Cleveland Fed on a Tiered System for Systemically Important Financial Institutions

James Thomson, an economist at the Federal Reserve Bank of Cleveland, has proposed his own tiered system for banks and financial institutions. The Obama administration has proposed a three tiered system with Tier 1 being the category of firms explicitly labled too big and interconnected to fail. Thomson and the Cleveland Fed have instead has propsed a five category way of looking at regulating financial companies, including systemically important financial institutions (SIFIs).

Thomson writes:

Of the five categories, only three would contain financial institutions that are considered systemically important. The rationale for a five-category system is that it allows for more consistent application of regulatory taxes and supervisory oversight across categories, following the notion that differential supervision and regulation can level the playing field by mitigating the advantages financial institutions derive from systemic importance. The categories would likely be defined as follows:

Category 1—Financial institutions that would be considered SIFIs on the basis of size alone (the classic too big to let fail category) or to concentration (the firm is a dominant player in an economically significant financial market or activity)

Category 2—Financial institutions that are systemically important because of interconnectedness (interbank or inter-firm exposure, also known as contagion)

Category 3—Financial institutions that are systemically important as a group because of correlated risk exposures (the too many to fail problem). Also included in category 3 would be financial institutions that are systemically important because of conditions or context

Category 4—Large fi nancial institutions that are not systemically important but whose failure could have economically signifi cant implications for regional economies. This category would include large regional banking companies and large insurance companies.

Category 5—Financial institutions not included in the other categories, consisting primarily of community financial institutions.

The thing is that even this system still doesn’t get rid of the TBTF policy that will lead banks into making poor decisions and leave the taxpayer on the hook for saving big financial institutions down the road. We should be changing our national attitude towards SIFIs to say that, even if their collapse is felt by the system, that pain is a natural part of growth. Firms should be prepared to handle the collapse a creditor. Firms should have contingency plans for bad times. But if firms believe the government will save the day, then why spend the time preparing? Why set aside money that can be used to make more profit, if the taxpayers will throw in money when needed.

Whether Tier 1 or Category 5, the regulation overhaul plan still creates the potential for Citi Mac and JP Morgan Mae.

The Cleveland Fed has also put together a simplified, 9-minute video explaining the tiered system UPS drawing board guy style.

Anthony Randazzo

Anthony Randazzo is a senior fellow at Reason Foundation, a nonprofit think tank advancing free minds and free markets.