Assessing Systemic Risk

In the US, the Financial Stability Oversight Council (FSOC) on 18^th January, 2011,  approved a proposal laying out six factors that regulators would use to determine if non-bank financial firms like hedge funds, insurance companies, broker-dealers and specialty finance companies threaten to destabilize the U.S. financial system. The factors that regulators would potentially consider include: size, the dominance of a firm in its industry, interconnectedness, use of leverage, liquidity risk, and the existing degree of oversight on the firm.   Under the FSOC’s proposed rule, if designated, the largest, most interconnected and highly-leveraged companies would face stricter prudential regulation, including higher capital requirements and more robust consolidated supervision.

On the face of it, this looks a bit opposite of what a regulator should be trying to do: To see how Insurers (and others as well) would weather systemic risk scenarios; while the FSOC says it is trying to determine the extent which the individual companies can destabilize U.S. Financial system, i.e., cause systemic risk.

From the proposal:

The Council proposes to use a framework for applying the statutory considerations to its analysis.(..) If adopted in a final rule, this framework would be used by the Council in meeting its statutory obligations of assessing the threat a nonbank financial company may pose to the financial stability of the United States. The proposed framework for assessing systemic importance is organized around six broad categories. Each of the proposed categories reflects a different dimension of a firm’s potential to experience material financial distress, as well as the nature, scope, size, scale, concentration, interconnectedness and mix of the company’s activities. The six categories are as follows:

1. Size;

2. Lack of substitutes for the financial services and products the company provides;

3. Interconnectedness with other financial firms;

4. Leverage;

5. Liquidity risk and maturity mismatch; and

6. Existing regulatory scrutiny

Each of the specific statutory factors is relevant to, and would be considered as part of, one or more categories within this analytical framework. In addition, the Council would consider any other risk-related factors that the Council deems appropriate, either by regulation or on a case-by-case basis, (..) in accordance with this analytical framework.