INTERNATIONAL MONETARY FUND

BANK FOR INTERNATIONAL SETTLEMENTS

FINANCIAL STABILITY BOARD

Report to G20 Finance Ministers and Governors

Guidance to Assess the Systemic Importance of Financial Institutions,

Markets and Instruments: Initial Considerations

The attached report and background paper respond to a request made by the G20 Leaders in
April 2009 to develop guidance for national authorities to assess the systemic importance of
financial institutions, markets and instruments. The report outlines conceptual and analytical
approaches to the assessment of systemic importance and discusses a possible form for
general guidelines.
The report recognizes that current knowledge and concerns about moral hazard limit the
extent to which very precise guidance can be developed. Assessments of systemic importance
will necessarily involve a high degree of judgment, they will likely be time-varying and state-
dependent, and they will reflect the purpose of the assessment. The report does not pre-judge
the policy actions to which such assessments could be an input.
The report suggests that the guidelines could take the form of high level principles that would
be sufficiently flexible to apply to a broad range of countries and circumstances, and it
outlines the possible coverage of such guidelines. A set of such high level principles
appropriate for a variety of policy uses could be developed, further, by the IMF, BIS and FSB,
taking account of experience with the application of the conceptual and analytical approaches
described here.
There are a number of policy issues where an assessment of systemic importance would be
useful. One critical issue is the ongoing work to reduce the moral hazard posed by
systemically important institutions. The FSB and the international standard setters are
developing measures that can be taken to reduce the systemic risks these institutions pose, and
the attached papers will provide a useful conceptual and analytical framework to inform
policy discussions. A second area is the work to address information gaps that were exposed
by the recent crisis (the subject of a separate report to the G20 from IMF staff and the FSB
Secretariat), where assessments of systemic importance can help to inform data collection
needs. A third area is in helping to identify sources of financial sector risk that could have
serious macroeconomic consequences. We will keep you informed on our respective future
policy work in these important areas.
 Guidance to Assess the Systemic Importance of Financial
Institutions, Markets and Instruments: Initial Considerations

Report to the
G-20 Finance Ministers and Central Bank Governors

Prepared by:
Staff of the International Monetary Fund and the Bank for International Settlements, and
the Secretariat of the Financial Stability Board
October 2009
 Guidance to Assess the Systemic Importance of Financial Institutions, Markets and
Instruments: Initial Considerations

Prepared by Monetary and Capital Markets Department, International Monetary Fund

Monetary and Economics Department, Bank for International Settlements and
the Secretariat of the Financial Stability Board

October 28, 2009

Contents Page

Executive Summary ...................................................................................................................2

I. Introduction ............................................................................................................................4

II. Definition ..............................................................................................................................5

III. Assessing the Systemic Importance of Institutions, Markets and Instruments....................7

A. Assessment Issues .....................................................................................................7
B. Assessment Criteria...................................................................................................8
C. Quantitative Assessments........................................................................................15

IV. Options for the Guidelines.................................................................................................21

A. Content of the Guidelines .......................................................................................21
B. Possible Uses of the Guidelines ..............................................................................24

Tables
1. Basic Indicators of Systemic Importance and Associated Risks .........................................25
2. Risk Measures and Systemic Risk .......................................................................................27

Boxes
1. Contributing Factors to Assessment of Systemic Importance .............................................13
2. A Practical Assessment Framework ....................................................................................14
3. Approaches Used in Practice ...............................................................................................20
 2

EXECUTIVE SUMMARY

This paper responds to the request of the G-20 leaders for guidelines on how national
authorities can assess the systemic importance of financial institutions, markets, or
instruments. Reflecting the current state of analysis and country practices, the paper outlines
conceptual and analytical approaches to the assessment of systemic importance and discusses a
possible form for general guidelines. The assessments would involve a high degree of judgment,
and the guidelines should be sufficiently flexible to apply to a broad range of countries and
circumstances. More detailed guidelines could be developed as the state of knowledge in this
field evolves and deepens.

The paper defines systemic risk as a risk of disruption to financial services that is (i) caused
by an impairment of all or parts of the financial system and (ii) has the potential to have
serious negative consequences for the real economy. Fundamental to the definition is the
notion of negative externalities from a disruption or failure in a financial institution, market or
instrument. All types of financial intermediaries, markets and infrastructure can potentially be
systemically important to some degree.

The assessment of systemic importance will be conditioned by a number of considerations.

The assessment is likely to be time-varying depending on the economic environment. It will also
be conditioned by the financial infrastructure and crisis management arrangements, and their
capacity to deal with failures when they occur. Institutions may be systemically important for
local, national or international financial systems and economies.

