What Investing In Too Big To Fail Means For Banking Investors

Mar. 05, 2015 3:20 PM ETBAC, C, GS, JPM, MS3 Comments
Celan Bryant profile picture
Celan Bryant
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Summary

  • Due to banking reforms, institutions with a higher risk rating must also hold a higher percentage of capital in reserve to make up for the increased risk.
  • Based on a 7 point scoring framework, 33 banks make the cut for having the highest systematic risk.
  • Of the 33 banks, 5 have the highest risk of contagion. These are Citigroup, JPMorgan, Morgan Stanley, Bank of America, and Goldman Sachs.
  • While these banks provide reduced risk to investors through an implicit government backing, the cost of this protection is a higher reserve requirement and greater regulatory scrutiny.

On February 26 the Federal Reserve Board extended the comment period for a proposed rule that would implement capital charges for the largest and most "contagious" banks. The rule would establish a framework for identifying systemically important banking organizations as well as the size of the associated charge, but there's already an established framework in practice.

The paper, Systemic Importance Indicators for 33 U.S. Bank Holding Companies: An Overview of Recent Data by Meraj Allahrakha, Paul Glasserman, and H. Peyton Young was published on February 12 by the Office of Financial Research (OFR). The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 established the OFR in support of the Financial Stability Oversight Council. The paper compares the systematic risk of 33 banks by dissecting the term "systematic" into five quantifiable areas including size, interconnectedness, complexity, substitutability and financial connectivity.

Some banks must hold a larger amount of capital as a percentage of risk-weighted assets than others. These banks are selected based on systematic risk scores as assessed by The Basel Committee. In conjunction with The Basel Committee, the Financial Stability Board published a list of these banks first in November of 2011. That list was later updated on November 6, 2014.

Each bank was scored based on the five indicators as mentioned above. Below is a table describing the relevance of each indicator as well as the calculation.

Indicator Relevance Calculation
Size Measures total exposure Total assets + net value of certain securities financing transactions + credit derivatives and commitments + counterparty risk exposures
Substitutability Banks that provide services that customers would have difficulty replacing if the bank failed Payments activity + assets under custody + total underwriting transactions
Complexity Banks with highly complex operations Notional amount of OTC derivatives + total amount of trading and available-for-sale securities + total illiquid and hard-to-value assets (Level 3)
Cross-Jurisdictional Activity Banks with international operations Total foreign claims + cross-jurisdictional liabilities
Interconnectedness Measured as the failure to meet payment obligations to other banks Total liabilities to the financial system + total value of debt and equity securities issued by the bank

It is this last indicator, interconnectedness, that is the ultimate reason behind the government's need to either socialize or isolate the risk of bank failure; the former is the "too big to fail" scenario, the latter is next to impossible. While all of these indicators are important, it is the interconnectedness of banks that leads to contagion. The authors surmised that:

the default of a bank with a higher connectivity index would have a greater impact on the rest of the banking system because its shortfall would spill over onto other financial institutions, creating a cascade that could lead to further defaults.

Indeed, the connectivity index is combined with size and leverage to arrive at a contagion index. The paper goes on to name five U.S. banks with "particularly high contagion index values - Citigroup, JPMorgan, Morgan Stanley, Bank of America, and Goldman Sachs".

What can investors conclude from these findings? If there is a measure of too big to fail it is the contagion index which suggests the Fed may be advised by the OFR, if asked today, that Citigroup (NYSE: C), JPMorgan (NYSE: JPM), Morgan Stanley (NYSE: MS), Bank of America (NYSE: BAC), and Goldman Sachs (NYSE: GS) are 'too big to fail'. For investors of these financial institutions, this provides additional security; an implicit government backing as they are tied to the success of the economy. On the other hand, investors in these holding companies may also see an increased level of regulatory scrutiny and an increase in the amount of regulatory capital needed to hold as reserve.

This article was written by

Celan Bryant profile picture
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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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