What Is Absolute Systemic Cushion?
An Absolute Systemic Cushion refers to the additional layers of regulatory capital that financial institutions deemed "systemically important" are required to hold. This financial regulation falls under the broader category of macroprudential policy, which aims to prevent and mitigate systemic risk across the entire financial system, rather than just individual firms. The purpose of an Absolute Systemic Cushion is to ensure that the failure or distress of a large, interconnected financial institution does not trigger a cascading collapse (known as contagion risk) that could severely destabilize the economy. These cushions act as shock absorbers, providing an enhanced buffer against unforeseen losses and promoting overall financial stability.
History and Origin
The concept of an Absolute Systemic Cushion gained significant traction following the 2007–2008 Financial Crisis. The crisis exposed the vulnerabilities of a financial system where the failure of "too big to fail" institutions could necessitate government bailouts to prevent economic catastrophe. In response, international bodies and national regulators sought to implement measures that would make these institutions more resilient.
A pivotal development was the introduction of the Basel III framework by the Basel Committee on Banking Supervision (BCBS). Basel III significantly increased capital requirements for banks and introduced the notion of a capital surcharge for Global Systemically Important Banks (G-SIBs). These surcharges, which form a key component of the Absolute Systemic Cushion, were designed to impose higher capital demands on banks whose failure would have the most severe impact on the global financial system. The Bank for International Settlements (BIS) provides extensive information on the framework for identifying G-SIBs and the additional loss absorbency requirements imposed on them. I7n the United States, the Dodd-Frank Act, enacted in 2010, further codified efforts to enhance financial stability and specifically addressed the risks posed by systemically important financial institutions.
6## Key Takeaways
- The Absolute Systemic Cushion is an additional capital buffer required for Global Systemically Important Banks (G-SIBs).
- Its primary goal is to enhance financial stability and mitigate systemic risk by providing greater loss absorbency.
- The concept emerged prominently after the 2007–2008 financial crisis, leading to international regulatory reforms like Basel III.
- These cushions aim to reduce the likelihood and severity of distress at large, interconnected financial institutions.
- They contribute to preventing "too big to fail" scenarios by ensuring these institutions can absorb significant losses without taxpayer bailouts.
Formula and Calculation
While there isn't a single, universally defined "Absolute Systemic Cushion" formula, the concept primarily manifests through the Global Systemically Important Bank (G-SIB) surcharge and other enhanced capital requirements mandated by regulators. The G-SIB surcharge, for instance, is an additional percentage of Common Equity Tier 1 (CET1) capital that a G-SIB must hold, determined by its systemic importance score.
This score is typically derived from a methodology that considers five key categories:
- Size: The overall scale of the institution's operations.
- Interconnectedness: The extent of its financial linkages with other institutions.
- Substitutability: The ease with which other institutions could take over its services if it failed.
- Complexity: The intricacy of its structure and operations.
- Cross-jurisdictional activity: The extent of its international operations.
Each category contributes to a bank's overall systemic indicator score, which then translates into a specific G-SIB surcharge bucket. The higher the score, the larger the required capital surcharge.
For example, a bank's CET1 capital requirement might be expressed as:
Where:
- Minimum CET1 Ratio: The baseline regulatory requirement (e.g., 4.5% under Basel III).
- Risk-Weighted Assets (RWA): The bank's assets weighted by their credit, market, and operational risks.
- 5 G-SIB Surcharge: The additional percentage (e.g., 1.0% to 3.5% or more) determined by the bank's systemic importance score.
This additional surcharge forms the core of the Absolute Systemic Cushion, ensuring an extra layer of capital above standard regulatory minimums.
Interpreting the Absolute Systemic Cushion
The Absolute Systemic Cushion is interpreted as a measure of a financial institution's capacity to absorb unexpected losses without relying on public funds or triggering broader financial distress. A larger cushion indicates greater resilience. For regulators, a robust Absolute Systemic Cushion implies a reduced likelihood of a "too big to fail" scenario, where the failure of a major institution could cripple the economy.
For investors and market participants, the size of this cushion can be an indicator of a bank's financial soundness and its ability to withstand adverse economic shocks. It signifies that the institution has ample regulatory capital to cover potential losses from various risks, including liquidity risk and credit defaults. A higher cushion generally suggests a lower probability of future bailouts or severe disruptions. The Federal Reserve's Financial Stability Report, for example, regularly assesses the resilience of the U.S. financial system, including the adequacy of capital buffers.,
Consider "GlobalBank Corp.," a fictional financial institution identified as a Global Systemically Important Bank (G-SIB). Due to its extensive international operations, complex derivatives portfolio, and interconnectedness with other major financial players, regulators have assigned GlobalBank Corp. to a G-SIB surcharge bucket requiring an additional 2% Common Equity Tier 1 (CET1) capital.
Assume the baseline CET1 requirement under standard regulations is 4.5% of Risk-Weighted Assets (RWA). If GlobalBank Corp. has $10 trillion in RWA, its base CET1 capital requirement would be $450 billion ((0.045 \times $10 \text{ trillion})).
