The Broader Market

by Jordan Eizenga

Legislation making its way through Congress and the Senate aims to create a resolution mechanism to wind down, in an orderly manner, struggling institutions that are deemed too big to fail. The worry is that these institutions are so large that, if they default in a disorderly manner, they could jeopardize the financial system at large.  For this reason, their failure would likely require the government to intervene (using taxpayer funds to prop up the institution).  Identifying those institutions that possess substantial systemic risk, therefore, is very important.

An IMF working paper by Jorge A. Chan-Lau outlines an alternative methodology for identifying those institutions that pose systemic risk. Rather than systemic risk being defined primarily as a function of size - the basis of the ‘too big to fail’ argument - Chan-Lau presents a methodology that aims to evaluate the systemic risk of a financial institution on the basis of its interconnectedness with other institutions.

As Chan-Lau notes, too connected to fail and too big to fail are concepts that are not necessarily related.  An institution can be too big to fail, yet not be terribly interconnected. This could be true of large banking institutions whose main source of funds is deposits.  Such institutions may not have much exposure to other institutions, yet the cost of their failures would mean very large government payments as part of a deposit insurance program.  This would be an instance of too big to fail, but not one of too connected to fail.

To evaluate the risk of too connected to fail, Chan-Lau uses a balance sheet-based network analysis, which focuses on the solvency of banking institutions as demonstrated in their accounting records.  To recall, on a balance sheet, assets must equal liabilities.  On the asset side, banks record their claims against other institutions, borrowers and corporations.  These are often recorded as loans receivables, but can also take the form of equity shares and fixed income securities.  The liability side, on the other hand, records everything that the institution owes to creditors, shareholders, and depositors.  It also includes additional items that constitute bank capital.  In the event of a deterioration in the value of an institution’s assets, it is this bank capital that cushions the blow.  Put simply, if total asset value declines  below what the bank has in capital, then its capital is wiped out and the institution defaults.

The effect of a default is felt by other institutions, most notably, by the creditors of the defaulted institution.  When a borrower defaults, the creditor’s asset base declines; the present value of the receivable (principal plus interest payments) that the creditor was entitled to receive has just decreased substantially.  Thus, the surviving institution now experiences an erosion of its own capital, which, if great enough, can require that institution to sell its assets at fire sale prices to cover its funding needs.  In this instance, the defaulted institution, may be ‘too connected to fail.’

Using Chan-Lau’s analysis, one can simulate whether a particular default could result in the further default of an exposed institution.  This is done simply by determining the amount of losses that would be required to bring the exposed institution’s asset base below the value of its capital.  If the exposed institution defaults, a similar analysis would be conducted to determine if further defaults would occur.  Such analysis would continue until it is determined that a given default would not produce subsequent defaults.

The benefit of Chan-Lau’s methodology is that it uses publicly available data sources and relies on simple accounting procedures - its virtue is that it could be implemented with relative ease.  However, it is his findings that should prove most useful to policymakers.  Using the balance sheet network analysis, Chan-Lau evaluated the impact of different shocks (e.g. credit and funding shocks) on the balance sheets of financial institutions in both developed and emerging market economies.  His results clearly demonstrate that adverse shocks to the balance sheets of American, British and German banks present a material threat to the global banking system. Thus, the current US financial regulatory reform legislation will no doubt have an impact on both domestic and foreign institutions.  The question is whether this impact will be positive or negative.