The Basics of Systemic Risk

The “systemic” label is used for banks whose failure might trigger a financial crisis.

Currently, regulations designate all financial institutions with more than $50 billion as systemic. This one-size-fits-all approach is flawed and is improperly calibrated, failing to take into account true measures of risk. Plus, this diverts capital away from local economies and inhibits economic growth. Congress should explore defining systemic risk to focus regulation on preventing a repeat of the 2008 financial crisis, and to assure that traditional regional banks are able to more efficiently help local communities create jobs and grow their economies

How Regional Banks Stack Up

From every risk perspective, regional banks are safe and sound: predominantly funded by deposits, characterized by high loan volumes with little in the way of risky capital markets activities. Their trading assets are less than one percent of their total assets, as are their broker dealer assets. Regional banks have less than one percent of the industry’s total credit default swap exposure. All of the derivatives contracts traded by regional banks total less than one percent of the total traded by the banking industry.

Using a test developed by the Financial Stability Board and the Basel Committee for Bank Supervision, recent studies, including one by the Treasury Department’s Office of Financial Research, have shown that regional banks do not exhibit the systemic risk factors attributed to the large Wall Street banks. That study concluded that JP Morgan Chase has a systemic risk score of 5.05 percent and Citigroup a score of 4.27 percent. None of the regional banks listed in the report have systemic risk scores exceeding 0.35 percent, mainly because the business model that regional banks operate is one of traditional lenders.

Changing the Way We View Risk

Instead of the current one-size-fits-all regulatory method, a more thoughtful, analytical approach would make for a safer and sounder financial system while freeing billions of capital for investment in good-paying American jobs. Congress needs to reexamine the definition of systemic in order to focus regulators on preventing a repetition of the 2008 financial crisis, and to assure that traditional regional banks are able to more efficiently help local communities grow their economies.

Systemic risk goes beyond conventional safety and soundness supervision and attempts to measure whether a bank’s failure could cause contagion and weaken other financial institutions. When the Dodd-Frank Act was enacted, it imposed significant systemic risk regulations on regional banks based on an arbitrary asset number of $50 billion, rather than taking into account a bank’s risk profile or business model. Since then, regulators at the Financial Stability Board and the Basel Committee for Bank Supervision have developed a more precise test to measure systemic risk by examining five factors: size, interconnectedness, complexity, global activity, and dominance in certain customer services, also known as substitutability.

I would have to say also it’s not just size…I think it has to do with opacity, complexity, interconnectedness, and a variety of other things. So it’s hard than just saying—you know, putting a size limit or something like that.”

– Ben Bernanke, Former Federal Reserve Chairman