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Rather than discuss whether to rescue or not, it is sensible to regulate ex ante financial institutions whose failure is likely to have major impacts on the financial and real sectors of the economy; for instance, regulate them to reduce their risk, and consequently the probability that taxpayers will face this choice.
Effective and efficient regulation of this type requires identification of systemically important financial institutions. A typical definition has been provided by Federal Reserve Governor, Daniel Tarullo, (2009): “Financial institutions are systemically important if the failure of the firm to meet its obligations to creditors and customers would have significant adverse consequences for the financial system and the broader economy”. This definition is useful because it highlights two important ideas. The first is that the core problem is a firm’s difficulty in performing financial services when it fails, i.e. when its capital falls short. The second is that systemic risk matters only to the extent there is an impact on the broader economy. There is a large theoretical and empirical literature that supports these two ideas.
The definition, however, misses a key feature of systemic risk. Systemic risk should not be described in terms of a financial firm’s failure per se but in the context of a firm’s overall contribution to system-wide failure. The intuition is straightforward. When only an individual financial firm’s capital is low, the firm can no longer financially intermediate. This has minimal consequences though, because other financial firms can fill in for the failed firm’s void. When capital is low in the aggregate, however, it is not possible for other financial firms to step into the breach. This breakdown in aggregate financial intermediation is the reason there are severe consequences for the broader economy.
Motivated from this one economic point, it is possible to provide a precise definition of the systemic risk of a financial firm. Acharya, Pedersen, Philippon, and Richardson (2010) develop a simple model in which a group of banks set leverage levels and choose asset positions in a broader economic environment with systemic risk emerging when aggregate bank capital drops below a given threshold. Within this framework, they show that the systemic risk of a firm is equal to the product of three components:
Real systemic risk of a firm = Real social costs of a crisis per dollar of capital shortage x Probability of a crisis (i.e. an aggregate capital shortfall) x Expected capital shortfall of the firm in a crisis
The focus of this column is on the third component, namely the expected capital shortfall of a firm in a crisis. Expected capital shortfall captures in a single measure many of the characteristics considered important for systemic risk such as size, leverage, and interconnectedness (e.g. Financial Stability Oversight Council 2011, formed in the US following the Dodd-Frank Act of 2010, for the determined regulatory factors for assessing systemic risk of financial firms). All of these characteristics tend to increase a firm’s capital shortfall when there are widespread losses in the financial sector. But a firm’s expected capital shortfall also provides an important addition, most notably the co-movement of the financial firm’s assets with the aggregate financial sector in a crisis.
Stress tests are a standard device used to determine the capital that an institution will need to raise if there is a financial crisis. Under the Dodd-Frank Act, the regulators in the US are required to conduct annual stress tests to assess capital adequacy of financial firms. The expected capital shortfall estimation we describe below can be a useful tool or substitute for such stress tests.