As I discussed in my previous post, the Dodd-Frank Act subjects "systemically important" nonbank financial firms to enhanced prudential standards and consolidated supervision by the Fed. All bank holding companies with over $50bn in assets — of which there are currently 36 — are also subject to the heightened Fed supervision. The enhanced prudential standards have to include capital requirements, leverage limits, liquidity requirements, and an ongoing resolution plan (or "living will"), among other requirements. So you can see why being designated systemically important would be a big deal for nonbank financial firms (which, for the sake of simplicity, I'll refer to in this post as simply "firms"). The Financial Stability Oversight Council (FSOC) is required to designate systemically important firms, and it has already gotten the ball rolling on this process.
So what makes a firm systemically important? Section 113 of Dodd-Frank deems firms systemically important if either (1) "material financial distress" at the firm would pose a threat to financial stability, or (2) the firm's ongoing activities pose a threat to financial stability. The "material financial distress" option is clearly the more important of the two, as it's difficult to imagine a firm whose ongoing activities were systemically important, but whose failure wouldn't pose systemic risks.1
Section 113(a)(2) requires the FSOC to consider 10 specific factors in determining whether a firm is systemically important:
As I noted in my previous post, a lot of firms, including hedge funds, are arguing that leverage should be the most important factor. That argument has a superficial appeal to it — after all, everyone knows that leverage was one of the main causes of the financial crisis — but it's still misguided. A highly leveraged firm may be more likely to fail, but the point isn't to identify the firms that are most likely to fail. The point is to identify the firms whose failure would cause the most damage to the financial system. The FSOC should just assume in its analysis that the firm it's examining has already failed — then ask, "What would happen, and how bad would it be?"
How likely a firm is to fail should play almost no role in the FSOC's decision — we don't want the Fed to only regulate systemically important firms that the FSOC thinks have a decent chance of failing. In 2004, almost no one would have thought that an AIG failure was in the realm of possibility, and if the FSOC had been making this determination in 2004, I can easily imagine them giving AIG a pass based on its sterling reputation and perceived invincibility. We don't want to give firms like AIG-circa-2004 the chance to go to the FSOC and push the argument that, "Sure, our failure would be catastrophic, but we're such a strong company that the chances of us failing are practically nil. It's just inconceivable. [Do you know who I am? I'm Hank f*cking Greenberg!]" That argument should be per se illegitimate. (And you're crazy if you think that's not exactly what Hank Greenberg wouldve been saying back in 2004.) Moreover, it was precisely the inconceivability of an AIG failure that caused the markets to hit the Sheer Panic Button in September 2008. Allowing firms to avoid the "systemically important" designation because the FSOC thinks they have sufficiently safe levels of leverage just sets us up for another AIG-like shock.
Of course, leverage can also magnify the damage caused by a firm's failure, so the FSOC should definitely still consider leverage in determining whether a firm is systemically important. My point is that the FSOC shouldn't be distracted by arguments about how firms with low leverage ratios shouldn't be deemed systemically important because they're less likely to fail.
I think it's hard to overstate the importance of interconnectedness. Size is important, yes, but it's interconnectedness that causes problems to turn systemic. Systemically important interconnectedness can take multiple forms as well. For example, LTCM, which by today's standards was a relatively small hedge fund, was systemically important not because of its size, or the number of counterparties it had, but because of its proximity to the dealer banks — LTCM was deeply enmeshed with all the dealers, both in terms of raw counterparty exposure and ridiculously correlated trading books. What makes this kind of interconnectedness systemically important is, obviously, the identity of the counterparties, and the nature of the firm's relationships with the counterparties. (Even though this clearly falls under the third factor in Section 113(a)(2), I think this factor is best thought of as a subset of "interconnectedness.")
Lehman, on the other hand, was involved in every corner of the market. The number of counterparties and customers affected by Lehman's bankruptcy was staggering, and meant that practically every market in the world was negatively impacted in some way when Lehman filed. Lehman's interconnectedness transmitted the losses — and the panic — all around the world at a shocking speed. This kind of interconnectedness is marked by the number and variety of markets (and counterparties) that a firm touches.
Proximity to Core Commercial Paper Market
A separate factor I think the FSOC should take very seriously is a firm's proximity to the commercial paper (CP) market — or, more specifically, the effect that a firm's failure would have on the CP market. One of the key lessons of the financial crisis, which is constantly overlooked, is that our domestic economy is critically dependent on the CP market. Even a temporary disruption in the CP market can cause large-scale employment losses. A lot of companies spent months recovering from the temporary breakdown in the CP market in September 2008 — and by "recovering," I mean "laying people off."
Any firm that threatens a repeat of the CP market troubles is, without question, systemically important.
Ultimately, I expect the FSOC to designate only a handful of nonbank financial firms (i.e., in the 4-8 range) systemically important and subject to consolidated Fed supervision. AIG, GE Capital, and Prudential are no-brainers. (No, I'm not forgetting MetLife — remember, it's a bank holding company now, so it's automatically included because it has over $50bn in assets.) It'll certainly be interesting to see who else is designated systemically important.
1 I suppose a firm would fit that description if the way it conducted its day-to-day business was important to the financial system, and it was also fairly easily replaceable. Like the DTCC, if it was easily replaceable. Which it is not.