Written by Systemically Important Financial Institutions (SIFIs) are financial institutions whose failure is likely to result in disruption of the financial system.
They are large institutions that are considered to be very important to the stability of the financial system because their failures can potentially result in severe undesirable externalities such as disruption of the financial system and the real economy.
According to the International Association of Deposit Insurers (IADI), “a systemically Important Financial Institution( SIFI) is a financial institution or a group that, because of its size, complexity and systemic interconnectedness would, in the view of the relevant authorities, cause significant disruption to the domestic or broader financial system and economic activity, if it were to fail in a disorderly manner”.
The rationale behind the designation of SIFIs is fairly simple.
If a large financial institution were to fail, it could trigger a chain reaction that could destabilize the entire financial system.
This is because, when large institutions fail, they can make other connected institutions fail too.
This is called systemic risk and can cause the whole financial system to collapse.
When a SIFI is designated as such, regulators can impose additional requirements and mitigate the risk of systemic failure.
So, the identification of systemic important Financial Institutions is designed to reduce cases of systemic risks.
SIFIs are deemed to be so important that their failure could have disastrous consequences for the economy.
Because their failures could potentially disrupt the financial system, systemically Important Financial Institutions are often subjected to stricter regulatory requirements.
We will look at the stricter supervisory and regulatory requirements shortly. But before then, let’s look at the factors that determine SIFIs.
Factors that determine the classification of a bank as a Systemically Important Financial Institution
1. Size: One of the most obvious factors that regulators consider when determining SIFI status is the size of the financial institution.
SIFIs are typically large institutions with significant assets and market share.
Generally speaking, the bigger the bank, the greater the potential impact on the financial system if it were to fail.
So, regulators usually considered the size of a financial institutions to decide whether it is a SIFIs or not.
Regulators may use different measures to determine size.
For example, it may use the total assets, liabilities, or market capitalization to determine if the bank is a systemically Important Financial Institutions.
2. Interconnectedness: Another important factor that regulators consider is the degree to which the bank is interconnected with other institutions in the financial system.
Generally speaking, the more interconnected a bank is to other financial institutions, the greater the potential for the failure of the bank to transmit distress through the financial system and broader economy.
So, If a bank is highly interconnected with other financial institutions, then it may be designated as a SIFI.
This is because if the bank fails, it can create a domino effect on other institutions that are connected to it, causing a contagion of losses and instability in the financial system.
3. Substitutability: Regulators also consider the degree to which a bank or financial institution can be substituted in determining whether to classify it as a SIFI.
This means that they assess whether other institutions could step in and perform the same functions as the bank in question in the case that the bank fails.
If the bank is deemed to be irreplaceable, it is more likely to be designated as a SIFI as the failure of such a bank could have serious consequences on the financial system and the economy.
4. Complexity: The risk profile or potential impact of a complex financial institutions or banks may be be difficult to assess.
A bank is considered complex if it:
- operates diverse types of activities through numerous legal entities (e.g., simultaneously operating banking, insurance and securities subsidiaries);
- Operates across borders with centrally managed capital and liquidity (as opposed to simpler networks of national subsidiaries);
- It has exposures to new and complex products and markets that have not been sufficiently tested.
The failures of complex financial institutions are likely to have far-reaching consequences for the economy as a whole.
For this reason, regulators may designate such banks as a SIFI so that it can impose stricter regulatory control on the financial institutions.
Regulatory requirements of Systemically Important Financial Institutions
Once a bank or financial institution has been designated as a SIFI, it is subject to stricter regulatory requirements than other financial institutions.
The regulatory requirements that SIFIs faced are:
1. Higher capital requirements: SIFIs are usually required to hold higher levels of capital compared to other financial institution so that they can have sufficient buffers to absorb losses.
By requiring SIFIs to hold higher capital, the likelihood of failures of SIFIs is reduced to the barest minimum.
2. Increased supervision: Due to their systemic importance, SIFIs are subject to more frequent and more detailed supervision by regulatory authorities.
This is done to ensure that SIFIs comply with regulatory requirements and operate in a safe and sound manner.
3. Stress testing: SIFIs may be required to undergo regular stress tests to assess their ability to withstand adverse economic conditions.
The main goal of subjecting SIFIs to stress tests is to identify potential weaknesses and vulnerabilities so that SIFIs can take remedial actions.
