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FEDERAL RESERVE BANK OF CLEVELAND

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NUMBER 27

By James B. Thomson

POLICY DISCUSSION PAPER

On Systemically Important
Financial Institutions and
Progressive Systemic Mitigation

AUGUST 2009

POLICY DISCUSSION PAPERS

FEDERAL RESERVE BANK OF CLEVELAND

On Systemically Important
Financial Institutions and
Progressive Systemic Mitigation
By James B. Thomson
One of the most important issues in the regulatory reform debate is that of systemically
important financial institutions. This paper proposes a framework for identifying and
supervising such institutions; the framework is designed to remove the advantages they
derive from becoming systemically important and to give them more time-consistent
incentives. It defines criteria for classifying firms as systemically important: size (the
classic doctrine of too big to let fail) and the four C’s of systemic importance (contagion,
concentration, correlation, and conditions); it also discusses the concept of progressive
systemic mitigation.

James B. Thomson
is a vice president in
the Office of Policy
Analysis of the Federal
Reserve Bank of
Cleveland. The author
thanks the regulatory
reform workgroup at the
Federal Reserve Bank of
Cleveland (Jean Burson,
Emre Ergungor, Mark
Greenlee, Joe Haubrich,
Paul Kaboth, Dan
Littman, Stephen Ong,
and Andy Watts) for their
thoughtful contributions
to this work, as well as
Ed Kane, Bill Osterberg,
Mark Sniderman, and
Walker Todd for their
insightful comments and
suggestions.
Materials may be
reprinted, provided that
the source is credited.
Please send copies of
reprinted materials to the
editor.

POLICY DISCUSSION PAPERS

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ISSN 1528-4344

FEDERAL RESERVE BANK OF CLEVELAND

Introduction
Central banks increasingly define financial stability as a key mission, second only to monetary policy. Achieving financial stability involves promoting time-consistent incentives for financial firms
and other market participants. Getting the incentives right requires supervisors to deal with systemic risk and, in particular, systemically important financial institutions. Establishing a financial
stability supervisor alone will not achieve stability; it is also crucial to deal proactively with systemically important financial institutions. To do so, it is necessary to have a workable definition of
“systemically important.”
On one level, the definition is fairly simple. A firm is considered systemically important if its
failure would have economically significant spillover effects which, if left unchecked, could destabilize the financial system and have a negative impact on the real economy. This definition is unsatisfactory because it provides little guidance in practice. What we need is a workable definition
of “systemically important.” However, because a variety of factors could make a firm systemically
important, a one-size-fits-all definition would not be very useful.
What can be gained from putting parameters around the term? Delineating the factors that
might make a financial institution systemically important is the first step towards managing the
risk arising from it. Understanding why a firm might be systemically important is necessary to
establish measures that reduce the number of such firms and to develop procedures for resolving
the insolvency of systemically important firms at the lowest total cost (including the long-run
cost) to the economy.
This paper aims to establish a set of criteria for designating financial firms as systemically important. First, the sources of systemic risk are identified by considering how a financial institution
becomes systemically important. Regarding systemic importance as a continuum rather than a
binary distinction, we then investigate the usefulness of establishing categories of systemic importance and the trade-off between a manageable definition and the number of categories used to
classify financial institutions. Next we discuss the establishment of a list of systemically important
financial institutions, weigh the merits of making such a list public, and offer criteria for categorizing institutions. We close with conclusions and policy recommendations.

Defining Systemically Important Financial Institutions
The purpose of creating a practical definition of systemic importance is to enable supervisors to discipline systemically important financial institutions. Understanding the nature and causes of systemic importance is the foundation for creating regulations, supervisory policies, and infrastructure that will rein in the associated systemic risk; in some cases, doing so sufficiently mitigates an
institution’s potential systemic impact so that it would no longer be considered systemically important. Because any two firms could be deemed systemically important for unrelated reasons, a onesize-fits-all designation such as “too big to fail” is inadequate.1 Consequently, the approach taken

