core sector communique

GLOBAL ECONOMIC CRISIS

‘Too Complex to Fail’ the Real Issue, Says IMF

IMF Survey online

November 10, 2009

• Size, linkages between firms are among the principles to consider
• Connections between financial sector and economy key to assessing risk
• Goal is framework to determine firm's importance to financial system

Governments should consider the potential of financial institutions to severely damage global financial and economic stability in assessing when firms are “too complex to fail,” according to the IMF.

In a paper issued on November 7 the IMF added to the policy debate on how to help countries determine the systemic importance of financial institutions and markets.

The collapse of Lehman Brothers in September 2008 laid bare the previously unrecognized potential for one firm’s demise to cause devastating effects to both global financial stability and the world economy. The large investment bank’s failure prompted a worldwide debate about the problems created by institutions that have come to be known as “too big to fail.” IMF Managing Director Dominique Strauss-Kahn recently said the core of the issue is not only a matter of size, but one of complexity and systemic importance.

Clear criteria guide policymakers

The paper, “Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations,” was prepared by the IMF, along with the Financial Stability Board and the Bank for International Settlements, at the request of the leaders of the G-20 group of industrialized and emerging market economies. It sets out the criteria and principles to help countries determine which firms and markets are systemically important.

The paper outlined three main principles:

• The size of a financial firm or market, and the volume of financial services it provides

• The extent to which other parts of the financial system can provide the same services in the event of a firm or financial market’s failure

• The linkages between financial institutions, which might create repercussions in the event of a firm’s failure

According to the paper, factors that might be considered indicators of a firm’s vulnerability, and its increasing risk to the financial system overall, include:

• Leverage, which is borrowed capital used to increase a firm’s potential returns

• Illiquid assets, which may need to be sold in order for a firm to raise funds

• The complexity of a firm, coupled with the availability of reliable information about a firm’s investments in a particular security or industry

Mix of policies a strong approach

Countries currently use a wide range of techniques to identify a firm’s systemic importance, according to the paper. A mixture of indicators, both quantitative and qualitative, along with stress testing are used, and many countries rely on more than one method to assess the importance of a firm in the overall financial system. The choice of the most suitable one for any given country depends on its financial system. The paper also said the use of judgment will be an important part of the assessments, as well as a review of the capacity to deal with failures of institutions and markets when they occur.

The IMF also said countries are increasingly focusing on the linkages between their financial systems and their economies in their analysis of a firm’s importance.

The IMF has examined individual countries’ proposals to incorporate systemic risk into the reforms of their financial regulations. In July this year, the IMF, as part of its annual assessment of the health of the U.S. economy, known as an Article IV Consultation, included a review of the government’s proposed reforms to financial regulation. The reforms are part of the U.S. plan to monitor risks across the financial system, which emerged as a critical regulatory gap in the current economic crisis.

The IMF said the U.S. government’s proposal leaves a number of issues unaddressed, including the rules for identifying who is systemically important.

Flexible framework

The IMF said the principles could be used by countries to set up a framework to determine the systemic importance of a firm, and would be flexible enough to apply to a broad range of countries. The framework set up by countries could include:

• The definition of systemic importance

• The roles and responsibilities of the agencies involved in the assessments

• The independence, accountability, and powers of the agencies involved

• The frequency of the assessments

• A periodic review of the framework

Countries might also want to take into account the mix of information to be used, both quantitative and qualitative, as well as how the results would be communicated to the various regulators, central banks, and financial markets, both nationally and internationally. Given the connections between financial institutions around the world, international cooperation will be a key element in assessing systemic importance.

Governments could use the guidelines to help them adjust their financial regulation and oversight, as they consider reforms to the rules governing their financial systems.

Eventually, once frameworks have been put in place and tested in the heat of battle, countries may wish to consider developing a new set of international standards for identifying firms and markets that are critical to international financial stability, the IMF said.