What it means
The 2008 financial crisis showed how the collapse of a few large firms could freeze lending and trigger a recession. Governments in many countries stepped in to rescue banks because the alternative looked worse.
Critics pointed out that this created a bad incentive: if a firm expects to be bailed out, it may take bigger risks. After the crisis, regulators created lists of firms they consider systemically important.
The Financial Stability Board, an international body, publishes a list of global systemically important banks each year, and national regulators designate others for their own markets. A firm is picked based on its size, its links to other institutions, how hard it would be to replace and how complex and international its business is.
Being on the list brings extra obligations. These firms must hold more capital than other banks, sometimes called a surcharge, and they must meet stricter liquidity and risk management standards.
They also have to prepare resolution plans, sometimes called living wills, which explain how they could be wound down in an orderly way without a government rescue. For business owners and managers, SIFIs matter in a few ways.
They are often the main banks that large companies use, so their stability affects credit and payments. Their extra capital costs may also be passed on in the pricing of loans, and rules aimed at them can change how banks compete.
There is ongoing debate about whether the framework works. Supporters say that it has made large banks safer, while critics argue that the label itself signals a government safety net and that risks may migrate to less regulated institutions.
Whatever the view, the designation is a key part of how regulators try to protect the system. The designation process is not static, and institutions can move on and off the lists as their size, activities and connections change.
A firm that shrinks its trading book or simplifies its structure can lower its score and, in time, its surcharge. Regulators also run stress tests, which model how firms would cope with a severe recession, and results can lead to restrictions on dividends if capital falls short.
In practice
Real-world examples.
Example
A large international bank is named on the global list of systemically important banks. It must hold an extra layer of capital, and its treasury team adjusts its lending and dividend plans to stay above the higher requirement.
Example
A multinational manufacturer deposits its cash with several banks and checks whether each is designated as systemically important. The treasurer treats the designation as a sign of heavy supervision but not as a guarantee of safety.
Example
A regional lender grows quickly through acquisitions and approaches the size at which regulators might apply tougher rules. Its board models the cost of extra capital before deciding whether to continue.
Formula
Calculation
Required CET1 ratio = Minimum + Capital conservation buffer + SIFI surcharge
CET1 (common equity tier 1) is the highest quality form of bank capital, mostly shareholders' equity.
Suppose the minimum is 4.5%, the capital conservation buffer is 2.5% and the surcharge for a large bank is 2.0%.
Required CET1 ratio = 4.5% + 2.5% + 2.0% = 9.0%
If the bank has risk-weighted assets of $500,000,000,000, required CET1 capital = $500,000,000,000 x 0.09 = $45,000,000,000.
Without the surcharge, the requirement would be 7.0%, or $35,000,000,000, so the surcharge alone adds $500,000,000,000 x 0.02 = $10,000,000,000 of required capital.Case study
Seen in the real world.
Meridian Global Bank is an illustrative, fictional bank with $800,000,000,000 of risk-weighted assets that was newly designated as systemically important. Regulators required an extra surcharge of 1.5% of risk-weighted assets, equal to $12,000,000,000 of additional capital.
The bank's finance team had two options: raise new equity or shrink its balance sheet. It chose to cut back some low-return trading activity, which reduced risk-weighted assets by $100,000,000,000 and cut the additional capital needed by $1,500,000,000.
In the illustrative result the bank also had to prepare a resolution plan showing how it could be wound down. The exercise exposed overlapping legal entities, and simplifying them lowered running costs as well as improving the bank's resilience.
Watch out
Common mistakes.
- Assuming a SIFI will always be rescued by the government, when the rules aim to make orderly failure possible.
- Thinking only banks can be designated, when insurers and other financial firms can also be named.
- Believing the designation measures a firm's health, when it measures its importance to the system.
Questions
People also ask.
What does too big to fail mean?
It describes a firm whose collapse would be so damaging that the government feels forced to rescue it.
Who decides which firms are systemically important?
International bodies such as the Financial Stability Board and national regulators, using measures of size, interconnectedness, substitutability and complexity.
What is a living will?
A plan that sets out how a firm could be wound down in an orderly way if it fails, without causing a wider crisis.
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