1. The first incarnation of
the philosophy of “too big
to let fail,” dates back to
the FDIC bailout of the
Continental Illinois Bank
and Trust Company of
Chicago in 1984. For a
discussion of the failure
and rescue of Continental
Illinois, see Irwin Sprague,
1986, Bailout: An Insider’s
Account of Bank Failures
and Rescues, N.Y.: Basic
Books.

here is to propose a means of classifying systemically important financial institutions (SIFIs).
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POLICY DISCUSSION PAPERS

NUMBER 27, AUGUST 2009

Size
The simplest—and potentially most flawed—way to classify SIFIs is a size threshold, whether it be
asset-based, activity-based, or both. Ideally, a size-based classification should have a flow of funds/
credit intermediation aspect. For instance, a bank with 5 percent of assets nationwide that holds a
portfolio made up largely of government and agency securities is likely to have less serious systemic
implications than a comparable bank with a portfolio of commercial and industrial loans. After all,
the bank holding mostly low-risk, marketable securities will be less likely to fail—and will suffer
fewer losses if it does fail—than the bank holding more opaque, riskier commercial and industrial
loans. Off-balance-sheet activities might also need to be accounted for. Credit substitutes, such as
letters of credit and lines of credit, are rightfully included in financial firms’ credit-intermediation
activities. Moreover, it is important to define SIFIs in a way that minimizes unintended consequences, such as reducing market discipline on firms added to the SIFI list.
Size alone is not an adequate criterion. Although the size threshold could certainly be set low
enough to capture most of the firms that are systemically important for other reasons, the majority would not be systemically important. Including these firms would put too heavy a burden on
them: One objective of defining systemically important institutions is to allow differential regulatory taxes across types. Efficiency and equity concerns therefore require more flexible definitions.
The definitions presented here will be based on four factors other than size which, individually
or collectively, can make a financial institution systemically important. These are the four C’s of
systemic importance: contagion, correlation, concentration, and conditions (context).
As a starting point for a size-based definition, a financial firm would be considered systemically
important if it accounts for at least 10 percent of the activities or assets of a principal financial
sector or financial market or 5 percent of total financial market activities or assets.2 Using current
financial-sector designations as a guide, a SIFI would satisfy any of the following criteria.3
• The consolidated entity holds 10 percent or more of nationwide banking assets
– Or has 5 percent of nationwide banking assets and 15 percent or more of loans.
• After converting off-balance-sheet activities into balance-sheet equivalents, the consolidated entity holds 10 percent or more of nationwide banking assets.
– Off-balance-sheet items would include, for instance, items from schedule RC-L from
the FFIEC Reports of Income and Condition and HC-L from the Federal Reserve Y9
reports; structured investment vehicles and other loan special purpose entities used to
remove assets from the firm’s balance sheet for regulatory capital purposes; and assets
sold or securitized.
– It might be prudent to apply the adjusted-asset test only to financial institutions that
hold more than 5 percent of U.S. banking assets.
• The consolidated entity accounts for 10 percent of the total number or total value of life
insurance products (whole and universal life policies and annuities) nationwide.
• The consolidated entity accounts for 15 percent of the total number or total value of all

2

2. These standards could
be established on a book
or fair-market basis.
Ideally, SIFI thresholds
would be determined
using fair-value accounting when possible.
3. These are examples
of possible thresholds.
However, any proposed
system of thresholds
must be vetted and, if
possible, established
(and periodically
updated) on the basis of
empirical studies.

FEDERAL RESERVE BANK OF CLEVELAND

insurance products (whole and universal life policies, property and casualty policies, annuities, etc.) nationwide.
• A nonbank financial institution (other than a traditional insurance company) such as an
investment bank might be considered systemically important if
– Its total asset holdings would rank it as one of the 10 largest banks in the country
0 Its total assets would rank it in the top 20 largest banks and its adjusted total assets (accounting for off-balance sheet activities) would rank it in the top 10 largest banks
– It accounted for more than 20 percent of securities underwritten (averaged over the
previous five years).

