Systemically important banks: From G-SIB to D-SIB identification and regulation Jan Frait

1. Systemically important banks: From G-SIB to D-SIB identification and regulation Jan Frait Executive Director Financial Stability Department June 2013

2. Outline I. Chronology of the G-SIB and D-SIB debate II. Concept of systemic importance III. How to identify SIBs in the Czech banking sector IV. BCBS recommendations for D-SIB regulation

3. I.The G-SIB and D-SIB debate thus far... 3

4. Chronology of the G-SIB and G-SIFI debate 2009: April G20 meeting endorses plan to strengthen resilience of globally operating banks (G-SIB) In October IMF, BIS, FSB issue “Guidance to assess the systemic importance of financial institutions, markets and instruments” 2010: October G20 meeting approves FSB document “Reducing the moral hazard posed by systemically important financial institutions” 2011: June G20 meeting confirms intention to increase capital requirements for G-SIBs In November BCBS issues “Global systemically important banks: Assessment methodology and the additional loss absorbency requirement”: SIB surcharge 1–2.5% CET1 November G20 meeting endorses FSB’s policy framework on systemically important financial institutions (G-SIFIs); initial list of 29 G-SIBs published 4

5. From G-SIB to D-SIB 2011: At November G20 meeting FSB is asked to work, in consultation with BCBS, on definition of modalities to extend expeditiously G-SIB framework to domestically important banks (D-SIBs) 2012: In October the FSB issued final version of framework for D-SIB identification and regulation Some countries are at advanced stage of their own D-SIB framework preparations (SE, NL, CH) with intention to implement them as soon as possible (in some cases from 2013 onwards) CH – SIFIs will have 10% CET1 plus 9% contingent capital SE – SIFI surcharge up to 5% CET1 NL – SIFI surcharge 1–3% CET1 5

6. CET1 capital for Swedish SIFIs 2.5% Capital conservation buffer 3.0 % SIFI-surcharge 4.5% Minimum requirement Countercyclical buffer 0-2,5 % Countercyclical buffer 12 % 2.5% 0-2,5 % 10 % Countercyclical buffer 5.0 % 0-2,5 % 7% 2.5% Capital conservation buffer 4.5% 4.5% 2% Minimum requirement 2% Minimum requirement Proposed 2013 Proposed 2015 Current requirement Basel III

7. CET1 capital for Nordic SIFIs Source: ICMA

8. From G-SIB to D-SIB 2013: CRD IV/CRR – OSII buffer, systemic risk buffer Major deviation from BCBS recommendations 8

9. II.Concept of systemic importance 9

10. Defining Systemically Important Financial Institution • For the purposes of microprudential supervision a SIFI can be defined as an institution whose failure would cause its creditors and shareholders to suffer large losses in the form of direct costs. • From a macroprudential perspective, SIFI is a system component that contributes significantly to the accumulation of systemic risk and/or whosefailure would impose large losses on its surroundings and would threaten the smooth functioning of the system as a whole and have adverse knock-on effects on the real economy. Komárková, Hausenblas and Frait(2012, CNB FSR 2011/2012) • Macroprudential factor is more important, since it is the indirect impacts on the SIFI’s surroundings which have the potential to trigger a major and protracted crisis.

11. Defining Systemically Important Financial Institution A SIFI can be defined from the negative point of view as an institution whose uncontrolled failure has the potential to seriously damage the financial system, but it can also be defined from the positive point of view as an institution whose viability is crucial for the smooth functioning of the financial system and the real economy. What do SIFIs entail in practice: positive externalities (economies from scale/scope, cross-border allocation of resources…), moral hazard (SIFI enjoys its „too-important-to-fail“ statute – implicit government guarantee distorts the markets), negative externalities (SIFI contributes to systemic risk which it is not able to fully manageneither it bears the costs). 11

12. Imperfect markets and moral hazard • Implicit government guarantees encouraged large banks to take on more risks. • Limited liability creates distorted incentives. • Debt holders incorporate the guarantees into the price of funding → debt is too cheap and the big get even bigger. • Risk-taking, high-leverage → probability of a crisis is higher. • High burden on tax-payers + negative impact on economic growth. • The gap further widened after the outset of crises. • The crises only increased the level of concentration when guarantees became more explicit.