The nature of the assessment will also be conditioned by its purpose—whether it will be used
for example, to define the regulatory perimeter, for calibrating prudential tools including the
intensity of oversight, or to guide decisions in a crisis. The paper is written primarily from the
perspective of assessing systemic importance in normal times for the purpose of mitigating the
exposure of the system to the risk of failure of systemic components and enhancing the financial
system’s resilience to shocks. The paper does not pre-judge the nature of the policy actions that
could follow from the assessments.

Three key criteria that are helpful in identifying the systemic importance of markets and
institutions are: size (the volume of financial services provided by the individual component of
the financial system), substitutability (the extent to which other components of the system can
provide the same services in the event of a failure) and interconnectedness (linkages with other
components of the system).

 For institutions, the size of exposures, volumes of transactions or assets managed are
indicative of the extent to which clients and counterparties could be disrupted. Clusters of
institutions can be individually small but collectively significant because they fall into
distress at the same time. Some institutions, for example those providing key services
such as clearing and settlement, lack immediate substitutes for this role.
Interconnectedness captures situations when distress in one institution raises the
likelihood of distress in others.
 3

 For markets, assessing systemic importance presents more conceptual challenges.

The systemic importance of a market derives to an extent from that of the institutions that
participate in it. However, the size of a market is a determinant of potential economic
costs in case of malfunction. If the function of a stressed market cannot be replicated by
other mechanisms, the economic impact can be significant. Interconnectedness refers to
markets’ interdependence on each other as well as on institutions.

An assessment based on these three criteria should be complemented with reference to

financial vulnerabilities and the capacity of the institutional framework to deal with
financial failures. Indicators of financial vulnerabilities include: leverage, liquidity risks,
maturity mismatches, and complexity, including the group structures and business models of
large institutions. Key elements of the institutional framework include clearing and settlement
systems, and the arrangements for handling institutional and market failures should they occur.

Assessments will require a detailed knowledge of the functioning of the financial system
and will be graduated involving a high degree of judgment. While some components of the
financial system may consistently be assessed as highly systemic, the significance of others may
fluctuate over time. The framework cannot be seen as a precise quantitative instrument, and
assessments of systemic importance are likely to be judgment-based and not binary in nature.

A range of quantitative tools can be used as inputs to the assessments. Indicator based
approaches are relatively simple and often effective in assessing systemic relevance. A number
of more sophisticated methodologies (for example, network analysis, portfolio models of risk
based on market data, stress testing and scenario analysis) can also be useful tools.
Implementation of quantitative methodologies is limited in some cases by availability of data. In
addition, assessments conducted in normal times using market data may have limited usefulness
in crisis times because of shifts in market sentiment.

Enhancements in data availability will likely need to accompany the increased attention to
identifying systemically important entities. The areas for attention include information on
bilateral cross-border exposures among financial institutions, and flow of funds data that would
include entities that are outside the regulatory perimeter.

Guidelines could codify the fundamental tenets pertaining to the assessment of systemic
importance and promote consistent implementation across countries. These could take the
form of high-level principles consistent with the general approach, and could cover issues such
as national frameworks for assessing systemic risk, frequency of assessment, use of information
and the methodologies outlined in this paper, communication of results and cross-border
cooperation. The G20 request did not specify the form of the guidelines or how enforceable they
though they should be. If the guidelines were to be applied in a formal manner, once experience
is gained, consideration could be given to eventually integrating them into existing sectoral
standards or developing a new international standard and related assessment methodology.
 4

I. INTRODUCTION

1. This paper responds to a call by the G-20 “on the IMF and the FSB to produce
guidelines for national authorities to assess whether a financial institution, a market, or an
instrument is systemically important.” 1 The G-20 Working Group 1 similarly asked “the IMF,
in consultation with the BIS, FSB and other bodies, to jointly develop a common international
framework and guidelines” in this area. This request was in response to the unprecedented reach
of the financial crisis that began in August 2007 and the growing awareness that the
macroprudential orientation of financial stability policy would need to be strengthened. The
guidelines are to be prepared by the next meeting of Finance Ministers and Central Bank
Governors, scheduled for November 7–8, 2009.

2. In issuing this call, the G-20 emphasized several points. First, the objective of the
guidelines would be to help mitigate systemic risk by ensuring that all systemically important
institutions, markets and instruments are subject to an appropriate degree of oversight and
regulation. Second, guidelines were to prevent regulatory arbitrage, and should therefore focus
on what institutions do rather than their legal form. These guidelines can potentially be relevant
for (i) defining the perimeter for regulation; (ii) defining the scope and intensity of regulation
and supervision applied to different institutions and markets; and (iii) the design and operation of
policy responses in the event of a financial crisis. Detailed discussion of these potential uses is,
however, beyond the scope of the present paper.