Contagion
The two classic cases of contagion as a source of systemic importance are Herstatt Bank and Continental Illinois, both in 1984. Although Herstatt was a relatively small institution, its closing had
the potential to disrupt the international payments system and imposed nontrivial losses on its
counterparties. As discussed in Todd and Thomson (1991), the stated rationale for the FDIC bailout of all Continental Illinois’s creditors was the threat that losses would be transmitted to some
2,300 community banks that had correspondent-banking relationships with Continental.4 Most
recently, the justification for the Federal Reserve of New York’s assisted acquisition of Bear Stearns
by JPMorgan Chase appears to have been concerns about contagion; in this case, the source of contagion was the potential of loss transmission through the credit-default-swaps market. In principle,

4. Walker F. Todd and
James B. Thomson,
1991, “An Insider’s
View of the Political
Economy of the Too Big
to Let Fail Doctrine.” In
Public Budgeting and
Financial Management:
An International Journal,
3:547–617.

the ability to put parameters around contagion as source of systemic importance should enable effective treatments to mitigate contagion.
A financial institution would be considered systemically important if its failure could result in
• Substantial capital impairment of institutions accounting for a combined 30 percent of the
assets of the financial system
• The locking up or material impairment of essential payments systems (domestic or international)
• The collapse or freezing up of one or more important financial markets.
A substantial impairment of a payments system or market would be one that is large or long
enough to affect real economic activity.5

Correlation
Correlation, as a source of systemic importance, is also known as the “too many to fail” problem.
Penati and Protopapadakis show how correlated risk exposure contributed to the overexposure of
large U.S. banks to borrowers in developing countries.6 There are two important aspects of correlation risk. First are the institutions’ incentives to take on risks that are highly correlated with other
institutions because policymakers are less likely to close an institution if many other institutions
would become decapitalized at the same time. This is consistent with the casual observation of
herding behavior in the financial system which, in the most recent episode, took the form of finan-

5. It is important to define
the parameters of a
material or substantial
disruption of the payments system carefully;
studies are needed to
establish these.
6. See Alessandro Penati
and Aris Protopapadakis,
1988, “The Effect
of Implicit Deposit
Insurance on Banks’
Portfolio Choices
with an Application
to International
Overexposure,” Journal of
Monetary Economics, 21:
107–26. For a discussion of the too many to
fail problem, see Janet
Mitchell, 1988, “Strategic
Creditor Passivity,
Regulation, and Bank
Bailouts,” CEPR discussion paper no. 1780.

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POLICY DISCUSSION PAPERS

NUMBER 27, AUGUST 2009

cial institutions overexposing themselves to subprime mortgages, mortgage-backed securities, and
related mortgage-derivative securities. Second is the potential for largely uncorrelated risk exposures to become highly correlated in periods of financial stress. Andrew Lo calls this phenomenon
“phase-locking

behavior.”7

This means that a group of institutions that would not typically pose

a systemic threat might, in certain economic or financial-market conditions, become systemically

7. See Andrew W. Lo, 2008,
Hedge Funds: An Analytic
Perspective. Princeton,
NJ: Princeton University
Press.

important. This second form of correlation-driven systemic importance is actually an example of
condition- or context-driven systemic importance.
The too-many-to-fail problem is a bit more difficult because it requires that a group or subset
of institutions be classified as jointly systemic. As in the case of contagion, putting parameters
around correlated risk exposure (including determining what level of correlation across portfolios
poses a systemic threat), is the first step towards developing and implementing regulatory treatments. Classifying institutions as systemically important because of correlated risks will mean
developing and estimating risk models, using stress testing and scenario analysis, and establishing
a set of fundamental risk exposures that financial institutions’ portfolios can be mapped into. Fortunately, some large financial institutions are doing this type of risk modeling and scenario analysis for looking at their own risk profile: their work provides a good foundation for other to work
from. Moreover, academic economists have begun thinking about modeling macro-financial risks
in the economy, a step towards modeling and quantifying correlated-risk exposure.8
What levels of correlated risks would give rise to systemic concerns? Thresholds that would
make groups of institutions systemically important include
• The probability that an economic or financial shock would decapitalize institutions accounting, in aggregate, for 35 percent of financial system assets or 20 percent of banking
assets

8. See for example, Dale F.
Gray, Robert C. Merton,
and Zvi Bodie, 2006,
“A New Framework for
Analyzing and Managing
Macrofinancial Risks
of an Economy,” NBER
Working Paper no. 12637,
October. Available at
<http://www.nber.org/
papers/w12637>.