13. Concept of systemic importance • Thomson (2009): • Size and concentration (too big to fail) • Interconnectedness and risk of contagion ( to interconnected to fail) • Degree of similarity and correlation of exposures (too many to fail) • Context (economic and political conditions). • Size is hardly the only factor. • We should not reduce the problem to “too-big-to-fail” or “too-important-to-fail”. • SIFI is a complex component of the structural dimension of systemic risk.

14. The role of macroprudential policy • Identification of SIFIs. • Measures to restrict the • size, complexity and scope of SIFIs… • Measures to reduce the probability of failure (PD): • capital surcharge, intensive supervision, • disclosure/transparency, • bail-in approach. • Measures to reduce potential costs of failure (LGD) via • ring-fencing, • effective resolution framework, • mandatory resolution plans (goodwill).

15. III. Identification of Systemically Important Banks in the Czech Banking Sector

16. Methods for identification of SIFI (1) • Econometric models (PDxLGD approach) • losses of the system as a whole analyzed, SIFIs are banks with largest contributionsto systemic events, • CDS (or equity prices or any market indicator) covariance during extreme events, • bias in market prices not accounted for due to assumption of highly effective markets (market participants may include bail-out in prices in reality). • Computational simulations, stress-testing (LGD) • simulation of whole spectrum of shocks • free to implement any channel (usually defaults of one or more banks, fire-sales, liquidity shocks, …), • for each bank a distribution of losses (resulting from its default) born by the rest of the economy is estimated, • shapley value, extreme value observations… • generally rather academic.

17. Methods for identification of SIFI (2) • Methods of quantitative and qualitative indicators (LGD) • systemic importance derived from simple indicators, • can be easily to implemented, • make use of data from regular reporting (supervision, payment system, Bankscope, …) – (off-)balance sheet exposures, transactions • considerable amount of expert judgment is necessary, • problem of setting the threshold (do we really need it?)

18. Underlying paper • CNB‘s Financial Stability Report 2011/2012 (June 2012) • feature article „How to Identify Systemically Important Financial Institutions”, • The objective of the article is to show the results of the SIFIs identification in the Czech banking sector using the BCBS method developed for G-SIB identification.

19. Indicators of systemic importance • BCBS (2011) method derives systemic importance from indicators aggregated into five categories: • Size • Cross-border activity • Interconnectedness • Non-substitutability/uniqueness • Complexity. • Only quantitative indicators‘ method applied, a set qualitative judgment by experts and supervisors should come next. • balance-sheet and off-balance-sheet indicators, • network analysis based on data from interbank money market and payment system.

20. Size and cross-border activity • Size • the most natural measure of SIFI, • balance sheet size and business activity, • indicators: total assets, credit exposure, revenues. • Cross-border activity • potential channel of contagion from abroad, • includes exposures to foreign sovereign risk and links to parent firms, • indicators: liabilities and assets with foreign entities.

21. Interconnectedness • Interconnectedness • the problems of interconnected institutions directly threaten the rest of system through mutual exposures, • default of an interconnected bank entitles huge losses for its counterparts on interbank market, for counterparts of counterparts etc, • domino effect increases systemic stress, may contract interbank market and boost credit and liquidity risk. • indicators: centrality in network of exposures, assets and liabilities to credit institutions.

22. Limited substitutabilityand complexity • Limited substitutability/uniqueness • some institutions provide unique services for the rest of the economy so that they cannot be easily and promptly replaced. • it can be a small institution in absolute terms, but it form a market on its own (CCP, stock exchange, insurance…). • indicators:assets under custody, payments cleared and settled through payment systems, values of underwritten transactions in debt and equity markets (not implemented yet).

23. Limited substitutabilityand complexity • Complexity • increases risks of insufficient supervision, regulatory arbitrage and costly crises resolution. • indicators: trading book value and available for sale value, level III assets (irrelevant in CZ), OTC derivatives notional value (not implemented yet).

