G-Sib regime: something’s broken

At the end of each year, like clockwork, the eight too-big-to-fail US banks lower their capital surcharges by cutting one or more systemic indicators. Then, like clockwork, these shoot up again at the start of the new year. 

It’s a well-known phenomenon, something Risk Quantum has written about many times, as we analysed what the systemic risk scores and resulting capital surcharges would look like if the Federal Reserve measured the risk to financial stability posed by the largest banks at different points in time, rather than in a single snapshot once every 12 months.

US global systemically important banks are designated using the Basel Committee on Banking Supervision’s assessment methodology to gauge systemic risk. The total score is found by averaging the scores of five systemic categories: size; interconnectedness; complexity; cross-jurisdictional activity; and substitutability. 

The Fed uses its own measure, known as Method 2, which applies a different calculation formula, deriving a G-Sib score from the sum of the first four categories above, plus a short-term wholesale funding factor. Individual indicator values are multiplied by fixed coefficients to produce a final G-Sib score.

These Method 2 scores are calculated quarterly, but only the year-end score is used to set each bank’s capital surcharge for the following year but one. Under both methods, the higher the score, the higher the G-Sib surcharge. 

The notional amount of over-the-counter derivatives is one of the three indicators that make up the complexity category. It is also the one US banks tend to reduce the most in their effort to adjust their final score.

It is such a well-known feature of the G-Sib regime, the Fed itself highlighted the pattern in a research bulletin published in January 2020. The article pointed out that banks use portfolio compression to lowball their derivatives notional numbers towards year-end.

There are three issues at stake here. First, as the Fed warned, banks may end up cutting essential services they provide to clients in the scramble to massage their figures. Second, by inflating and deflating their scores as they please, banks are effectively taking the regulators for a ride. It may not be something to lose sleep over, but it makes one wonder how seriously financial firms take their supervisors. 

The third and most important issue is what this means for the wider financial system. A systemic score and the surcharge associated with it, acts as a warning label being slapped on a bank for posing a higher systemic risk. It’s a serious admonition and should be treated as such. 

But the lack of accountability for the remainder of the year begs the question: what’s the point of a yearly health check, if the real risk a bank poses is not properly assessed? 

Every law has its loophole – and the G-Sib scoring system has a giant one. Perhaps it’s time for the Fed to start addressing it.