• Potential for economic/financial shock to decapitalize institutions accounting, in aggregate,
for 15 percent of financial system assets or 10 percent of banking assets, and for nationwide
shares amounting to
– 50 percent of wholesale or retail payments, or
– 35 percent of a major credit

activity,9

or

– 50 percent of securities processing or 30 percent of securities underwriting (five-year
average), or
– 20 percent of the total number or total value of life insurance products (universal and
whole life policies and annuities), or
– 30 percent of the total number or total value of insurance products (whole and universal life policies, property and casualty policies, annuities, etc.).

Concentration
Dominant firms’ presence in key financial markets or activities can give rise to systemic importance
if the failure of one of these firms could materially disrupt or lock up the market. Concentration
has two important aspects: the size of the firm’s activities relative to the contestability of the mar4

9. Fairly broad definitions
of credit activities should
be used: For instance,
the categories might
include commercial credit,
housing finance, smallbusiness credit, agricultural credit, and consumer
credit. Moreover, it is
necessary to establish a
threshold for categorizing
a credit activity as major.

FEDERAL RESERVE BANK OF CLEVELAND

ket. That is, concentration is less likely to make a financial institution systemically important if,
other things being equal, the activities of a distressed institution can easily be assumed by a new
entrant into the market or by the expansion of an incumbent firm’s activities. Hence, it is logical
to adjust concentration thresholds to account for contestability.
A financial institution is systemically important if its failure could materially disrupt a financial market or payments system, causing economically significant spillover effects that impede the

10. See Joseph G. Haubrich,
2007, “Some Lessons on
the Rescue of Long-Term
Capital Management,”
Federal Reserve Bank
of Cleveland, Policy
Discussion Paper. No. 19,
April.

functioning of broader financial markets and/or the real economy. Thresholds for concentration
that would render a financial institution systemically important include any firm (on a consolidated basis) that
• Clears and settles more than 25 percent of trades in a key financial market.
• Processes more than 25 percent of the daily volume of an essential payments system.
• Is responsible for more than 30 percent of an important credit activity.

Conditions/Context
In certain states of nature or some macro-financial conditions, closure policy may not be independent of these conditions. In other words, regulators are reluctant to allow the official failure
(closure) of a distressed financial institution under particular economic or financial market conditions if its solvency could have been resolved under more normal conditions. Hence, conditions/
context are sources of systemic importance. For instance, Haubrich notes that the New York Fed’s
reluctance to allow the failure of Long-Term Capital Management resulted largely from the fragility of financial markets at that time—due to the Southeast Asian currency crises and the Russian default.10 This might explain, in part, why LTCM was treated as systemically important and
Amaranth (which was more than twice as big) was not. Another example would be intervention
to prevent the bankruptcy of Bear Stearns by merging it (with assistance) into JPMorgan Chase
in early 2008, whereas Drexel Burnham Lambert was allowed to enter bankruptcy in early 1990.
Firms that might be made systemically important by conditions/context are probably the most difficult to identify in advance. Certainly, stress testing and scenario analysis will be needed to identify them. As discussed above, during periods of financial market distress, phase-locking behavior
can cause what would otherwise be slightly correlated risk exposures to become highly correlated.
As a result, a group of institutions that would not pose a systemic threat under normal economic
or financial-market conditions become systemically important.
Two sets of criteria must be established to classify firms that are systemically important because
of context. First is the probability that economic or financial conditions will materialize that produce the state of nature where a firm or group of firms becomes systemically important. Second
are the thresholds for systemic importance, which presumably would be based on those used to
classify SIFIs according to contagion, concentration, and correlation during normal market conditions; which thresholds are applied would depend on which type of systemic importance the
conditions produce.