24. Indicator-based method – data • Both supervision and payment system integrated in the CNB → in-house data. • detailed balance-sheet reporting, • 15 largest exposures to credit institutions (to built the interbank market network), • payment system transactions (to built payment system network), • off-balance sheet items.

25. Network analysis and the concept of centrality • Position in a network (importance of individual nodes/banks) is given by both number and size of exposures and by the topology (shape) of the network. • To avoid performing complex network simulations of contagion we can reduce the analysis to measures of centrality. • Heavily used in other sciences (physics, information theory and social sciences…) • Are there some central nodes of the network (hubs) that may be critical for performance of the whole system?

26. Centrality measures (1) • Degree • Number/total size of interbank claims or liabilities • Betweenness • How does the bank interconnect all the parts of the network, • Better reflects the whole structure of the network, • Eigenvector centrality • Connectedness to highly interconnected banks

27. Centrality measures (2) Cumulative degree distribution • Financial networks have scale-free properties – efficient and quite robust but heavily dependent on few of its elements.

28. Results of the network analysis (MM) Network analysis: Position in network (importance of individual nodes/banks) is given by both number and size of exposures and by the shape of the network Interconnectedness points to 5 potential SIBs (other categories lead to different numbers) By size, interbank exposures are not dominant in banks’ balance-sheets. Nodes with the fewest links are located at the edge; the interconnectedness of the nodes increases towards the centre. Account is taken of the number, size (indicated by the thickness of the link) and frequency of the links. 29

29. Indicator-based method – results (1) • All factors of systemic importance have similar distribution: • low number of banks with high values (high importance) and large number of banks with low value. • Systemic importance is highly concentrated in the Czech banking system in all dimensions. • Large number of bankswithlow values of indicators • High values of indicators in case of a few banks

30. Indicator-based method – results (2) • Indicators are unique (low overlap) • Systemic importance cannot be reduced only to size. • However, the biggest banks are also the most interconnected, active in cross-border business etc… Higher triangle does not cover five on average most important banks. Lower triangle of correlation matrix computed on full sample.

31. Indicator-based method – results (3) • Four banks have composite indicator of significance above average for whole sector – these may be labeled SIBs • Other banks that have below-average indicators of importance (they form a cluster below the line) • Weighted averages: • Baseline BCBS: equal weights • Alternative 1: accounted for features of Czech banking (lower weight to interconnectedness and complexity). • Alternative 2: assumption of potential increase in interconnectedness and complexity in the future. 32

32. Possible improvements of the method • Additional indicators? • share of deposits insured by the Deposit Insurance Fund on the total size of the Fund. • interconnectedness to specific “systemically important” corporations or industries. • burden of potential “bridge bank” on the public budget.

33. Beware • BCBS method can be used to sort a list of institutions according to their importance and for identification of a group of banks with high deviation from average importance. • The approach cannot tell the banks capable to absorb systemic risk from those that can spread it in the financial sector or to the real economy. • The approach is therefore not directly usable for setting the SIB capital surcharges (SCS) for individual banks. • Further analysis (especially of substitutability and complexity) and additional methods (correlation of balance sheets) would be necessary. • No method can be applied mechanically, expert judgment is necessary.

34. SCS setting When setting SCSs it is vital to start by realising that the objective is primarily macroprudential. The aim is not to stop SIFIs from getting into trouble or failing, but to at least partially reduce the likelihood of systemic crises, and in particular (as in the case of countercyclical capital buffers) to reduce the intensity of such crises by absorbing the negative impacts of SIFI failures. SCSs should therefore enhance the resilience of the system in terms of loss absorbency. The usual objection to SCSs is that capital is costly and SCSs force banks to downsize their balance sheets. The advocates of SCSs usually respond to this objection by saying that investors in bank shares are currently demanding a higher rate of return than investors in non-financial corporations’ shares, because banks are more leveraged and therefore more risky. If SCSs cause leverage to fall, banks will become less risky and investors will not demand such high returns on their shares. And if SIFIs decide not to provide some types of loans because of SCSs, they will be substituted by smaller non-SIFI banks subject to lower capital requirements. 35

