. Contingent capital is a form of catastrophe insurance subscribed to by the bank. In general, contingent capital is a type of facility or instrument that automatically converts into equity when a certain stress-related trigger is breached, meaning that (typically) private investors provide an automatic boost to loss-absorbing capital at the time when it is most needed.”

  61. 61.

    Consequently, contingent capital could be called bail-in-able debt, see Kleinow (2015), in this compilation of papers. The concept is not a result of the recent crises, but goes back to suggestions such as Culp (2002).

  62. 62.

    Extensively, see Lehmann and Manger-Nestler (2014).

  63. 63.

    See European Commission (2014a).

  64. 64.

    See European Commission (2014b). With respect to the original US approach, see Kwan and Laderman (1999).

  65. 65.

    The concept of complementarity was elaborated by several authors dealing with different economic problems. As a seminal contribution, see Milgrom and Roberts (1995). On the complementarity of financial systems, see Hackethal and Tyrell (1998).

  66. 66.

    For a comprehensive study, see Lang and Schröder (2013).

  67. 67.

    See Financial Stability Board (2013).

  68. 68.

    See Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU, and Regulations (EU) No 1093/2010 and (EU) No 648/2012, of the European Parliament and of the Council. Official Journal of the European Union 57:190–348 (L 173/190, 12.06.2014).

  69. 69.

    Regulation (EU) No 806/2014 of the European Parliament and of the Council of 15 July 2014 establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and a Single Resolution Fund and amending Regulation (EU) No 1093/2010. Official Journal of the European Union 57:1–90 (L 225/1, 30.07.2014).

  70. 70.

    Herring (2009), especially p. 180.

  71. 71.

    Pointedly, see Avgouleas et al. (2013), especially p. 216.

  72. 72.

    Supportively, see Doluca et al. (2010).

  73. 73.

    See Rudolph (2014), especially pp. 85–86.

  74. 74.

    See, e.g., Krishnamurthy (2014).

  75. 75.

    Herring (2009), p. 171.

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Acknowledgment

This paper was originally prepared for, and presented at, the HTW Berlin/University of Oslo Research Seminar on “The European Institutional Responses to the Challenges of Supervising Financial Markets” in Berlin, Germany, in December 2014. I would like to thank the seminar participants, the reviewers, and in particular Gudula Deipenbrock, Mads Andenas, and Jacob Kleinow for their valuable comments and suggestions that greatly improved the paper.

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  1. Technische Universität Bergakademie Freiberg, Freiberg, Germany

    Andreas Horsch

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Correspondence to Andreas Horsch .

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  1. Faculty of Law, University of Oslo, Oslo, Norway

    Mads Andenas

  2. HTW Berlin University of Applied Sciences, Berlin, Germany

    Gudula Deipenbrock

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Horsch, A. (2016). Regulating SIFIs in the European Union: A Primer from an Economic Point of View. In: Andenas, M., Deipenbrock, G. (eds) Regulating and Supervising European Financial Markets. Springer, Cham. https://doi.org/10.1007/978-3-319-32174-5_16

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