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NUMBER 27, AUGUST 2009

Establishing SIFI Categories
One way to classify systemically important financial institutions was suggested in the Geneva report: 11 Institutions may be systemic on their own, as part of group, or in a particular context (or
state of the economy). Under this classification scheme, there would likely be four or five categories
of institutions: Category four would consist of large—but not overly complex—regional financial
institutions; category five would consist of community financial institutions. Institutions could
migrate between categories as their activities and risks evolve.

11. Markus Brunnermeier,
Andrew Crocket, Charles
Goodhart, Avinash D.
Persaud, and Hyun Shin,
“Fundamental Principles of
Financial Regulation,” 2009.
Geneva Reports on the
World Economy, 11.

Constructing categories permits application of the modern tax principles of horizontal and
vertical equity in regulating FISIs. Within each category, every financial institution would be
subject to equivalent regulatory treatment and intensity of supervision. Of course, because two
institutions could fall under the same category for different reasons, the exact forms of their regulatory taxes would logically differ. In this case, equitable treatment consists of the same degree
of regulatory interference (level of regulatory taxes), although the forms of regulation may not
be exactly the same. As you move up the categories, firms would be subject to increased levels
of regulatory interference and supervisory attention—that is, progressive systemic mitigation—
analogous to the prompt corrective action provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991.
Increased regulatory taxes and supervisory scrutiny for higher categories can be justified in
terms of economic efficiency and equity. For instance, economic efficiency dictates that regulatory taxes increase to the point where the cost of the last increment of these taxes equals the benefit
of imposing them. It is likely that the cost of complying with additional regulations is inversely
related to an institution’s size and complexity, while the benefits from additional regulation are
directly related. Hence, as institutions become larger and more complex, increased regulation
and more intensive supervision may be consistent with economic efficiency. Furthermore, to the
extent that the wedge between the private and social costs of failure is related to an institution’s
size and complexity, economic efficiency demands graduated sets of regulatory taxes, which are
designed to internalize the externalities.
There are equally compelling arguments for progressively intensive or intrusive regulatory
treatments on the grounds of equity as you move up the systemic category ladder. One such is the
“level playing field” argument: To the extent that systemic importance confers competitive advantages on an institution, equity concerns would dictate a system of graduated regulatory taxes to
remove (or at least minimize) the advantages of being (or becoming) systemically important.
Of the five categories, only three would contain financial institutions that are considered systemically important. The rationale for a five-category system is that it allows for more consistent
application of regulatory taxes and supervisory oversight across categories, following the notion
that differential supervision and regulation can level the playing field by mitigating the advantages financial institutions derive from systemic importance.12 The categories would likely be
defined as follows:
6

12. Another rationale for
systemic categories is
that the degree to which
markets can or would
be allowed to discipline
systemic institutions
differs across categories,
with higher categories
containing financial
institutions where market
discipline is less likely to
be effective (or those that
are allowed to operate
unfettered).

FEDERAL RESERVE BANK OF CLEVELAND

Category 1

Financial institutions that would be considered SIFIs on the basis of size alone (the classic
too big to let fail category) or to concentration (the firm is a dominant player in an economically significant financial market or activity)
Category 2

Financial institutions that are systemically important because of interconnectedness (interbank or inter-firm exposure, also known as contagion)
Category 3

Financial institutions that are systemically important as a group because of correlated risk
exposures (the too many to fail problem). Also included in category 3 would be financial
institutions that are systemically important because of conditions or context
Category 4

Large financial institutions that are not systemically important but whose failure could
have economically significant implications for regional economies. This category would
include large regional banking companies and large insurance companies.
Category 5