35. SCS setting Another argument against the introduction of SCSs is based on economies of scale and states that the global financial system needs SIFIs. This argument is undermined by the fact that some global banks have expanded well beyond the point at which the economies of scale can increase any further and which is needed to fund activities in the global economy. Consequently, the main argument against identifying SIFIs and imposing SCSs is still that labelling an institution as a SIFI leads to growth in the moral hazard associated with it, since both it and the public are being told de facto that it is “too important to fail”. The counter-argument is that market participants do not need a formal label to know which institutions are systemically significant. In this situation, imposing capital surcharges on such an institution can only reduce its riskiness, as they will cause individual and economy-wide expectations of its profitability to converge. This is because the surcharges will increase the institution’s funding costs, which were previously held down because the market regarded it as being too important to fail. 36

36. SCS setting In principle, SCSs should be set to reflect the difference between the private and social profitability of the SIFI. Consequently, the size of the SCS should create an incentive for SIFIs to stop expanding, to stop becoming more interconnected and to stop taking on more risks if there are no related benefits for the economy as a whole. On the general level, the calibration of SCSs should be based on an estimate of the potential impact of SIFI failures on the entire financial system, which should be compared with the costs of additional regulation. This implies that the principal factors when setting SCSs should be those which determine the potential impact of failures. If we accept the assumption that SIFI failures are the exception rather than the rule since most SIFI resolution situations end in rescue, the expected social costs of a SIFI rescue operation should be relevant for determining the SCS. Those costs can be determined by the institution’s expected losses in a worst case scenario. This is why the Basel Committee focused directly on the additional capital needed to absorb SIFIs’ losses when formulating its SCS recommendations. 37

37. SCS setting The models used by the BCBS to estimate this capital produced results lying in a wide range of 1–8% of risk-weighted assets in terms of CET1 equivalent, with a central tendency of around 2–4%. The final recommended calibration for G-SIBs of 1–2.5% was therefore in the lower half of the range of estimates. This low SCS calibration assumes coverage by high-quality capital capable of fully absorbing losses. If the risks of SIFIs are to be covered also by lower-quality capital, the total SCSs should be set at a higher level. SCSs are just one of the elements that can mitigate the systemic risks associated with SIFIs. The resolution framework occupies first place in the overall G-SIFI supervisory framework. The specific resolution rules should allow a SIFI to remain a going concern during a crisis, and the shareholders must accept losses associated with the institution’s poor financial condition. 38

38. IV. BCBS recommendations for D-SIB regulation(A framework for dealing with domestic systemically important banks, October 2012) 39

39. BCBS principles for the D-SIB framework General approach: Framework has to be based on assessment by local authorities, who are best placed to identify which banks are systemic within their borders G-SIB framework is overly prescriptive and application largely mechanical; D-SIB framework should be more principle-based and include appropriate degree of national discretion Necessary to avoid “double counting” of capital for D-SIBs that are part of G-SIBs or D-SIB subsidiaries that are part of D-SIB parent groups A D-SIB framework is best understood as taking the complementary perspective to the G-SIB regime by focusing on the impact that the distress or failure of banks (including by international banks) will have on the domestic economy. Home authorities should assess banks for their degree of systemic importance at the consolidated group level, while host authorities should assess subsidiaries in their jurisdictions, consolidated to include any of their own downstream subsidiaries, for their degree of systemic importance. 40

40. BCBS principles for the D-SIB framework – assessment methodology The impact of a D-SIB’s failure on the domestic economy should, in principle, be assessed having regard to bank-specific factors: (a) Size; (b) Interconnectedness; (c) Substitutability/financial institution infrastructure (including considerations related to the concentrated nature of the banking sector); and (d) Complexity (including the additional complexities from cross-border activity). In addition, national authorities can consider other measures/data that would inform these bank-specific indicators within each of the above factors, such as size of the domestic economy. National authorities should have national discretion as to the appropriate relativeweights they place on these factors depending on national circumstances. National authorities should publicly disclose information that provides an outline of the methodology employed to assess the systemic importance of banks in their economy. 41

