The IMF is warning that governments should consider the potential of financial institutions to severely damage global financial and economic stability. The goal is to create a framework to determine a firm’s importance to the financial system.
The three main ideas the IMF is promoting are as follows:
- Size and linkages between firms are among the principles to consider
- Connections between the financial sector and the economy are the key to assessing risk
- The goal is a framework to determine a firm’s importance to the financial system
Governments should consider the potential of financial institutions to severely damage global financial and economic stability in assessing whether or not a firm is “too complex to fail,” according to the IMF.
In a paper issued on November 7, the IMF added to the policy debate on how to help countries determine the systemic importance of financial institutions and markets.
The collapse of Lehman Brothers in September 2008 laid bare the previously unrecognized potential for one firm’s demise to cause devastating effects to both global financial stability and the world economy. The failure of large investment banks prompted a worldwide debate about the problems created by institutions that have come to be known as “too big to fail.” IMF Managing Director Dominique Strauss-Kahn recently said that the core of the issue is not only a matter of size, but one of complexity and systemic importance.
Clear criteria guide policymakers
The paper, - Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations - was prepared by the IMF along with the Financial Stability Board and the Bank for International Settlements, at the request of the leaders of the G-20 group of industrialized and emerging market economies. It sets out the criteria and principles to help countries determine which firms and markets are systemically important.
The paper outlined three main principles:
• The size of a financial firm or market and the volume of financial services it provides
• The extent to which other parts of the financial system can provide the same services in the event of a firm or financial market’s failure
• The linkages between financial institutions which might create repercussions in the event of a firm’s failure
Mix of policies a strong approach
According to the paper, countries currently use a wide range of techniques to identify a firm’s systemic importance. A mixture of indicators - both quantitative and qualitative - along with stress testing are used, and many countries rely on more than one method to assess the importance of a firm in the overall financial system. The choice of the most suitable method for any given country depends on its financial system.
The paper suggests that the use of judgment will be an important part of the assessments, as well as a review of the capacity to deal with failures of institutions and markets as and when they occur.
The IMF also said that countries are increasingly focusing on the linkages between their financial systems and their economies in their analysis of a firm’s importance.
The IMF said that the principles could be used by countries to set up a framework to determine the systemic importance of a firm, and would be flexible enough to apply to a broad range of countries. The framework could include:
• The definition of systemic importance
• The roles and responsibilities of the agencies involved in the assessments
• The independence, accountability and powers of the agencies involved
• The frequency of the assessments
It concluded that there should be a periodic review of the framework
Countries might also want to take into account the mix of information to be used, both quantitative and qualitative, as well as how the results might be communicated to the various regulators, central banks and financial markets, both nationally and internationally. Given the connections between financial institutions around the world, international cooperation will be a key element in assessing systemic importance.
© International Monetary Fund
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