Too big to fail

4 Policy measures implemented after the crisis

Capital requirements and resolution regimes were at the core of the regulatory reforms that were implemented after the global financial crisis. This section describes what was actually decided and how policies are evaluated. We start with an overview of the institutions in charge.

The institutional framework

Clearly, TBTF is a problem that cannot be solved at the national level. The failure of Lehman Brothers had global repercussions and contributed to triggering a global recession. This does not necessarily mean that we need a global authority that regulates all global banks. Instead, financial regulation is closely coordinated internationally while leaving national (or European or other economic and political unions) authorities in charge of implementing global standards and supervising banks. This is partly because many financial stability risks can arise from specific features of the domestic financial system. Furthermore, many of the costs of financial crisis—in terms of output losses, social costs, and fiscal expenses—occur at the national level.

G20

A group of 20 jurisdictions with similar economic interests that meet in informal advisory sessions to make joint decisions and share initiatives. The members of the G20 are Canada, France, Germany, Italy, Japan, the UK, the US, the EU, Argentina, Australia, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, South Korea and Turkey. The G20 represents around two-thirds of the global population and 80% of world GDP. Source: Bundesbank glossary.

European Systemic Risk Board (ESRB)

The (ESRB) is an EU body which is responsible for overseeing the financial system in the EU as a whole and for the timely identification of systemic risk (macroprudential oversight). The ESRB can issue warnings, making such warnings public where appropriate, and make recommendations. Based at the European Central Bank (ECB), the ESRB comprises representatives from the ECB, national central banks, supervisory authorities and the European Commission. Source: Bundesbank glossary.

Yet domestic policymakers might act too late when risks are building up, and they may not take into account cross-border spillovers. At the international level, risks to financial stability are thus monitored, and policy principles are decided that are then implemented at the national level. This is the role of the Financial Stability Board (FSB), created in April 2009, in which all G20 countries are represented. It promotes international financial stability by coordinating national and international authorities. Around the FSB table, central banks, ministries of finance, bank regulators and market regulators agree on international standards or give guidance. At the national level, these standards need to be drafted into national law, and national institutions are in charge of implementing these policies.

Another important institution is the Basel Committee on Banking Supervision (BCBS), which was established in 1974. It is the main global standard setter for the prudential regulation of banks. The Committee typically meets in Basel, Switzerland, hence the name.

In the European Union, there is also an important role in risk monitoring and the co-ordination of policy implementation at the supranational level, because of the close degree of financial integration of member countries. The European Systemic Risk Board (ESRB) is one such institution and plays an important role in coordinating macroprudential policies across countries.

The reforms

Basel Committee on Banking Supervision

An international group that develops international standards for supervising and regulating the banking sector. The most important regulatory frameworks are known as Basel II and Basel III. Representatives of central banks and supervisory authorities from different countries are members of the Basel Committee. The committee is located at the Bank for International Settlements (BIS) in Basel. Source: Bundesbank glossary.

In 2009, G20 leaders called on the Financial Stability Board to propose measures to address the systemic and moral hazard risks associated with systemically important financial institutions. Subsequently, the FSB proposed a policy framework for reducing the moral hazard posed by systemically important banks.^1 2 This was complementary to a package of banking reforms which applies to all internationally-active banks. This package, introduced by the Basel Committee on Banking Supervision in 2010, is called Basel III, because it is the third of a series of reforms in banking regulation.

You can read more about the FSB’s policy recommendations in their 2010 report ‘Reducing the Moral Hazard Posed by Systemically Important Financial Institutions’ and their 2011 report ‘Policy Measures to Address Systemically Important Financial Institutions’.

A global minimum capital requirement was introduced for the first time in 1988 with the Basel Accord. In Exercise 1, you calculated a capital ratio and leverage ratio that did not take account of the varying risk of assets on the balance sheet. The Basel Accord tried to account for the fact that some assets are riskier than others. Each type of asset was assigned a risk weight: 20% for loans to banks and 100% for loans to corporates, for example. The sum of its assets multiplied by their risk weights is called its risk-weighted assets (RWAs), and the capital requirement was a risk-weighted capital requirement. Specifically, the 1988 Accord required internationally-active banks to fund themselves with capital of at least 8% of their risk-weighted assets. The 2010 Basel III package narrowed the definition of capital and increased minimum capital ratios. It added a second type of minimum capital requirement—a leverage ratio—as a supplementary measure. (See Unit 10.10 of The Economy 1.0 for an explanation of how leverage is measured.)

systemically important financial institution (SIFI)

A financial institution is considered systemically important if its insolvency would have a serious impact on the functioning of the domestic financial system and have negative effects on the real economy. Systematically important banks are subject to stricter capital requirements and loss absorbency capacity than other banks. Global systemically important banks and domestic systemically important banks are further classifications of systemically important financial institutions. Source: Bundesbank glossary.

