The report presents a methodology to compute and smooth a systemic-risk-based capital surcharge. It also formally examines whether a mandate, by itself, to explicitly oversee systemic risk, as envisioned in some recent proposals, is likely to be successful in mitigating it.
The report aims to contribute to the debate on systemic-risk-based regulation in two ways. First, it presents a methodology to compute and smooth a systemic-risk-based capital surcharge. Second, it formally examines whether a mandate, by itself, to explicitly oversee systemic risk, as envisioned in some recent proposals, is likely to be successful in mitigating it.
Systemic-Risk-Based Surcharges
While not necessarily endorsing the adoption of systemic-based capital surcharges, the first part of the chapter presents a methodology to calculate such surcharges. Underpinning this methodology is the notion that these surcharges should be commensurate with the large negative effects that a financial firm’s distress may have on other financial firms—their systemic interconnectedness.
The chapter presents two approaches to implement this methodology:
• A standardized approach under which regulators assign systemic risk ratings to each institution and then assess a capital surcharge based on this rating.
• A risk-budgeting approach, which borrows from the risk management literature and determines capital surcharges in relation to an institution’s additional contribution to systemic risk and its own probability of distress.
Regulatory Architecture
The chapter also argues that an important missing ingredient from most architecture reform proposals is the analysis of regulators’ incentives—including regulatory forbearance incentives to keep institutions afloat when they should be unwound—that will likely vary across the alternative ways the regulatory functions could be allocated.
In particular, the chapter shows how adding a systemic risk monitoring mandate to the regulatory mix without a set of associated policy tools does not alter the basic regulator’s incentives at the heart of some of the regulatory shortcomings leading to this crisis. In fact, in the absence of concrete methods to formally limit the ability of financial institutions to become systemically important in the first place— regardless of how regulatory functions are allocated—regulators are still likely to be more forgiving with systemically important institutions than with those that are not.
For this reason, it is necessary to consider more direct methods to address systemic risks, such as instituting systemic-risk-based capital surcharges, applying levies that are related to institutions’ contribution to systemic risk, or perhaps even limiting the size of certain business activities. Which measures are finally chosen will have a significant impact on the financial sector.
© International Monetary Fund
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