Calibrating the GSIB Surcharge
Print- Alternatives to the Expected Impact Framework
Alternatives to the Expected Impact Framework
Federal Reserve staff considered various alternatives to the expected impact framework for calibrating a GSIB surcharge. All available methodologies are highly sensitive to a range of assumptions.
Economy-Wide Cost-Benefit Analysis
One alternative to the expected impact framework is to assess all social costs and benefits of capital surcharges for GSIBs and then set each firm's requirement at the point where marginal social costs equal marginal social benefits. The principal social benefit of a GSIB surcharge is a reduction in the likelihood and severity of financial crises and crisis-induced recessions. Assuming that capital is a relatively expensive source of funding, the potential costs of higher GSIB capital requirements come from reduced credit intermediation by GSIBs (though this would be offset to some extent by increased intermediation by smaller banking organizations and other entities), a potential loss of any GSIB scale efficiencies, and a potential shift of credit intermediation to the less-regulated shadow banking sector. The GSIB surcharges that would result from this analysis would be sensitive to assumptions about each of these factors.
One study produced by the Basel Committee on Banking Supervision (with contributions from Federal Reserve staff) finds that net social benefits would be maximized if generally applicable common equity requirements were set to 13 percent of risk-weighted assets, which could imply that a GSIB surcharge of up to 6 percent would be socially beneficial.12 The surcharges produced by the expected impact framework are generally consistent with that range.
That said, cost-benefit analysis was not chosen as the primary calibration framework for the GSIB surcharge for two reasons. First, it is not directly related to the mandate provided by the Dodd-Frank Act, which instructs the Board to mitigate risks to the financial stability of the United States. Second, using cost-benefit analysis to directly calibrate firm-specific surcharges would require more precision in estimating the factors discussed above in the context of surcharges for individual firms than is now attainable.
Offsetting the Too-Big-to-Fail Subsidy
It is generally agreed that GSIBs enjoyed a "too-big-to-fail" funding advantage prior to the crisis and ensuing regulation, and some studies find that such a funding advantage persists. Any such advantage derives from the belief of some creditors that the government might act to prevent a GSIB from defaulting on its debts. This belief leads creditors to assign a lower credit risk to GSIBs than would be appropriate in the absence of this government "subsidy," with the result that GSIBs can borrow at lower rates. This creates an incentive for GSIBs to take on even more leverage and make themselves even more systemic (in order to increase the value of the subsidy), and it gives GSIBs an unfair advantage over less systemic competitors.
In theory, a GSIB surcharge could be calibrated to offset the too-big-to-fail subsidy and thereby cancel out these undesirable effects. The surcharge could do so in two ways. First, as with an insurance policy, the value of a potential government intervention is proportional to the probability that the intervention will actually occur. A larger buffer of capital lowers a GSIB's probability of default and thereby makes potential government intervention less likely. Put differently, a too-big-to-fail subsidy leads creditors to lower the credit risk premium they charge to GSIBs; by lowering credit risk, increased capital levels would lower the value of any discount in the credit risk premium. Second, banking organizations view capital as a relatively costly source of funding. If it is, then a firm with elevated capital requirements also has a concomitantly higher cost of funding than a firm with just the generally applicable capital requirements. And this increased cost of funding could, if calibrated correctly, offset any cost-of-funding advantage derived from the too-big-to-fail subsidy.
A surcharge calibration intended to offset any too-big-to-fail subsidy would be highly sensitive to assumptions about the size of the subsidy and about the respective costs of equity and debt as funding sources at various capital levels. These quantities cannot currently be estimated with sufficient precision to arrive at capital surcharges for individual firms. Thus, the expected impact approach is preferable as a primary framework for setting GSIB surcharges.
References
12. See Basel Committee on Banking Supervision (2010), An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements (Basel, Switzerland: Bank for International Settlements, August), p. 29, www.bis.org/publ/bcbs173.pdf 
. The study finds that a capital ratio of 13 percent maximizes net benefits on the assumption that a financial crisis can be expected to have moderate permanent effects on the economy. Return to text