Systemically important banks have to meet additional requirements. Since 2011, the FSB has, for this purpose, published an annual list of global systemically important banks (G-SIBs). In 2019, 30 G-SIBs were identified (see Figure 3). The identification of G-SIBs is based on an assessment methodology produced by the Basel Committee. This methodology uses bank size, interconnectedness, availability of substitutes for its services, international activity and complexity as inputs to calculate a G-SIB score, which is a measure of a bank’s systemic importance. Hence, in defining which financial institutions are ‘systemically important’, size is relevant, but it is not the only factor. Instead, the approach also considers whether a bank is highly connected with other parts of the financial system or whether it provides critical financial services.

In 2012, the G-SIB framework was extended to cover domestic systemically important banks (D-SIBs). While not all D-SIBs are systemically important from a global perspective, their failure could cause harm to their domestic economy, with the potential to generate contagion effects across borders. By 2018, 132 banks had been designated by the national authorities as D-SIBs in FSB jurisdictions (see Figure 3).

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https://books.core-econ.org/insights/too-big-to-fail/04-policy-measures-implemented-after-the-crisis.html#figure-3

Figure 3 Number of SIBs by jurisdiction as at end 2018.
Note: The total number of banks in each country is shown below the country label. China (CN) and the US have not designated D-SIBs.

FSB 2021
Country codes: DE = Germany, RU = Russia, ID = Indonesia, JP = Japan, SG = Singapore, CA = Canada, TR = Turkey, MX = Mexico, FR = France, HK = Hong Kong, ZA = South Africa, SA = Saudi Arabia, CH = Switzerland, BR = Brazil, NL = the Netherlands, ES = Spain, AR = Argentina, KR = South Korea, CN = China, IT = Italy, SE = Sweden, AU = Australia, IN = India.

It is not the purpose of the TBTF reforms to ensure that there are no systemically important banks. Rather, the reforms aim to reduce the negative external effects from the decisions of systemically important banks so that they are not TBTF. The FSB policy framework has the following elements:

total loss absorbing capacity (TLAC)

A regulatory standard that requires global systemically important banks (G-SIBs) to have sufficient financial instruments available during resolution to absorb losses and enable them to be recapitalized, so they can continue performing their critical functions while the resolution process is ongoing. The objective of TLAC is to have an orderly resolution by making debt/equity holders absorb losses (enabling a ‘bail-in’) instead of using public funds (conducting a ‘bailout’). Source: BIS - TLAC – Executive Summary. See also: bail-in, bank bailout, resolution, systemically important financial institution.

• Capital requirements: G-SIBs are required to meet an additional capital buffer requirement, which comes on top of the minimum capital requirement applying to all internationally-active banks. The G-SIB buffer depends on the bank’s systemic importance, as measured by its score.³
• Loss-absorbing capacity: To have sufficient funds that can be used in the event of failure, G-SIBs are required to have a minimum total loss absorbing capacity (TLAC) above the Basel III minimum. The purpose of the FSB’s TLAC standard is to designate a class of capital and liabilities on which losses are likely to be imposed in the event of the bank’s failure, and to define minimum requirements for the issuance of such liabilities.
• Effective resolution regimes: The FSB has developed criteria and guidance for effective resolution regimes for financial institutions. The main purpose is to strengthen authorities’ powers to resolve failing financial firms in an orderly manner. How jurisdictions have progressed in implementing these guidelines is summarized in a Resolution Reform Index (RRI), which is published on the FSB’s homepage. There has been progress in the implementation of resolution reforms: legal powers and coordination arrangements are in place, particularly in jurisdictions that are home to G-SIBs. The resolution approach for all the G-SIBs is bail-in, as described in Section 3.
• Enhanced supervision: Supervision is a way to mitigate the principal-agent problem that is inherent in banking, thereby reducing moral hazard. After the global financial crisis, the FSB developed guidelines to strengthen supervision through greater independence, more resources, supervisory powers, improved supervisory techniques, and better coordination of the supervision of global banks.

