Recent Reports that the Basel Committee Found U.S. Banks to Present More Systemic Risk Are Extremely Misleading

On November 21, the Basel Committee and the Financial Stability Board (FSB) published its annual assessment of globally systemically important banks (GSIBs), which ranks GSIBs according a mathematical formula and forms the basis of the Basel Committee’s GSIB capital surcharge framework.  According to the release, although the number and names of the banks included in the assessment sample remained the same relative to the past year, three U.S. GSIBs moved to a higher systemic risk bucket.  Namely, Citigroup moved from bucket 3 to 4, Bank of America moved from 2 to 3 and Wells Fargo moved from 1 to 2.  (Higher-numbered buckets imply higher systemic risk.)  In contrast, just one U.S. GSIB moved to a lower bucket – Morgan Stanley moved from 2 to 1.  These results led some analysts to erroneously conclude that the systemic risk posed by U.S. GSIBs actually increased over the past year, despite extensive efforts by banks and regulators to reduce systemic risk.  In this blog post we show that the increase in the GSIB score under the Basel Committee’s methodology is misleading for two reasons:

  • First, because the FSB GSIB methodology is denominated in euros and is therefore sensitive to foreign exchange rates, much of the increase in the score of U.S. banks simply reflects the appreciation of the dollar vis-à-vis foreign exchange rates.  If one instead uses the same EUR/USD exchange rate used in last year’s assessment, three of largest U.S. banks are less risky, while the risk of the remaining five GSIBs was about unchanged.
  • Second, and relatedly, because the scores reflect the position of each GSIB relative to the other 75 banks that comprise the GSIB assessment sample from around the world, and not the risk profile of any GSIB in absolute terms, the score of some U.S. GSIBs moved up simply because the score of banks in jurisdictions outside the U.S. moved down.1

 As we noted in our comment letter to the Federal Reserve when it proposed the GSIB surcharge in the U.S., the FSB’s methodology for estimating the degree of systemic risk is opaque and lacks empirical support for two reasons in particular.  First, because the methodology computes everything in euros and thereby requires conversion of balance sheet assets denominated in other currencies, movements in foreign exchange rates are an important driver of changes in the surcharge for GSIBs.  This results in significant fluctuations in the capital surcharge based entirely on a factor that is completely outside the GSIBs control and has no relationship to a GSIB’s actual systemic importance or risk.  Second, the systemic score is importantly determined by the relative position among GSIBs in each of the twelve systemic indicators that comprises a GSIB’s systemic score, and not on any stand-alone, absolute measure of each bank’s risk.  As such, reductions in systemic risk across all GSIBs have no effect on a bank’s systemic indicator score – indeed, the aggregate systemic risk posed by GSIB could fall by half, and not a single surcharge would change under the FSB’s approach.  Under the U.S. calculation of the GSIB surcharge, the U.S. agencies took into account these concerns and replaced the “relative approach” with absolute dollar amounts for each bank and converted the global indicator amounts from euros to U.S. dollars using an average exchange rate covering the period 2011-2013.

The distortive impact of movements in the EUR/USD exchange rate in the 2016 GSIB assessment is shown in Table 1.  Column 1 shows the 2016 GSIB assessment assuming the EUR/USD exchange rate used in last year’s GSIB assessment.  Column 2 shows the GSIB score based on the November 21, 2016 release.  As shown in column 3, the scores of U.S. GSIB rose up to 12 percent solely as a result of the appreciation of the dollar vis-a-vis the euro over the assessment period.  In particular, if the EUR/USD exchange rate hadn’t changed over the past year, none of the U.S. GSIBs would have moved to a higher risk bucket.  Indeed, JPM, GS, and MS would have all moved to a lower risk-bucket relative to last year’s assessment.  That is, according to the Basel Committee’s metric and using last year’s exchange rate to eliminate the distortive impact of a stronger dollar, three of the largest U.S. banks are less risky while the risk of the remaining five GSIBs was about unchanged.

The importance of the FSB methodology’s emphasis on the relative position of a GSIB in each indicator on its systemic score is best conveyed by an example.  For instance, while Citigroup reduced its holdings of trading and AFS securities by 2.5 percent, or $4 billion, during 2015, its score for total trading and AFS securities nonetheless moved up 3 points — 75% of the overall increase in its systemic score.  The reason is that the score for total trading and AFS securities is calculated relative to the amount of total trading and AFS securities outstanding at the world’s 76 banks that comprise the GSIB assessment sample and such exposures declined by more than $400 billion during 2015 at those banks.

1Of the 76 banks that comprise the GSIB assessment sample, there are 16 banks from North America, 27 banks from Europe, 30 banks from Asia and 3 banks from South America.