Adjusting for economic growth (as called for by the Fed), GSIB surcharges should be lowered

Adjusting for economic growth (as called for by the Fed), GSIB surcharges should be lowered

Introduction

In the United States, the eight “global systemically important banks” (GSIBs) are required to hold more capital than other banks by an amount equal to their “GSIB surcharges.”  As shown in the table, those surcharges currently range from 1.5 to 3.5 percentage points.  The surcharges are based on proxies for the systemic cost of default of each GSIB (its “systemic indicator score”).  In the final rule defining the GSIB surcharges, the Fed noted that four of the five indicators that enter into the score would grow with the economy and so would need to be periodically adjusted.  While we have broader concerns about the GSIB surcharge methodology, in this note we focus solely on the effects of making the growth adjustment called for by the Fed, leaving all other aspects of the surcharge equal.  The corrected GSIB surcharges are, on average, 19 basis points lower.

Background on the GSIB surcharge

The GSIB surcharge is an additional capital buffer that U.S. GSIBs are required to hold, over and above their risk-based capital requirements and other capital buffers.   In the United States, the surcharge is calculated as a fixed constant times the GSIB’s systemic indicator score mapped into discrete ranges.  The ranges each correspond to 50 bp increments in the surcharge.

The GSIB surcharge is a component of the Basel III international capital framework, but the Fed uses a different method to calculate the GSIB surcharges of U.S. GSIBs.  In the Basel methodology, known as Method 1, the systemic indicator score is calculated using an equally weighted average of five measures of systemic importance—complexity, interconnectedness, cross-jurisdictional activity, substitutability, and size.  However, in the U.S. implementation of the G-SIB surcharge framework, the Fed requires U.S. banks to calculate their systemic indicator scores under two different methods, with the higher of the two resulting surcharges applying.  The U.S. score, known as Method 2, replaces the “substitutability” category with “short-term wholesale funding”.  In all cases, the Method 2 score is higher, so we focus on that measure, which we will henceforth refer to simply as the systemic indicator score.

Four of the measures entering the systemic indicator score – complexity, interconnectedness, cross-jurisdictional activity, and size – are calculated as the sum of balance sheet and off-balance-sheet items for a GSIB at the end of each year, divided by the average over the 2012 and 2013 levels of the aggregate sum across global GSIBs of those same items.  These four measures will trend up over time with both inflation and with economic growth1. The fifth measure, “short-term wholesale funding” (STWF) is calculated as the ratio of the GSIB’s STWF divided by its average risk-weighted assets over the previous four quarters.  Because the STWF measure is divided by a number that also will grow over time, it will not trend up with economic growth and inflation.

Adjusting for economic growth

In the final rule establishing the GSIB surcharge, the Fed notes

Scores calculated under the fixed approach could be influenced by factors unrelated to systemic risk such as general economic growth. Method 2 does not include an automatic mechanism to adjust for such potential effects in order to avoid unintended consequences.  [FN For example, under a fixed approach scores could potentially increase over time as a result of general economic growth as the economy expands.  One way to address this effect could be to deflate scores by the rate of economic growth. However, such an approach could have the unintended consequence that scores would increase procyclically in the event of an economic contraction, thereby potentially raising capital surcharges in a way that could further exacerbate the economic downturn.]… The Board will periodically reevaluate the framework to ensure that factors unrelated to systemic risk do not have an unintended effect on a bank holding company’s systemic indicator scores.

The Fed notes that the factors entering into the score should be adjusted for economic growth, but expresses concern that doing so would make the surcharges procyclical:  If nominal GDP fell, capital requirements would go up. To address this concern, we use the CBO’s estimate of potential nominal GDP rather than actual nominal GDP as our measure of activity.  Potential GDP is essentially the trend in output after removing business cycle variation.  Potential nominal GDP in 2017 was 16.4 percent higher than the average of its level in 2012 and 2013. We recalculate the GSIB surcharges adjusting the four components that are subject to a trend and report the results below.

As shown in the table, the adjusted systemic indicator scores fall for each bank, with the average score falling by 10 percent. For five of the banks, the adjusted scores, while lower, fall within the same surcharge band.  For the other three, the surcharges fall by 50 basis points. The average surcharge declines by 19 basis points. Put another way, nominal GDP growth since the GSIB surcharges were adopted has inflated the surcharges by 19 basis points on average.

The Clearing House

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1In the Basel method, for each component, the year-end level of the component for the GSIB is divided by the year-end aggregate level for global GSIBs.  As a result, the Method 1 scores do not trend up with the economy.

 

 

Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.