Financial institutions not included in the other categories, consisting primarily of community financial institutions.
Under the philosophy of progressive systemic mitigation, institutions in category 5 would be
subject to a basic level of safety-and-soundness regulation and supervisory oversight. No special
reporting requirements, targeted risk exams, or other treatments would be necessary.13 Category
4 institutions would not face any special capital surcharges or activity restrictions that might apply in categories 1–3, but they would be subject to additional reporting requirements and expected to implement risk management systems and more sophisticated risk controls than category
5 institutions. Moreover, category 4 institutions would be subject to more vigorous supervision
than those in category 5.14
At a minimum, category 3 institutions should be subject to periodic stress tests and be required to have contingency plans in place. Regulatory agencies need to conduct routine scenario
analysis and simulations to ascertain the financial system’s vulnerability to a correlated-risk event
and establish the appropriate regulatory treatment. Such treatment might include actions like
portfolio limits, add-on capital requirements, and loss reserves tied to the activities driving the
correlated risks. Scenario analysis and risk simulations would be used as part of contingency plans
for handling correlated risk events. Stress tests, scenario analysis, risk simulations, and contingency plans would also be part of the operational regulatory system for dealing with institutions
that are rendered systemically important by conditions or context.
Progressive systemic mitigation implies that the treatments adopted for category 3 institutions
should also be applied to those in categories 1 and 2. For category 2 institutions, it is necessary to

13. These institutions
would remain subject to
consumer regulation.
14. Recently, Federal
Reserve Bank of
Cleveland President
Sandra Pianalto outlined
a new regulatory scheme,
“tiered parity,” in which
financial firms would
be separated into three
classes or tiers based
upon their complexity. As
in the present proposal,
the regulatory treatment
of a firm would be determined according to the
tier it is assigned to (with
equal regulatory treatment
of firms within a tier). To
go from the five-category
progressive systemic
mitigation scheme to the
three tiers of the tieredparity scheme, you simply
combine categories 4 and
5 into tier 3 and categories 2 and 3 into tier 2.
Category 1 of progressive
systemic mitigation is essentially the same as tier
1 of the Cleveland Fed’s
tiered-parity proposal.
For a description of tiered
parity, see Sandra
Pianalto, “Steps toward a
New Financial Regulatory
Architecture,” Ohio
Banker’s Day address,
April 1, 2009, available at
<http://www.clevelandfed.
org/For_the_Public/
News_and_Media/
Speeches/2009/
Pianalto_20090401.cfm>.

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NUMBER 27, AUGUST 2009

establish regulatory reporting requirements that allow for inter-bank/inter-firm exposures, direct
and indirect, to be tracked and measured. In addition, limits on direct and indirect exposure
to counterparties should be instituted, along with specific reserves and add-on capital charges
designed to limit contagion across firms. For category 1 institutions, two more types of regulatory treatment need to be added to those faced by category 2 institutions. First, market discipline should be enhanced through mandatory debt-structure requirements, which could include
a mandatory subordinated debt requirement and/or reverse convertible debentures.15 Moreover,
a system of double indemnity for shareholders in category 1 institutions could be an effective
device for providing socially compatible incentives for those institutions.16
This is only a partial set of remedies that might be applied progressively to financial institutions in each category. Naturally, the exact regulatory treatments and the nature of the increased
supervisory attention would need additional study. After all, as a system of regulatory taxes, progressive systemic mitigation is subject to the regulatory dialectic. Consequently, it is important to
understand the unintended consequences of whatever treatments are adopted.17 Such an understanding will help reduce the deadweight losses of the regulatory regime and increase regulators’
ability to respond dynamically to an evolving financial system.

Transparency versus Constructive Ambiguity:
Should the List of SIFIs Be Public?
How much information is made public (details about SIFIs, criteria for inclusion in the categories, and the associated regulatory treatment) depends on several factors: the extent to which the
supervisory regime utilizes market discipline; whether inclusion on the list has unintended certification effects (or, alternatively, whether ambiguity reduces the credibility of implicit government
guarantees); and the degree to which markets can reliably indentify the financial institutions that
populate the categories.18 The more information is released—that is, the closer the regime is to full
disclosure—the more side issues must be addressed. For instance, how will an institution’s inclusion in—or removal from—the list of SIFIs or the promotion (demotion) to a higher (lower) category be communicated? Will there be watch lists of SIFIs that are under consideration for change
in status? Would the names of firms that are systemically important because of context/conditions
be made public and, if so, what additional information (such as risk models, scenario analysis, and
simulations) should be provided?
The choice of disclosure regime would seem to be between transparency (publication of the
list of firms in each category) and some version of constructive ambiguity, where selected information is released. The term “constructive ambiguity” has been attributed to former Secretary of
State Henry Kissinger;19 in a diplomatic context, it refers to the use of ambiguous statements as
part of a negotiating strategy. However, in the context of central banking and financial markets,
the term refers to a policy of using ambiguous statements to signal intent while retaining policy
flexibility. In the context of the federal financial safety net, many have argued for a policy of

