It’s the question that’s seemingly stumped Tim Geithner: how to identify a priori systemically important non-bank financial institutions.
The Federal Reserve on Tuesday suggested further rules regarding who might be considered for attention by the Financial Stability Oversight Council (FSOC) as per section 113 of Dodd-Frank. In short, they need to be “financial” and “significant”.
It suggests that companies be defined as “financial” if they meet the following “two-year test”:
– The consolidated annual gross financial revenues of the company in either of its two most recently completed fiscal years represent 85 percent or more of the company’s consolidated annual gross revenues (as determined in accordance with applicable accounting standards) in that fiscal year; or
– The consolidated total financial assets of the company as of the end of either of its two most recently completed fiscal years represent 85 percent or more of the company’s consolidated total assets (as determined in accordance with applicable accounting standards) as of the end of that fiscal year.
The Federal Reserve proposes using the same definition of “financial activities” as currently defined via the Bank Holding Company Act.
And it suggests some of the factors that would mean a could firm be designated as “significant”:
Among the factors the Council must consider in determining whether to designate a nonbank financial company for supervision by the Board is the extent and nature of the company’s transactions and relationships with other “significant” nonbank financial companies and “significant” bank holding companies. Under the proposal, a firm would be considered “significant” if it has $50 billion or more in total consolidated assets or had been designated by the Council as systemically important.
(Note the wiggle-room in the second clause of the final sentence.)
This emphasis on size implies that the FT may have been right when it said in its November survey of financial regulation that “the smart money is on a handful of non-banks – almost certainly fewer than 10 and possibly half that number – joining the banks as the guinea pigs of the new system.” It’s still not clear which firms will be in the frame.
But if true this would mean that many “shadow banking” players would remain outside the scope of the FSOC. For a sense of who might be breathing sighs of relief, check out this masterful overview of the non-banking financial sector.
Of course the Dodd-Frank bill and the FSOC’s January 17 paper described what activities and characteristics might lead firms to receive federal scrutiny. The FSOC paper contained a handy table that described the criteria for determining a systemic institution (click to expand):
This is a solid list, but as this post from Economics of Contempt argues, it’s crucial that the FSOC distinguishes probability of failure with impact of failure. To use a deliberately abstract example, a large, highly leveraged unconnected firm will likely have less impact than a small, modestly leveraged but highly connected firm. We’re not experts on the failure of Long-Term Capital Management in 1998, but some cite this as an appropriate case study.
It’s also worth applying some Geithnerish scepticism to what the FSOC can achieve before the fact. There is no perfect, static answer to a dynamic problem. Any list of “systemic” institutions needs to be updated as they and conditions change — and, crucially, those not on the list can’t be forgotten.
Related links:
Too big to fail, fail? – FT Alphaville
US financial regulation (in-depth) – FT
Volcker rule — coming, slowly, to a bank near you – FT Alphaville