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Regulating Financial System Risk Key Issue in Reforms, says IMF

Financial district of New York: Regulations should prevent firms from becoming too important to fail, IMF said (photo: Richard B. Levine).

GLOBAL FINANCIAL STABILITY REPORT

Regulating Financial System Risk Key Issue in Reforms, says IMF

By Marco A. Espinosa-Vega
IMF Monetary and Capital Markets Department

April 13, 2010

  • Reforms should prevent institutions from being too important to fail
  • New tools may be needed to limit systemic risk
  • A closer look at systemic risk-based capital surcharges

Financial regulatory reforms should aim to prevent institutions from being too important to fail, according to the IMF.

A range of financial reform proposals are being considered to address systemic risks, and the April 2010 Global Financial Stability Report takes an in depth look at two of them: whether and where to add a systemic-risk oversight function to the regulatory architecture, and how to construct systemic risk-based capital surcharges if policymakers decide to go this route.

Supervision division

Some proposals to reform the financial system suggest that the systemic risk monitoring role should be carried out by a new regulator. Other proposals keep the current division of supervisory functions unchanged, such as provision of emergency liquidity and solvency regulation, while adding to regulators’ role the task of monitoring the buildup of systemic risks.

The IMF’s analysis suggests that one of the main advantages of consolidating regulators would be to reduce the regulatory tendency of excessive leniency toward financial institutions. Regulators often have the incentive to keep an institution afloat, even when it is insolvent, because it is politically costly for them to close institutions under their watch and they may hope that, given enough time, an insolvent institution will get back on its feet.

Consolidating regulatory authority reduces the incentives toward leniency that exist under multiple regulators by allowing the unified regulator to look at the big picture. However, consolidation does not completely solve the problem of lessening systemic risk, because even a unified regulator has a tendency to be lenient with systemic institutions.

The chapter shows that regardless of which regulatory body oversees the systemic institutions, they will tend to be even more lenient towards systemically important institutions than other institutions. That’s because the failure of systemically important institutions will have a more damaging effect on other institutions under the regulators’ purview, and regulators would loathe to see serial failures. As a result, they would become more, not less, lenient with systemically important institutions. 

This tendency toward leniency suggests reforms should prevent institutions from becoming systemic, and try to reverse the cases in which they already are. Of course, this is easier said than done, and several measures have been proposed, including instituting systemic risk-based capital surcharges, directly limiting the size or scope of certain business activities, or establishing central counterparty clearing systems.

Pay for the risks you take

While not necessarily endorsing the introduction of systemic risk capital surcharges, the analysis provides a methodology to compute such surcharges. The methodology uses existing risk management methods and tools. It also presents a way to remove the surcharge’s potential procyclicality—that is, the propensity to increase in a downturn and drop in an upturn—a counterproductive attribute associated with most risk-based capital charges.

Underpinning this methodology is the notion that these surcharges should be commensurate with the large negative effects that a financial firm’s distress may have on other financial firms—their systemic interconnectedness. The IMF suggests two approaches to implement this methodology:

• Standardized approach: regulators assign systemic risk ratings to each institution and then assess a capital surcharge based on this rating.

• Risk-budgeting approach: determines capital surcharges in relation to an institution’s contribution to systemic risk and its own probability of distress.

Nowadays, most systemic institutions have a global presence, meaning they conduct their businesses in multiple countries at the same time. Therefore, to properly account for the systemic risk that these institutions really impose on the global financial system, one would have to take into account their cross-border linkages. This would require, in turn, that supervisors in different countries collaborate closely—and share key information—in order to design systemic risk-based capital surcharges.