These policies are in line with measures based on economic principles, as discussed in Section 3. The new regulations enhance the resilience of banks through capital surcharges, and they increase the loss absorbing capacity for banks that are failing.

Cycle for the evaluation of the reforms

Have these reforms worked? Have they achieved their intended effects, and what could be possible unintended consequences? To answer these questions, a structured framework for the evaluation of reforms is useful (a ‘policy evaluation cycle’). Such a policy evaluation cycle involves four steps:

Financial Stability Board (FSB)

An international institution that coordinates the work of national financial supervisory authorities and international standard-setting bodies in the financial sector. It consists of representatives from central banks, finance ministries, supervisory authorities and international organisations. The FSB’s secretariat is located at the Bank for International Settlements. The FSB is the successor of the Financial Stability Forum, which was set up by G7 countries in 1999 and underwent reforms (including renaming) in 2009. Source: Bundesbank glossary.

shadow banks

The Financial Stability Board (FSB) defines shadow banks as financial market players that engage in activities and perform functions similar to those of banks (particularly in the lending process) but are not banks themselves, meaning that they are not subject to banking regulation. Shadow banks do not necessarily belong to the semi-legal or illegal ‘shadow economy’. Regulated credit institutions can outsource operations to specialised shadow banks and thus – perfectly legally – circumvent regulatory measures. Source: Bundesbank glossary.

• Step 1: Identify the policy objective. Governments regulate financial markets in order to address market failures. In line with this, the Financial Stability Board (FSB) defines the objective of TBTF policies as being to reduce the moral hazard and systemic risk arising from systemically important financial institutions, as described in Section 2.
• Step 2: Identify intermediate objectives and choose appropriate indicators. Moral hazard and systemic risk are not directly observable. There is no metric or indicator that tells us whether a manager of a bank engages in risky activities because she hopes that some of this risk can be shifted to the taxpayer if things go wrong. Intermediate indicators are therefore needed that provide evidence of changes in systemic risk and moral hazard. Based on what we know about the economics of TBTF, and how to manage it, the main indicators of interest are leverage ratios (scale), the extent to which banks link short-term incentives to risk-taking, and the degree of connectedness.
  A large part of the work of public institutions in charge of macroprudential policies is therefore to monitor such indicators: do they signal problems? Has systemic risk increased? Should policymakers act?
• Step 3: Evaluate prior to implementation (‘ex ante’) which policy instruments are needed that address systemic risk externalities. Good macroprudential policies are preventative policies. They do not come into play when indicators are flashing and when a crisis is already imminent, but they are activated early on, when vulnerabilities are building up. Addressing risks early on is less expensive for the taxpayer and less disruptive for the real economy than managing a crisis that has already happened. So if indicators signal that systemic risk has increased, policymakers can use different tools from their toolbox. They can use the least intrusive one by strengthening supervision of banks, or they can impose binding restrictions on banks by, for example, suspending payouts to shareholders or managers or increasing capital requirements.
  Any of these choices has advantages and disadvantages. Before decisions are actually taken, an ex ante evaluation provides information about the performance of different instruments in contributing to reducing systemic risk, given the context at the time. It can be based on a variety of methodological approaches including historic case studies, theoretical models, experimental studies, quantitative simulations, and also qualitative information.
• Step 4: Evaluate the effects and side effects of policy instruments after imple­mentation (‘ex post’). After measures have been taken, this step provides information about their effectiveness, about intended effects or uninten­ded side effects, and it also serves as an input into a possible modification (a ‘recalibration’) of the policy. Policy evaluations can, for example, look at the impact of the policy on bank lending, the costs of funding, or at shifts in market shares across institutions. Tighter regulation of systemically important banks can shift activities to banks that are not systemically important. But some activities and risks can also move outside of the banking sector to non-bank financial intermediaries that are often dubbed ‘shadow banks’. Section 5 will explain this issue in more detail.
  Step 4 need not be the end of the story. It may well be the case that the ex post evaluation of policies signals that the intended effects of the policies have not been strong enough. There might also be unintended side effects that need to be addressed. In such cases, the policy might be amended (going back to Step 3).

For more details on the policy cycle of macroprudential policies, read the paper ‘Evaluating macroprudential policies’ or the FSB’s framework for policy evaluation.