Bank Size Does Not Tell the Whole Story in Measuring Systemic Importance

Since the last financial crisis, policymakers have sought to impose tougher standards on any bank whose failure would pose the greatest risk to financial stability. Where should the line be drawn in identifying banks to subject to those standards?

A new OFR viewpoint, “Size Alone is Not Sufficient to Identify Systemically Important Banks,” argues that a multifactor approach is superior to considering asset size alone to assess a bank’s systemic importance.

Regulators already use such an approach to identify global systemically important banks (G-SIBs). They consider size and four other factors to measure a bank’s systemic importance: (1) interconnectedness, (2) substitutability, (3) complexity, and (4) cross-jurisdictional activity. The eight G-SIBs based in the United States face the most stringent standards.

Our analysis indicates that a multifactor approach could replace the $50 billion asset-size threshold that some U.S. regulations use to identify U.S. banks that are not G-SIBs, but warrant enhanced regulation.

Such an approach could identify a much smaller group of non-G-SIB banks for enhanced prudential standards. Relatively large but less-systemic U.S. institutions might no longer face regulatory costs disproportionate to their importance. Smaller banks that play unique roles in U.S. markets, are more complex, or rely on short-term wholesale funding could continue to face higher standards.

The viewpoint also examines other measures researchers have proposed to evaluate a bank’s systemic risk. These measures use market data and information about bank balance sheets. They can be used to see whether market participants and regulators agree on which banks are systemic. For the G-SIBs, these measures show general agreement between the market and regulators.

Six of the eight G-SIBs are also the six largest U.S. bank holding companies. However, the correlation between size and risk is weaker for smaller companies. The viewpoint uses six measures to compare U.S. bank holding companies that each hold more than $50 billion in assets. Each measure highlights a different vulnerability, such as contagion risk.

The viewpoint suggests two changes to the G-SIB multifactor approach for identifying non-G-SIB banks for enhanced regulation. One change would better account for “substitutability” risks from banks that offer unique services that are central to the functioning of financial markets. The second change would better incorporate the systemic importance of a foreign bank’s U.S. operations, including its U.S. branches and agencies. The U.S. operations of foreign banks can be relatively complex or dependent on wholesale funding, adding to their systemic importance.

Richard Berner is the Director of the Office of Financial Research