.A new report from the office of Financial Research, an independent bureau within the Treasury Department, makes the case that, as its title says, “Size Alone is Not Sufficient to Identify Systemically Important Banks.” It argues that “a multifactor approach” is superior to considering asset size alone when assessing a bank’s 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,” OFR Director Richard Berner wrote in an Oct. 26 blog post. “Where should the line be drawn in identifying banks to subject to those standards?”

OFR was established by the Dodd–Frank Act with a mission to promote financial stability through research, data collection, and analyzing market risks.

Some banks have been subject to enhanced regulation since the 2007-09 financial crisis because the failure of any one of them could pose risks to the financial system. The Dodd-Frank Act directed the Federal Reserve to establish enhanced prudential standards for any bank holding company with total consolidated assets of $50 billion or more.

OFR’s analysis of systemic importance data reveals that size alone may not be optimal to identify such banks. “Some large banks may not be systemically important; and conversely, some smaller banks might be,” it says. “Bank size alone does not equate to risks a firm may pose to financial stability.”

An alternative approach, used to identify global systemically important banks (G-SIBs), relies on multiple measures, not just size. G-SIBs face the most stringent standards. For large banks that are not G-SIBs, “asset-size thresholds are too simplistic to assess systemic importance,” the report says. “For this second tier of banks, a modified version of the G-SIB multifactor approach could help determine the appropriate level of enhanced regulation.”

“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,” Berner wrote. “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, he added.

The new report 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 current G-SIB approach may understate the systemic importance of some banks that provide critical services, OFR researchers wrote. The regulation establishing extra capital surcharges for U.S. G-SIBs either caps or eliminates substitutability measurements. Although the Basel Committee has proposed some modifications, "they still do not address the concentration of critical services in a bank that substitutability indicators need to capture" and "more work on substitutability indicators is needed."

The second recommendation would better incorporate the systemic importance of a foreign bank’s U.S. operations, including its branches and agencies. A regulatory weakness, as detailed in the report, is that U.S. branches and agencies of foreign banks do not report systemic importance data.

Each U.S. bank holding company and intermediate holding company with more than $50 billion in assets is required to disclose its systemic importance indicators quarterly to the Federal Reserve on Form Y-15. Systemic importance scores are then calculated annually using data from the Basel Committee on international peers.

The operations of foreign banks’ U.S. branches and agencies are not required to disclose systemic importance indicators annually on Federal Reserve Form Y-15, even though some of these firms’ footprints and operations are significant. Some foreign G-SIBs have U.S. intermediate holding companies and branches, but the combined risks of these operations are considered in only one regulation implementing enhanced prudential standards.

In 2015, the latest year for which those data are currently available, 34 U.S. bank holding companies and intermediate holding companies filed the Y-15 report. However, systemic importance data are not gathered for foreign banks’ U.S. branches and agencies. "The absence of Y-15 data for large U.S. branches and agencies of foreign banks impedes the evaluation of the overall systemic importance of the U.S. operations of foreign banks," the OFR report says. "During the financial crisis, U.S. branches and agencies of several foreign banks received considerable liquidity support from the Federal Reserve. In some cases, this support exceeded the Federal Reserve’s support for Lehman Brothers before it failed."

Concentration of critical activities in a handful of banks was raised in the report as a potentially overlooked source of financial stability concerns. For example, settlement of government securities trades is now provided by two banks and JPMorgan Chase & Co. announced in July 2016 that it will stop offering the service later this year. Once JPMorgan Chase exits the market, the Bank of New York Mellon will be the only settlement service provider. However, the change will not increase Bank of New York Mellon’s systemic importance score nor its G-SIB capital surcharge.

“It should," the authors wrote. "Concentrating government securities settlement services in one provider raises systemic risk concerns because of the potential impact on the financial system if that firm falters or fails. In 1985, Bank of New York Mellon, then known as the Bank of New York, received a $23 billion discount-window loan from the Federal Reserve after an operational failure left the firm unable to redeliver securities it had received as an intermediary from other institutions.

On Oct. 25, one day or to the release of the report, OFR introduced two new tools for risk measurement and monitoring: the Financial System Vulnerabilities Monitor(FSVM) and the Financial Stress Index (FSI).

The FSVM improves upon and replaces the OFR’s Financial Stability Monitor, which combined signals of vulnerabilities and stress. It focuses only on vulnerabilities for clearer and earlier signals of potential risks, while the FSI focuses on monitoring stress.

The FSVM will be released quarterly rather than semiannually. The FSI will be updated daily.

“The logic for two monitoring tools is simple: Just as monitoring health requires tracking both blood pressure and body temperature, monitoring financial stability requires tracking both vulnerabilities and stress,” the announcement says.

The FSVM is a heat map of 58 indicators of potential vulnerabilities. It gives early warning signals for further investigation, not conclusive evidence of vulnerabilities. We investigate these signals as part of our broader monitoring and assessment.

This monitor has six categories of indicators that reflect key types of risks that have contributed to financial instability in the past: macroeconomic; market; credit; solvency and leverage; funding and liquidity; and contagion. The colors in the heat map mark the position of each indicator in its long-term range. For example, red signals that a potential vulnerability is high relative to its past. Orange signals that it is elevated. Movement toward red indicates that a potential vulnerability is building.

The latest monitor shows red or orange signals in a number of areas, including key asset valuations and risk premiums, some consumer and nonfinancial business debt ratios, and federal government debt and deficits. The OFR’s full assessment of these potential vulnerabilities and others will appear in our forthcoming 2017 Financial Stability Report.

The FSI is a daily market-based snapshot of stress in global financial markets. It is constructed from 33 financial market indicators. The indicators are organized into five categories: credit; equity valuation; funding; safe assets; and (5) volatility.

The index measures systemwide stress. It is positive when stress levels are above average, and negative when stress levels are below average. Unlike financial stress indexes produced by others, the OFR’s FSI can be decomposed into contributions from each of the five categories. It also can be broken down by the region generating the stress.

The OFR’s FSI has other novel elements and methodology. It uses a dynamic process to account for changing relationships among the variables in the index. The daily frequency improves on the weekly or monthly frequency of other FSIs.

Currently, the FSI shows that overall stress in the financial system is near its lowest level since the 2007-09 financial crisis. Extremely low volatility is the largest contributor to the low stress level. Low volatility may lead investors to take more risks. As discussed in the OFR’s recent Financial Markets Monitor, this behavior can make the financial system more vulnerable to shocks.

 

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