However, because it is a G-SIB, it must hold an additional 2% as an Absolute Systemic Cushion. This translates to an extra $200 billion ((0.02 \times $10 \text{ trillion})) in CET1 capital. Therefore, GlobalBank Corp.'s total required CET1 capital is $650 billion ($450 billion + $200 billion). This additional $200 billion serves as its Absolute Systemic Cushion, providing a substantially larger buffer to absorb potential losses from extreme market events or operational failures before it poses a significant threat to global financial stability.
Practical Applications
The concept of an Absolute Systemic Cushion is primarily applied in the realm of financial regulation and banking supervision. It directly influences the capital planning and risk management strategies of the world's largest financial institutions.
- Regulatory Compliance: G-SIBs are mandated to comply with specific capital surcharges as part of their Absolute Systemic Cushion, influencing their balance sheet management and business activities.
- Stress Testing: Regulatory bodies use stress testing scenarios to assess whether institutions have sufficient capital, including their Absolute Systemic Cushion, to withstand severe economic downturns. This helps ensure that the cushion is truly effective under adverse conditions.
- Market Perception: The adequacy of an institution's Absolute Systemic Cushion can impact its credit ratings and market confidence, influencing its cost of funding and ability to conduct business.
- International Cooperation: The framework for the Absolute Systemic Cushion is a product of international collaboration through bodies like the Basel Committee, highlighting a global effort to maintain financial stability. The International Monetary Fund (IMF) conducts Financial Sector Assessment Programs (FSAPs) globally, evaluating the resilience of countries' financial sectors, including their capital buffers and regulatory frameworks.
##2 Limitations and Criticisms
Despite its importance in enhancing financial stability, the concept of an Absolute Systemic Cushion, particularly the G-SIB surcharge, faces certain limitations and criticisms.
One common critique is that the methodologies for determining systemic importance and the resulting capital surcharges may not fully capture all facets of systemic risk. Some argue that the indicators used might encourage banks to shift risk to less regulated areas or to engage in "window dressing" around measurement dates to reduce their apparent systemic footprint. There are also debates regarding whether the prescribed capital levels are truly sufficient to prevent future financial crisis events or fully address the "too big to fail" problem, with some analyses suggesting surcharges might need to be higher.
Fu1rthermore, critics occasionally suggest that higher capital requirements, including the Absolute Systemic Cushion, could potentially constrain lending, economic growth, or market liquidity, though proponents argue that the benefits of enhanced stability outweigh these potential costs. The ongoing evaluation of leverage ratio requirements also plays into these discussions about optimal capital levels.
Absolute Systemic Cushion vs. Global Systemically Important Bank (G-SIB) Surcharge
The terms "Absolute Systemic Cushion" and "Global Systemically Important Bank (G-SIB) Surcharge" are closely related but represent distinct concepts.
The G-SIB Surcharge is a specific regulatory tool—a quantifiable additional capital requirement imposed on banks identified as globally systemically important. It is a direct, calculated percentage of capital that these institutions must hold above the baseline.
The Absolute Systemic Cushion, on the other hand, is a broader, more conceptual term. It refers to the overall enhanced buffer of capital and other loss-absorbing capacity that a systemically important institution maintains to protect against its failure threatening the entire financial system. The G-SIB surcharge is the most prominent and direct component of this cushion, but other regulatory requirements, such as enhanced stress testing and resolution planning (living wills), also contribute to the idea of a comprehensive Absolute Systemic Cushion by ensuring institutions are prepared to absorb losses and fail in an orderly manner without public bailouts. Essentially, the G-SIB surcharge is a means to achieve a significant part of the Absolute Systemic Cushion.
FAQs
What type of institutions are required to hold an Absolute Systemic Cushion?
Only Global Systemically Important Banks (G-SIBs) are required to hold this enhanced capital buffer, specifically through mechanisms like the G-SIB surcharge. These are financial institutions whose failure could trigger a widespread financial crisis due to their size, interconnectedness, and complexity.
How is a bank identified as systemically important?
Regulators use a comprehensive methodology to identify systemically important banks, often considering factors such as a bank's size, its degree of interconnectedness with other financial entities, the substitutability of the services it provides, its operational complexity, and the extent of its cross-jurisdictional activities. This assessment helps determine the level of their required Absolute Systemic Cushion.
What is the goal of having an Absolute Systemic Cushion?
The primary goal is to enhance overall financial stability and mitigate systemic risk. By requiring large, interconnected institutions to hold more capital, the cushion aims to reduce the likelihood of their failure and, if they do fail, to ensure they can do so without causing a broader economic collapse or requiring taxpayer bailouts.
Does the Absolute Systemic Cushion apply to all banks?
No, the Absolute Systemic Cushion, as it relates to specific surcharges like the G-SIB surcharge, applies only to those financial institutions designated as systemically important. Smaller or less complex banks are subject to standard capital requirements but typically not these additional systemic buffers.