IMF Survey: ‘Too Complex to Fail’ the Real Issue, Says IMF

IMF News, November 10, 2009

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Publication date: November 10, 2009
Objective: Launches a paper to help determine which firms and markets are systemically important, emphasizing that potential for severe damage to global financial and economic stability—not just size—should guide assessments of when firms are “too complex to fail.”
Background events noted:
- The collapse of Lehman Brothers in September 2008 exposed the potential for one firm’s failure to inflict devastating effects on global financial stability and the world economy.
- The paper was prepared at the request of the leaders of the G-20 and issued on November 7.

The IMF, together with the Financial Stability Board and the Bank for International Settlements, set out criteria and principles to help countries determine systemic importance.
The paper outlined three main principles:
- The size of a financial firm or market, and the volume of financial services it provides
- The extent to which other parts of the financial system can provide the same services in the event of a firm or financial market’s failure
- The linkages between financial institutions, which might create repercussions in the event of a firm’s failure
Indicators of a firm’s vulnerability and increasing risk to the financial system include:
- Leverage, which is borrowed capital used to increase a firm’s potential returns
- Illiquid assets, which may need to be sold in order for a firm to raise funds
- The complexity of a firm, coupled with the availability of reliable information about a firm’s investments in a particular security or industry

Countries currently use a wide range of techniques to identify a firm’s systemic importance, including:
- A mixture of indicators, both quantitative and qualitative
- Stress testing
- Multiple methods used concurrently in many jurisdictions
The choice of method should depend on the country’s financial system.
The use of judgment will be an important part of assessments, along with reviewing the capacity to deal with failures of institutions and markets when they occur.
Countries are increasingly focusing on the linkages between their financial systems and their economies in their analysis of a firm’s importance.

The principles could be used to set up a flexible framework applicable to a broad range of countries. Possible framework components include:
- The definition of systemic importance
- The roles and responsibilities of the agencies involved in the assessments
- The independence, accountability, and powers of the agencies involved
- The frequency of the assessments
- A periodic review of the framework
Countries might consider:
- The mix of information to be used, both quantitative and qualitative
- How results will be communicated to regulators, central banks, and financial markets, nationally and internationally
- International cooperation given global connections between financial institutions
Governments could use the guidelines to help adjust financial regulation and oversight when considering reforms to the rules governing their financial systems.
Once frameworks have been put in place and tested, countries may wish to consider developing a new set of international standards for identifying firms and markets that are critical to international financial stability.

The IMF has examined individual countries’ proposals to incorporate systemic risk into regulatory reforms.
In July (of the year referenced), the IMF included a review in its Article IV Consultation on the U.S. economy of the government’s proposed reforms to financial regulation and noted that the U.S. proposal left issues unaddressed, including the rules for identifying who is systemically important.
IMF Managing Director Dominique Strauss-Kahn emphasized that the core issue is not only size, but complexity and systemic importance.

IMF Survey: ‘Too Complex to Fail’ the Real Issue, Says IMF — November 10, 2009.