11.08.2011
By Terry Flanagan

Regulators Tackle Systemic Risk

Basel Committee to measure interconnectedness among financial institutions.

Internal regulators and bank supervisors are mapping out plans to both reduce the risk of a large bank failure, and to limit the damage to the financial system when a failure occurs.

The Basel Committee on Banking Supervision (BCBS) has issued rules on the assessment methodology for global systemic importance, the magnitude of additional loss absorbency that global systemically-important financial institutions should have, and the arrangements by which they will be phased in.

Whether and to what extent these rules are put in place depends in large part on how they comport with national legislation, in particular Dodd-Frank.

“Part of the issue is that the Dodd-Frank Act comes into force ahead of the Basel rules, and nothing that Basel can do that contradicts Dodd-Frank,” an attorney and former counsel to the Senate Banking Committee told Markets Media.

Titles I and II of Dodd-Frank deal with supervisory and prudential standards for systemically-important financial institutions, and resolution of failed financial institutions, respectively.

“Title I is primarily designed to address systemic, risk,” the attorney said. “Title II addresses orderly liquidation of failed institutions so they don’t create follow-on effects on the financial system.”

The rationale for the new rules is to deal with the cross-border “negative externalities” created by global systemically-important banks which current regulatory policies do not fully address, according to the BCBS.  The measures will enhance the going-concern loss absorbency of G-SIBs and reduce the probability of their failure.

The assessment methodology is based on an indicator-based approach and comprises five broad categories: size, interconnectedness, lack of readily available substitutes or financial institution infrastructure, global (cross-jurisdictional) activity and complexity.

The additional loss absorbency requirements will range from 1% to 2.5% Common Equity Tier 1 (CET1) depending on a bank’s systemic importance, with an “empty bucket” of 3.5% CET1 as a means to discourage banks from becoming even more systemically important.

If the empty bucket becomes populated in the future, a new empty bucket will be added with a higher additional loss absorbency level applied.

The higher loss absorbency requirements will be introduced in parallel with the Basel III capital conservation and countercyclical buffers, and are to become fully effective in 2019.

National regulators have taken steps to address systemic risk in a more granular fashion.

In the United States, for example, financial market utilities that handle post-trade processes will become to regulatory scrutiny under a rule adopted by the Financial Stability Oversight Council (FSOC).

The FSOC was created by to fulfill statutory obligations under the Dodd-Franks Act to assess the threat the failure or disruption of a financial market utility (FMU) may pose to the stability of the U.S. financial system.

Under FinReg, in making a determination on whether a FMU is systemically important, the FSOC must consider the aggregate monetary value of transactions processed by the utility, the aggregate exposure of the financial market utility to its counterparties, and the relationship, interdependencies, or other interactions of the financial market utility with other financial market utilities.

Once an FMU has been tagged as systemically important, it will fall under the jurisdiction of the Federal Reserve, the SEC, and the CFTC, which are authorized to prescribe risk management standards related to the payment, clearing and settlement activities of systemically important FMUs.

These standards may address areas such as risk management policies and procedures, ability to complete timely clearing and settlement of financial transactions, capital and financial resource requirements for FMUs. Designation also subjects the FMU to additional examinations and reporting requirements, as well as potential enforcement actions.

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