The architects of coming global financial reforms must soon decide how best to identify, measure and curb systemic risk in the banking system. Their initial reflex was to propose the break-up of banks that were seen as “too big to fail”. The shortcomings of this approach quickly became apparent, so the focus is now on a surcharge in the form of higher capital requirements, levied on those institutions deemed to be systemically significant. But this focus is too narrow.
The Basel Committee on Banking Supervision said on Tuesday that it will make systemic risk one of its main priorities in the coming months. As it does, it should consider introducing a wider set of incentives to ensure all banks improve their resilience and financial stability.
Two important arguments need to be kept in mind when examining risks that can affect the entire financial system. First, systemic risk is only in small part correlated with size. The failure of a small or medium-sized bank can trigger a systemic crisis, as Britain’s Northern Rock showed. There are also several large banks, and I would count Santander among them, that have acted as systemic stabilisers by dint of their ability to absorb other failing institutions and maintain lending throughout a crisis.