A “SIFI”—a “Systemically Important Financial Institution” — is a key concept of the Dodd-Frank Act and of the post-crisis attempts to understand and control systemic financial risk. All banks with assets over $50 billion are automatically SIFIs under the legislation, and the “Financial Stability Oversight Council” (FSOC) is given power to designate non-bank institutions as SIFIs.
The problem is that FSOC does not seem to understand the government itself is a principal creator of systemic risk. So amazingly, FSOC has not even designated the utterly obvious cases of Fannie Mae and Freddie Mac as SIFIs, let alone some additional very big and very notable SIFIs which are part of the government, as discussed below.
- Fannie Mae and Freddie Mac unquestionably qualify as SIFIs.
Fannie Mae and Freddie Mac (the GSEs) are two of the largest and most highly leveraged financial institutions in the world. Fannie Mae is larger than JPMorgan or Bank of America; Freddie Mac is larger than Citigroup or Wells Fargo. Each of them sells trillions of dollars of debt obligations and mortgage-backed securities (MBSs) throughout the financial system and around the world. The US and the global economy have already experienced the systemic risk of Fannie Mae and Freddie Mac. When they failed in September 2008, default on their obligations would have greatly exacerbated the financial crisis on a global basis.
Fannie Mae headquarters in Washington February 21, 2014.
REUTERS/Kevin Lamarque.
The obligations of Fannie Mae and Freddie Mac are widely held throughout the financial system and around the world, including by official bodies and by financial institutions. U.S. depository institutions hold about $1.4 trillion of their obligations; the Federal Reserve Banks hold $1.7 trillion in their MBS. Their obligations are granted preferential risk-based capital treatment, which means bank investors have less capital support against the risk of Fannie Mae and Freddie Mac. Since the two GSEs themselves have approximately zero capital, the combined systemic leverage when banks and the central bank hold their obligations becomes in the aggregate hyper-leverage.
The interconnectedness of GSE debt and mortgage-backed securities with the global financial system became critical in the financial crisis. As then-Secretary of the Secretary Henry Paulson recounted:
From the moment the GSEs’ problems hit the news, Treasury had been getting nervous calls from officials of foreign countries that were invested heavily with Fannie and Freddie. To them, if we let Fannie and Freddie fail and their investments go wiped out, that would be no different from expropriation. …They wanted to know if the U.S. would stand behind this implicit guarantee”– and “what this would imply for other US obligations, such as Treasury bonds.
In a revealing comment, Paulson added, “I was doing my best, in private meetings and dinners, to assure the Chinese that everything would be all right.”
2. The Federal Reserve Banks also qualify as SIFIs.
In total, the Federal Reserve Banks have assets of $4.5 trillion, together making them by far the largest financial entity in the country. Eleven of the twelve are each bigger than the $50 billion benchmark which automatically designates banks as SIFIs, and eight are more than double the benchmark. Moreover, they run at extremely high leverage—at leverage which would cause any bank to be categorized as significantly undercapitalized. This is true of all Federal Reserve Banks, but especially of the Federal Reserve Bank of New York, which by itself represents $2.5 trillion in assets with a capital ratio of 0.51% or leverage of 196:1.
The Federal Reserve Banks are deeply intertwined with the banking system, as lenders and as holders of the banks’ deposits; the housing finance system, as the largest investors in long-term, fixed rate mortgage assets; the finances of the US government; and the international monetary system. They run exceptionally large maturity mismatches and thus extremely large market risk. Their maturity mismatch relative to their capital would be deemed unsafe and unsound if undertaken by any bank.
Understanding the Federal Reserve Banks as SIFIs is necessary to any adequate understanding of the riskiness of the overall financial system.
- The Federal Reserve Open Market Committee poses vast significant systemic risk and therefore should be included in any appropriate definition of SIFIs.
The Federal Reserve Open Market Committee is an institution which represents remarkable systemic risk. If it is successful in its monetary and credit efforts (known as “policy” by supporters and “manipulations” by critics), this Committee may be risk reducing. But if it fails, as it often has, it can create more systemic financial and economic risk than any other institution in the world. Its actions, based on the quite debatable theories, models, estimates, forecasts and guesses of a committee, have historically at various times stoked runaway consumer price inflation, and runaway asset price inflation, forced negative real returns on the savings of the American people, reduced real wages, helped inflate disastrous financial bubbles, distorted markets, and led to financial instability.
Ironically, all of these actions were taken in the name of promoting stability. Moreover, The Open Market Committee creates systemic risk not only for the United States, but for the entire world, since it commands by fiat the world’s dominant currency.
- Federal direct loan, loan guarantee, and insurance programs also pose substantial systemic risk, and risk to the taxpayer, and should be included in any appropriate definition of SIFIs.
In the United States, Federal loans and loan guarantees have grown dramatically. Raghuram Rajan, formerly Professor at the University of Chicago wrote:
Easy credit has large, positive, immediate, and widely distributed [perceived] benefits, whereas the [inevitable] costs all lie in the future. It has a payoff structure that is precisely the one desired by politicians, which is why so many countries have succumbed to its lure.
The results can be seen in the chart below, from the FY2016 Federal Budget document:
In conclusion, we suggest that to capture all the real threats to systemic financial stability, the definition of SIFI needs to include not only banks and other financial companies, but also the quasi-governmental institutions Fannie Mae and Freddie Mac, the Federal Reserve Banks and the Federal Reserve Open Market Committee, and government credit and insurance programs of any substantial size.
For more detail on our arguments, please see our new report.
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