Essays on SYSTEMICALLY IMPORTANT FINANCIAL INSTITUTIONS

The regulation of systemically important financial institutions is an important task for the effective management of financial markets.

This question has received special attention during the crisis of 2008 – 2009, when the problems of several large participants in the U.S. financial system triggered instability of the global economy. Therefore, the identification and oversight of systemically important financial institutions are important to enhance macroeconomic stability.

In the literature there are several definitions of systemically important financial institutions. Praet (2010) proposed the following: “The financial company may be considered systemically important if it’s bankruptcy would have significant negative consequences for the financial system.”(Praet, 2010, p.3)

The size of the financial institution is often considered the main criterion of systemic importance. In 2009, the International Monetary Fund (IMF), together with the Bank for International Settlements (BIS) and the Council, including the Financial Stability Board (FSB) conducted a study in order to identify the characteristics which determine the systemic importance of the organization in different countries. The results showed that in the pre-crisis period, the size and the degree of interconnectedness of organizations considered to be the main determining parameters, and after the crisis were added the level of debt and the value of liquidity gaps (difference between assets and liabilities by maturity).

As a result of the crisis 2008 – 2009 the authorities of many countries have paid particular attention to the issue of regulation of systemically important financial institutions. In the report Financial Services Authority (FSA) discussed the concept of an action plan in case of insolvency (“living will”). Banks should have a plan of action for a period of crisis, including finding alternative sources of financing, sale of assets, and plan to increase capital. (FSA 2009)

On the other hand, regulators should also be prepared to address problems in connection with the default of the company in order to reduce losses to creditors and taxpayers. There are various proposals to limit the size and range of systemically important financial institutions.

FUNCTIONAL SEPARATION OF BANKING BETWEEN COMMERCIAL BANKING AND INVESTMENT BANKING

On February 2, 2011 the Financial Crisis Inquiry Commission (FCIC), chaired by Phil Angelides, released a study of the causes of the financial collapse of 2008. The report concluded that the main cause of the crisis was an attempt for the past three decades to get rid of measures to protect citizens, created by Franklin Roosevelt in the mid-twentieth century, including the Glass-Steagall Act. (Financial Crisis Inquiry Commission 2011)

The Commission pointed out two initiatives on Wall Street that contributed to the crisis. First, in November of 1999 was eliminated the Glass-Steagall Act. After the commission’s report, Angelides LaRouche has called for the restoration of Glass-Steagall Act. This proposal was put forward in the Senate but was blocked by Obama and his supporters.

It is therefore important to consider the essence of Glass-Steagall Act, to consider investment and commercial banks, and the problem of their separation in the United States.

Separation of investment banks and commercial appeared in 1933 in the United States according to the Glass-Steagall Act. In order to protect the banking system from the risk of systemic failure caused by failed transactions in the securities market, it was decided on the division of banking into two parts – the activities of investment banks and commercial banks.

The functions of commercial and investment banks in the United States were separated during the economic crisis 1929 – 1933’s., which led to the bankruptcy of many banks. Then it was considered advisable to isolate the long-term loans and financing from short-term credit operations. The separation of commercial and investment banks was due to the view that many commercial banks until 1933 were engaged in underwriting many high-risk securities. If some of these securities could not be sold at the minimum price, these securities just stayed in the asset portfolio of the bank.

It is also necessary to point that separation also means that commercial banks could not carry out some non-professional securities transactions (to invest in corporate securities), which is the main source of risk, as well as certain types of professional activity, which carry an increased risk (for example, dealers).

In 1999, according to the Graham-Leach-Bliley Act, the distinction in the United States was partially canceled, and commercial banks were allowed to open branches and subsidiaries, which could carry out transactions with securities. It should also be noted that in the last decade in the U.S. there is a “blurring” of the boundaries between investment and commercial banks due to certain amendments to the legislation extending the competence of commercial banks, as well as through the introduction of new types of banking operations (particularly financial derivatives) that do not directly fall under the existing restrictions.

In fact, separation of investment and commercial banks in the United States finally ended in 2008, as a result of the crisis, when investment banks were forced to take loans in the U.S. Federal Reserve. Because the loans from the Fed could get only commercial banks, all investment banks have received such a license.

Lets consider the arguments for the separation of banks.

Transactions in securities, as the activities of investment banks, are associated with greater risk than traditional banking. The investment bank could incur significant losses if it can not sell the securities at the price promised by the issuer. That is why investment activities of commercial banks can increase the number of bankruptcies and undermine the stability of the financial system.

This problem could rise due to the current federal deposit insurance system. Permission for commercial banks to carry out additional activities related to risk exacerbates the problem of misconduct and false choices. Another argument against operating of commercial banks in the securities market is the possibility of conflicts of interests of commercial banks while underwriting.

The debate on the question of whether to allow banks to conduct securities transactions have not been yet completed. However, the profit motive encourages banks, like other financial institutions, to intrude on the traditional territory of the business activity of each other.

Works cited
IIF. Systemic Risk and Systemically Important Firms: An Integrated Approach. London and Washington DC. 2010.
Gauthier C., Lehar A., Souissi M. Macroprudential Regulation and Systemic Capital Requirements. Bank of Canada Working Paper 4, 2010.
Financial Crisis Inquiry Commission. The Financial Crisis Inquiry Report, Authorized Edition: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States 2011
FSA. “A regulatory response to the global banking crisis: systemically important banks and assessing the cumulative impact”. Turner Review Conference Discussion Paper 09/4, 2009.
Huertas, T.F. “Systemically important financial institutions: an international perspective” Brussels, 2010.
IMF/BIS/FSB. “Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations Background Paper”. 2009.
IMF/BIS/FSB. “Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations”. 2009.
Marshal A. The Global Economic Crisis The Great Depression of the XXI Century. Global Research Publishers, 2010

Praet P. “Macro-prudential and financial stability statistics to improve financial analysis of exposures and risk transfers”. Fifth ECB Conference on Statistics on “Central Bank statistics: What did the finan-cial crisis change”. 2010
Segoviano M., Goodhart C. “Banking Stability Measures”. IMF Working Paper 09/4. 2009.
Sorkin Andrew S. Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System – and Themselves. Viking Adult, 2009
Tarashev N., Borio C., Tsatsaronis K. “The systemic importance of financial institutions”. BIS Quarterly Review, 2009.
Thomson J. B. “On Systemically Important Financial Institu-tions and Progressive Systemic Mitigation”. Policy discussion paper, 2009.
Zhou C. “Are Banks Too Big to Fail? Measuring Systemic Importance of Financial Institutions”. International Journal of Central Banking, 2010.

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