8

15. For a discussion of mandatory subordinated debt
requirements, see Rong
Fan, Joseph G. Haubrich,
Peter Ritchken, and
James B. Thomson, 2003,
“Getting the Most Out of a
Mandatory Subordinated
Debt Requirement,”
Journal of Financial
Services Research,
24:2/3, 149–79; Reverse
convertible debentures
are discussed in Mark J.
Flannery, “No Pain, No
Gain? Effecting Market
Discipline via ‘Reverse
Convertible Debentures’”
(November 2002).
Available at <http://ssrn.
com/abstract=352762
or DOI: 10.2139/
ssrn.352762>.
16. See Edward J. Kane,
1987, “No Room for
Weak Links in the Chain
of Deposit Insurance
Reform,” Journal of
Financial Services
Research, 1:77–111.
17. For a discussion of the
regulatory dialectic, see
Edward J. Kane, 1977,
“Good Intentions and
Unintended Evil: The
Case against Selective
Credit Allocation,”
Journal of Money, Credit,
and Banking, 9:1, 55–69.
18. For an analysis of how
markets discover regulatory information, see Allen
Berger, Sally M. Davies,
and Mark J. Flannery,
2000, “Comparing
Market and Supervisory
Assessments of Bank
Performance: Who Knows
What When?” Journal
of Money, Credit, and
Banking, 32:3, 641–67.
19. <http://en.wikipedia.org/
wiki/Constructive_ambiguity>.

FEDERAL RESERVE BANK OF CLEVELAND

constructive ambiguity to limit expansion of the federal financial safety net.20 The notion here
is that if market participants are uncertain whether their claim on a financial institution will be
guaranteed, they will exert more risk discipline on the firm. In this context, constructive ambiguity is a regulatory tactic for limiting the extent to which de facto government guarantees are extended to the liabilities of the firms that regulators consider systemically important. Uncertainty
about whether a firm is considered systemically important and which category it belongs to in
the progressive systemic mitigation regime may, at the margin, exert stronger market discipline
on institutions than if the list of SIFIs were made public.
For a number of reasons, a policy of supervisory transparency is superior to constructive ambiguity for our purposes. First, constructive ambiguity, broadly viewed, is a competitor of the progressive systemic mitigation regime proposed in this paper. Constructive ambiguity is a supervisory policy aimed at reducing the agency problems associated with firms’ systemic importance by
creating uncertainty about which firms and creditors might be rescued if a firm fails. Progressive
systemic mitigation is an explicit set of regulations and supervisory policies designed to reduce (if
not eliminate) the advantages of being systemically important. Under its rules, the social costs of
systemic importance would be internalized by the institution and its stakeholders. Second, to the
extent that SIFIs would be subject to specific sets of regulatory treatments, it is unlikely that there
would be much value in continuing the policy of constructive ambiguity in the proposed progressive systemic mitigation system. After all, markets will probably be able to surmise which firms
are on the SIFI list by observing differences in capital structure, balance sheet entries (including
footnotes), and intensity of regulatory scrutiny. Finally, the benefit of constructive ambiguity in
avoiding an SIFI certification effect that might result from publishing a list of SIFI firms would
only affect a small number of firms at the margin. The efficiency gains of avoiding the certification
effect on these marginally systemic firms is likely to be swamped by efficiency losses associated
with withholding information from the market. Hence, the list of SIFIs, including categories
and criteria for inclusion, should be made public, along with a watch list of financial institutions
whose SIFI status might change.
An effective system of supervisory transparency entails more than simply disclosing information; it must also include producing information and disseminating it in a useful form.21 A case
in point is the argument for requiring credit rating organizations to disclose information, such
as probabilities of default and loss given default, upon which a rating is based.22 In the supervisory transparency regime, this means that all information used to assign institutions to an SIFI
category—including supervisory risk models and their results—should be disclosed. 23 Furthermore, stress tests of SIFIs, along with contingency plans for handling the financial distress of one
or more large financial institutions, should be implemented and disclosed.

