Features of the enhanced capital requirement

• First, in keeping with the macroprudential aims of SIFI regulation, an additional capital requirement should be calculated using a metric based upon the impact of a firm’s failure on the financial system as a whole. Size is only one factor to be considered. Of greater importance are measures more directly related to the interconnectedness of the firm with the rest of the financial system. Several academic papers try to develop this concept based on inferences about interconnectedness from market price data, using quite elaborate statistical models. Others have proposed using more readily observed factors such as intra-financial firm assets and liabilities, cross-border activity, and the use of various complex financial instruments.

• Second, the metric should be transparent and replicable. In establishing the metric, there will be a trade-off between simplicity and nuance. For example, using a greater number of factors could capture more elements of systemic linkages, but any formula combining many factors using a fixed weighting scheme might create unintended incentive effects. On the other hand, using a small number of factors that measure financial linkages more broadly might reduce opportunities for unintended incentive effects, but at the cost of some sensitivity to systemic attributes of firms. Whatever the set of factors ultimately chosen, the metric must be clear to financial firms, markets and the public.

• Third, the enhanced capital standards should be progressive in nature. Dodd-Frank itself mandates that they “increase in stringency” with the systemic footprint of the firm, though the statute gives the Federal Reserve Board discretion in deciding how to realise this goal. There are good reasons for this requirement. Systemic importance is not a binary determination, but one of degree. A related point is that it is generally better to avoid cliff effects, whereby significant regulatory consequences ensue based on relatively modest differences among firms. On this point, I would note that, while Dodd-Frank requires us to apply enhanced capital standards to all bank holding companies with more than $50 billion in assets, we would not want a big difference between the capital requirements for firms with assets just over that level and those just under that level. Thus the supplemental capital requirement for a $50 billion firm is likely to be very modest.

• At the same time, it is important to build in constructive incentive effects. That is, the regulatory structure for SIFIs should discourage systemically consequential growth or mergers unless the benefits to society are clearly significant. There is little evidence that the size, complexity and reach of some of today’s SIFIs are necessary in order to realise.

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