3. The current state of analysis limits the extent to which very precise guidance can be
developed. The paper therefore outlines conceptual and analytical approaches to the assessment
of systemic importance, and discusses a possible form for general guidelines. The latter would be
structured as high level principles rather than detailed quantitative guidelines. There are several
reasons for this:

 Responses to a survey of FSB members undertaken in April–July 2009 indicate that

approaches vary quite widely. Moreover, the application of specific methodologies is
constrained by data availability and has not advanced to a stage that could lead to a set of
best practice quantitative methodologies. 2

 Assessment of systemic importance involves a major element of state dependency and

time-variability. A high degree of judgment and flexibility to reflect national and
conjunctural circumstances will inevitably be involved in the assessments. While

1
See the “Declaration on Strengthening the Financial System,” Global plan for recovery and reform: the
Communiqué from the London Summit, April 2, 2009 (http://www.londonsummit.gov.uk/en/summit-aims/summit-
communique/ ).
2
This survey was sent to central banks of FSB members and a few other countries, and was also sent to the Basel
Committee, IAIS, and IOSCO for distribution to their members. See the Background Paper, Chapter 1 for a
summary of responses.
 5

quantitative approaches can provide useful inputs to the assessment, they cannot
substitute for qualitative analysis.

 Developing (and communicating) assessment criteria that are too specific may raise
moral hazard by creating incentives for firms to game the system, and weaken its
usefulness in mitigating systemic risk.

 The choice of assessment methodologies is not independent of their possible policy uses
(as outlined in paragraph 2). The paper is written primarily from the perspective of
assessing systemic importance in normal times for the purpose of calibrating instruments
that would mitigate systemic risk and enhance the financial system’s resilience to shocks.
The paper does not prejudge the nature of the policy actions which could vary by the type
of institutions and form of the systemic risks. The techniques may be different when the
assessments are conducted in crisis times.

4. The paper is outlined as follows. Section II discusses the definition of systemic

importance. Section III examines the approaches to identifying whether institutions, markets or
instruments are systemically important; and Section IV discusses the nature of possible guidance,
its coverage and possible uses. 3

II. DEFINITION

5. Establishing what constitutes systemic importance has proved difficult, and most
G - 20 members do not have a formal definition. Nonetheless, in practice G-20 members
consider an institution, market or instrument as systemic if its failure or malfunction causes
widespread distress, either as a direct impact or as a trigger for broader contagion. The
interpretation, however, is nuanced in that some authorities focus on the impact on the financial
system, while others consider the ultimate impact on the real economy as key.

6. The survey illustrated that country authorities recognize the state dependence of
systemic importance. In particular, while some entities may be of high systemic importance at
all times, during periods of extreme turbulence the systemic importance of a larger set of entities
is likely to increase , often because their problems may lead to widespread re-assessment of the
robustness of other entities. As a result, drawing bright lines between systemic and non-systemic
components runs the risk of overlooking sources of systemic threats.

7. Against this background, this paper defines systemic event broadly. In particular, it is
the disruption to the flow of financial services that is (i) caused by an impairment of all or parts

3
The main contributors to this paper are Li Lian Ong, Liliana Schumacher, Amitabh Arora, Marco Espinosa, Brenda
Gonzalez-Hermosillo, Mangal Goswami, Erlend Nier, Andre Santos, Ian Tower, Nai Seng Wong, and Karim
Youssef under the direction of R. Barry Johnston (all IMF/MCM); Kostas Tsatsaronis and Nikola Tarashev (BIS)
and Marina Moretti (FSB).
 6

of the financial system; and (ii) has the potential to have serious negative consequences for the
real economy.

 Fundamental to the definition is the notion that systemic events are associated with
negative externalities Every financial institution’s incentive is to manage its own
risk/return trade-off but not necessarily the implications of its risk taking for the
operation of the financial system as a whole. While this behavior is common to all
financial institutions, some have specific features that imply that failure would cause a
significant disruption to the rest of the financial system and to the real economy. These
features determine the systemic importance of individual institutions.

 An impairment or disruption to the flow of financial services would include situations

where certain financial services are temporarily unavailable, as well as situations where
the cost of obtaining the financial services is sharply increased. It would include
disruptions due to shocks originating outside the financial system that impact on it, as
well as shocks originating from within the financial system. A systemic event should be
contrasted with more general wealth effects that may have severe macroeconomic
consequences but are not associated with the impairment of the financial system. 4

 The definition requires significant spillovers to the real economy, without which an
impairment of financial services would not be considered systemic. The real economy
impact could be either through an effect on supply or through an effect on demand for
other goods and services, and could materialize over an extended period of time.

8. The definition stresses the critical importance of the continued provision of financial
services by the financial system, which includes:

 Financial institutions, which perform critical functions in financial markets, including

credit intermediation, maturity transformation, the provision of savings vehicles, risk
management and payments services, and the support of primary and secondary funding
market functioning.

