An understanding of Systematic Important Banks (SIB)

What is SIB?

There was this time prior to 2007-08 global financial meltdown, when the big players in the United States of America’s financial market players such as Lehman Brothers, Merill Lynch, AIG, Freddie Mac were considered to be humongous and stable organizations that can neither be collapsed nor get bankrupted.

This was merely a theory supported by human psychology and not on mathematical integers. A belief had crept in that like a gigantic tree, a colossus company cannot face bankruptcy, as it would have lot of avenues to acquire further capital in the event of any hostile situation. Taking example of our Indian  companies such as SBI or ICICI Bank which offers various kinds of products and services. In financial term, it is known as diversification of its base, the exposures portfolios are well balanced and in the event of loss in one portfolio, other portfolios will keep generating the revenues to support its existence. The companies are also publishing huge reserves and surpluses. Moreover in case of any unfavorable event or crisis kind of scenario, the regulatory body will come to bail out the banks. Isn't it the best thing in financial world? It’s like the company is carrying a parachute and a reserve parachute in case of malfunction.

However the economy and the financial world does not operate on linear equation. It is way more complicated than that. A large Bank if faces a liquidity crunch out of short on cash / fund flow, loss due to exposures, market downturn or any other financial crisis, which would be very much venerable to Run on Bank. In the event of a Run on Bank, creditors get apprehensive of the stability of the banks, depositors panic, potential Investors become cautious and the capital market loses confidence on the stock. A mere rumor of liquidity crunch is enough to crumble the market and break the trust of people even though for a short time. What happens afterwards needs no detailing. The support from the government can help the giant to stay afloat for a while but the damage is done.

A giant financial institution (FI) in crisis is not only the internal problem of the institution alone, but the entire financial market and it may turn the economy at large the arena of bloodshed. The Bank/ FI on its regular activities will have bulk of open positions with other banks and FIs. Not only domestic but also having exposures in overseas. A Bank / FI under stress will send shock waves to the entire area of its operations. The commitments will be breached, the payments will be defaulted and the Bank/FI will struggle to meet the outflows. The payment defaults will create burden on counter parties that will deepen the crisis further. The bigger and complicated the Bank /FI is, the bigger cascading effect it will create. The outcome of this will create a scenario where the small institutions will face severe funding crisis. An outcome of collapse of the giant FI is the ripple effect which will tear down the financial sector and send the economy under severe distress.

So what did we learn from the 2007-08 recession? The important lessons we have are: the Banks/FIs which are considered as Too big To Fall (TBTF) are not always immune to the risk. The monetary intervention by government can save the bank/FI but cannot stop the ripple effect in the economy completely. And, the impact of fall of a TBTF would spread through the financial sector, invoking the systemic risk in manifold. Please note here, the systemic risk associated with a particular sector cannot be mitigated by diversifying its exposure portfolios. It is there in every layer of the industry. The Banks /FIs are part of systemic risk and also influence the intensity with their actions.

The Banks which are having potential to send high disruptive shock waves in the real economy during their distress period are considered as Systemically Important Banks.

What BCBS Says?

In response the 2007-08 crisis, the Basel Committee on Banking supervision (BCBS) has come up with various reforms and steps to improve the resilience of banks and banking system. This included increasing of quality and quantity of capital, introducing leverage ratio, enhancing risk coverage, capital conservation buffer and counter cyclical buffer as an international standard for liquidity management. However all the steps were at general level and beneficial for the banks with moderate complexity level. Given the business model of a banking giant, it require special treatment and supervision to control or mitigate the spillover of risk to the financial industry or economy.

The BCBS has developed a methodology for assessing the Global Systemically Important Banks (G-SIBSs). The indicator based measurement approach captures the features of a bank such as: the size of the bank, cross-jurisdictional activities, and interconnectedness, lack of substitutability and complexity of the bank. Indicators are again classified into various categories. The methodology gives equal weightage of 20% to these 5 indicators. The score of a particular indicator is calculated by dividing the value of the indicator (expressed in EUR) by the aggregated sum of values of all the banks combined for the same indicator. The banks having the score more than the threshold limit set by the BCBS are considered as G-SIBs.

What RBI Follows?

The RBI adopted the BCBS methodology however the banks are selected for computation of systemic importance on the basis of their size. In order to avoid the burden on the small banks which does not have much systematic importance, size criteria is applied. The RBI assesses systematic importance of those domestic banks whose size as per Basel III leverage ratio exposure measure exceed 2% of the GDP. In short, the RBI filters out all those banks which does not qualify the size criteria of 2% of GDP scale. The size is given more importance as it was felt that size is the most important indicator of all.

Compared to BCBS, the RBI has taken into account 4 indicators namely: Size, Interconnectedness, Substitutability and Complexities. The indicator “Cross Jurisdictional activity” is included as a sub indicator under “Complexity” A weight of 40% is allocated to the size, wherein the remaining 60% is equally distributed among the sub-classifications of the 3 indicators.

The score of an individual indicator score is calculated by dividing the indicator value in Rupee by the aggregated value of the indicator collated from all the banks. The overall score of SIB is calculated by multiplying the indicator scores with the weightage allocated to the respective indicators.

What are the implications?

The RBI has identified the Domestic SIBs, now what? The implications of being identified as SIB are as follows: 1) Additional Capital requirement 2) Stringent measures on risk mitigation tools and 3) Differentiated supervisory implications

Additional Capital requirement: The SIB banks are arranged in buckets according their SIB scores. Every bucket is design to provide the additional capital requirement. The SIB qualifying under a particular bucket needs to maintain the additional Common equity Tier 1 capital over the regulatory prescription.

Stringent Measures on risk mitigation tools: Though the RBI has not come up with any regulatory measures such as liquidity surcharges, tighter large exposure restrictions, etc. for the identified SIBs, the same may be implemented on a later date when international frameworks on these aspects are decided to by BCBS.

Differentiated supervisory implications: The RBI based on the recommendation of Financial Stability Board (FSB) applies differentiated supervisory assessment of risk and compliance in the banks. The intensity of supervision, periodicity and the risk focus are aligned based on the risk profiling of the banks. The banks identified as SIB no doubt will experience a tighter and stringent supervisory review and assessment process.

Domestic-SIBs in India

The RBI has recently added the name of HDFC bank in the list of SIB already populated by SBI and ICICI bank. As per the bucketing of the SIBs, the SBI (in bucket 3) will have to maintain 0.30% of additional CET1 capital as a percentage of Risk weightage assets (RWA) for the financial year 2017-18, The ICICI bank is in bucket 1 and therefore needs to maintain 0.10 % CET1 capital. The newly identified HDFC bank has positioned itself in bucket 1, and need not maintain any capital during the current FY 2017-18. However from FY 2017-18 it will be required to hold the extra capital as per the RBI's capital matrix.

Conclusion:

The Too Big To Fall theory states that the large banks and FIs which satisfy all the criteria of SIB are too valuable, their economies of scale is worth preserving. In case any adverse situation is faced by such institutions, the government and regulator must intervene to save from the fall to avoid any spillover of the financial stress in the economy, just like Adam Smith's invisible hand in economics.

Such intervention must be proactive by installing safeguards beforehand without waiting for a crisis. Isn't it better to make the banks well capitalised and ready for any misadventure of financial market instead of preparing a bailout package at the last moment of the financial crisis.