41. National authorities may choose to include some country-specificfactors. A good example is the size of a bank relative to domestic GDP. If the size of a bank is relatively large compared to the domestic GDP, it would make sense for the national authority of the jurisdiction to identify it as a D-SIB whereas a same-sized bank in another jurisdiction, which is smaller relative to the GDP of that jurisdiction, may not be identified as a D-SIB. See Skořepa, M.-Seidler, J. (2013): An Additional capital requirements based on the domestic systemic importance of a bank. Czech National Bank Financial Stability Report 2012/2013, pp. 96-102 BCBS principles for the D-SIB framework – assessment methodology 42

42. National authorities should document the methodologies and considerations used to calibrate the level of HLA that the framework would require for D-SIBs in their jurisdiction. The HLA requirement imposed on a bank should be commensurate with the degree of systemic importance. National authorities should ensure that the application of the G-SIB and D-SIB frameworks is compatible within their jurisdictions. Home authorities should impose HLA requirements that they calibrate at the parent and/or consolidated level, and host authorities should impose HLA requirements that they calibrate at the sub-consolidated/subsidiary level. The home authority should test that the parent bank is adequately capitalised on a stand-alone basis, including cases in which a D-SIB HLA requirement is applied at the subsidiary level. The HLA requirement should be met fully by Common Equity Tier 1 (CET1). In addition, national authorities should put in place any additional requirements and other policy measures they consider to be appropriate to address the risks posed by a D-SIB. BCBS principles for the D-SIB framework – higher loss absorbency (HKA, ie. SCS) 43

43. Discussions whether and how implement D-SIB surcharge in CRD IV. SIB identified on national level and allocated to 5 categories according to systemic relevance. Surcharge 1% plus 0,5% for each subsequent category The general approach discussed in the final stage finally not containing this concept. However, the systemic risk buffer may serve regulators as a substitute. Some EU authorities still signal readiness to go for it as soon as possible. The way of introducing the SIB surcharge difficult to predict On which level, who decides, what size, how to avoid duplicities between G-SIB and D-SIB? Banking union consideration may have some impact. D-SIB regulation in the EU 44

44. Děkuji za pozornost www.cnb.cz Prof. Dr. Ing. Jan Frait ředitel samostatného odboru finanční stability Jan.Frait@cnb.cz Kontakt na samostatný odbor finanční stability ČNB: E-mail: financial.stability@cnb.cz http://www.cnb.cz/cs/financni_stabilita/

45. KP v Basel III ve formě equity:  4,5 % CET1 + 2,5 % konzervační polštář + až 2,5 % proticyklický polštář. Celkový požadavek je: minimum Tier1 6% (CET1 4,5 % - other T1 2,5 %) + Tier2 2 % + 2,5% konvervační polštář plus  až 2,5 % proticyklický polštář

47. Basel III capital – GS 1 • The starting point is Basel III new regulatory capitalization minimums (cont.): • Goldman Sachs view of Basel III (GS Global Investment Research): • CT1 ratio of 7% as the new regulatory minimum for banks of non-systemic importance - for banks deemed to be of systemic importance, the CT1 minimum is subject to an additional surcharge and is therefore to be set at a level above the 7% CT1 minimum. • A regulatory minimum is just that: a minimum. In practice, banks will aim to exceed the minimum to be on the safe-side; and exceeded it further, before capital return to shareholders is considered. 7% is not the “magic” number; rather, it is a floor. • From an equity investor’s perspective, the relevant level of capital is not the regulatory minimum but rather one above which all key parties—bank managements, regulators, debt holders, “the market”—would not object to capital being returned to shareholders. This level—the GS target capitalization—will also differ among banks.

48. Basel III capital – GS 2 • The starting point is Basel III new regulatory capitalization minimum • Goldman Sachs view of Basel III