The heavy burden of being labelled systemically important

Robert C. Pozen

Almost everyone would agree that large banks like JPMorgan and Citigroup should be classified as Sifis — the melodious acronym for systemically important financial institutions, whose failure would produce widespread shocks to the financial system.

To reduce the chances of failure, regulators have imposed a broad array of extra requirements for capital, liquidity and risk controls on these Sifis.

The need for these requirements is less clear for two other categories of financial institutions currently labelled as Sifis: midsize regional banks and large insurance companies. Both types of institutions have been unsuccessful in getting their Sifi label dropped by regulators or legislators.

However, activist hedge funds have taken a more fruitful tack, pushing for structural changes to avoid the label at some midsize banks and large insurers.

In the Dodd-Frank Act of 2010 that sought to prevent systemic risks building in markets, Congress effectively applied the label to any banking institution with more than $50bn in assets.

But size is not a good indicator of potential adverse effects on the financial system. For instance, the dozen or so US bank holding companies with between $50bn and $100bn in assets are primarily regional institutions with low profiles in the global financial system.

One counter example is CIT Group, a banking institution that has made so many acquisitions it has crossed the $50bn threshold. It is headed by John Thain, former chief executive of Merrill Lynch, who seemed comfortable with Sifi status. Nevertheless, his strategy met resistance late last year, when CIT announced his March retirement and the probable divestiture of a large leasing unit.

On February 1 2016, a new activist hedge fund, Hudson Executive Capital, announced it had bought a chunk of CIT’s stock to push for a reduction of its assets below $50bn.

At the same time, Hudson announced it had taken a stake in Comerica, a regional bank with between $50bn and $100bn in assets. The Hudson activists reportedly believe that both regional banks would do better if they were not Sifis, or they were acquired by a megabank with systemically risky status.

In a parallel move, Carl Icahn, the well-known activist investor, bought a substantial position in AIG, a large insurer that was labelled a non-bank Sifi by US regulators. Under the Dodd-Frank Act, federal regulators have the authority to label non-banks as Sifis if they pose a serious potential threat to the financial system. In Mr Icahn’s view, AIG should sell or spin off enough problematic units to avoid the extra burden of being a Sifi.

Of course, AIG did threaten the financial system in 2008 by writing a lot of credit default insurance on mortgage-backed securities. But AIG is no longer in that business. Instead, it engages primarily in property casualty insurance and other traditional insurance businesses.

Does a traditional insurance business, if very large, threaten the whole financial system? Again, size per se should not determine the answer. As federal regulators have recognised, Sifi status should depend on a variety of risk-related characteristics of the insurer, such as its capital and leverage ratios, its vulnerability to rapid redemptions and its role as a counterparty in complex transactions.

In addition, federal regulators have stressed the importance of the factor of “substitutability” when determining if a non-bank is a Sifi. In other words, if a non-bank became insolvent, would other financial institutions readily be able to replace the functions of the insolvent company?

This factor is clearly relevant to large insurers, which are big buyers in the market for high-quality bonds. Would the failure of a large insurer have a devastating impact on this market? That seems unlikely since there are so many other companies prepared to fill the gap by buying high-quality bonds.

These arguments against Sifi status by midsize banks and large insurers are worthy of consideration. But their requests for exemption from Sifi status have not been grantedby the regulators or legislators.

Filling the vacuum, activists investors have been pushing to reshape the parameters of which institutions should be labelled Sifis. These activists are leading the fight for structural changes at certain midsize companies and large insurers that would, in practice, relieve them from the extra burden of being labelled a Sifi.

Editor’s note: This piece originally appeared in the Financial Times.