20. For a discussion of
constructive ambiguity as a tool for limiting
conjectural government
guarantees of bank
creditors, see Frederic S.
Mishkin, 1999, “Financial
Consolidation: Dangers
and Opportunities,”
Journal of Banking and
Finance 23:2–4, 675–91.
For a discussion of
constructive ambiguity in
the context of lender-oflast-resort policies, see
Marvin Goodfriend and
Jeffrey M. Lacker, 1991,
“Limited Commitment and
Central Bank Lending,”
Federal Reserve Bank
of Richmond, Economic
Quarterly, 85:4, 1–27.
21. For an example of useful
information, see the recommendations of the 2001
Working Group on Public
Disclosure, which suggests
that supervisors release
information (such as data
about risk exposure) that
provides a consistent view
of a bank’s risk management approach. See Board
of Governors of the Federal
Reserve System, 2001,
SR 01-6: Enhancement to
Public Disclosure. Division
of Banking Supervision,
April.
22. See Charles W. Calomiris,
2008, “The Subprime
Turmoil: What’s Old,
What’s New, and What’s
Next,” presentation at the
Federal Reserve Bank of
Kansas City’s symposium,
“Maintaining Stability in
a Changing Financial
System,” August 21–22.
23.In cases where releasing a
piece of information could
result in the disclosure
of confidential business
information, suppression
of the information should
be predicated on a careful
cost-benefit analysis,
which weighs the financial
institution’s private interests
against the benefits to
society.

9

POLICY DISCUSSION PAPERS

NUMBER 27, AUGUST 2009

Conclusions and Policy Recommendations
The legacy of economic and financial crises is a post-crisis regime characterized by increased government interference in markets. However, simply increasing the amount of formal regulation and
the degree of supervisory oversight and interference is not necessarily the best path forward. Financial market reforms must deal in the least-cost way with the fundamental issues that contributed
to the current crisis. One of the most important issues that regulators, legislators, and other policymakers must face is that of systemically important financial institutions.
We propose the study and subsequent adoption of a financial-market supervisory infrastructure in which SIFIs are identified, categorized according to the nature or source of their systemic
importance, and subjected to specific regulatory treatments that address the risk these firms impose. The ultimate objective of progressive systemic mitigation is to improve economic efficiency
by promoting socially compatible risk incentives for SIFIs and to increase fairness in the financial system by leveling the playing field; the means of achieving this are reducing or removing,
through regulatory taxes, the advantages of being systemically important.
Specific regulatory treatments to deal with the four C’s of systemic importance (contagion,
correlation, concentration, and context/conditions) must be carefully studied before they are adopted. These regulatory treatments might include (but are not limited to) capital surcharges, special reserves, mandatory subordinated debt and/or reverse capital debentures, inter-firm exposure
limits, and increased regulatory reporting requirements. Moreover, banking supervisors should
be required to conduct periodic systemic risk analyses, stress tests, and other simulations as part
of a contingency planning process that would improve regulators’ ability to deal in a least-cost
manner (combined short- and long-term costs) with the failure of one or more SIFIs. Finally, the
information disclosure regime must be addressed when implementing the new supervisory architecture. We argue for full transparency, which includes publishing the list of SIFIs, presumably on
a quarterly basis; the criteria for inclusion in an SIFI category; and specific regulatory treatments.
In addition, financial institutions whose systemic status may be upgraded or downgraded should
be included on a published watch list.
One issue we have not dealt with here is the need to establish a credible resolution process for
SIFIs. This, of course, involves careful consideration of the types of resolution authority needed,
the funding source for operating any such authority, and the related infrastructure. While a credible resolution process should involve addressing contingency plans as part of the supervisory
regime, we leave discussion of the type and form of resolution authority to a companion paper.

10

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