 Financial markets and instruments, which represent another key channel of funding
from savers to investors, a source of liquidity, and support the management and pricing of
risk. These services are underpinned by financial infrastructure in the form of the clearing
and settlement of financial transactions, as well as the trading, pricing and liquidity of
financial instruments.

4
For example, a collapse in an asset price can affect net worth, expenditure and the real economy but would not
constitute a systemic event by this definition unless it disrupted the provision of some financial service. If a fall in
asset prices weakens the balance sheets of financial institutions, which might in turn reduce the amount of credit
provided to the real economy, this would be an important systemic event.
 7

This implies that, in principle, all types of financial intermediaries or markets can potentially be
systemically important. Moreover, it suggests that the degree of their importance can depend on
the economic and financial environment and be time-varying (see next section).

III. ASSESSING THE SYSTEMIC IMPORTANCE OF INSTITUTIONS, MARKETS AND INSTRUMENTS

A. Assessment Issues

9. The assessment of systemic importance will be conditioned by a number of

considerations:

 Assessing the systemic importance of an institution, a market or an instrument does

not lend itself to binary outcomes. While some components of the financial system may
rank consistently be assessed as highly systemic, the significance of others may differ
depending on a number of factors including the state of the overall economy (see below).
An assessment will therefore need to be graduated and take into account their potential
systemic impact. This is likely to involve scoring along a range of potential outcomes.
Drawing any sharp distinction between systemic and non-systemic components will
require the exercise of considerable judgment on where to draw the line.

 The characterization of systemic importance is partly “endogenous” as it will depend

on the structure of the financial system and the rules of the game. The systemic impact
of a malfunction of one component may depend critically on the functioning of other
elements, such as the robustness of markets and market infrastructure, and the
institutional framework for crisis management and handling of failures when they occur.
For example, robust crisis resolution frameworks and clearing and settlement systems can
mitigate the potential externalities on the rest of the financial system due to failures in
institutions and markets. The presence (absence) of such elements may act as potential
mitigants (amplifiers) of the systemic importance of institutions, markets or instruments
in the financial system.

 The assessment is likely to be time-varying depending on the economic environment.

Systemic importance will depend significantly on the specifics of the economic
environment at the time of assessment. Structural trends and the cyclical factors will
influence the outcome of the assessment. For instance, under weak economic conditions
there is a higher probability that losses will be correlated and failures in even relatively
unimportant elements of the financial sector could become triggers for more general
losses of confidence. A loss of confidence is often associated with uncertainty of asset
values, and can manifest in a contagious “run” on short-run liabilities of financial
institutions, or more generally, in a loss of funding for key components of the system.
The dependence of the assessment on the specific economic and financial environment
has implications about the frequency with which such assessments should take place,
with the need for more frequent assessments to take account of new information when
 8

financial systems are under stress or where material changes in the environment or the
business and risk profile of the individual component have taken place.

 The nature of the assessment may be conditioned by its purpose. The assessment
methodology and criteria may differ depending on whether the outcome would be used
primarily for the purpose of defining the regulatory perimeter, of calibrating the intensity
of oversight or of guiding decisions during a crisis. Assessments intended to define the
regulatory perimeter will cover entities that may not normally report information, and
thus may require innovative approaches to data collection. Further, if the purpose of the
assessment is linked to stricter regulations, firms may structure and manage themselves in
ways to avoid the criteria; if linked to support operations firms may try to meet the
criteria, aggravating moral hazard. Assessments of systemic importance using real-time
market information could be of high value for decisions on interventions to prevent
systemic failures during crisis times. However, such analysis may yield little information
on potential inter-dependencies in normal times.

 The nature of the assessment may be conditioned by its geographical context.

Institutions may be systemically important for the local, national or international financial
systems and economies or just for one of them. While the principles adopted in this paper
can be applied to all levels, the actual implementation will vary. For institutions that are
systemically important at an international level, the assessment may require coordination
mechanisms among domestic authorities and a role for international bodies.
Arrangements for international cooperation are discussed in Section IV.

10. A high degree of judgment founded in a detailed knowledge of the functioning of the
financial system will thus be required in any assessment. Authorities will need to draw on an
intimate knowledge of their financial system as part of the assessment, and judgment of systemic
importance cannot be based simply on quantitative indicators/methods. Qualitative analysis will
require a system-wide approach, similar to that used in the preparation of financial stability
analysis as part of national financial stability reports or FSAP assessments.

B. Assessment Criteria

11. The main criteria for assessing systemic importance relates to their potential to have
a large negative impact on the financial system and the real economy. The criteria should
take into account both direct and indirect channels.

12. Typically, the magnitude of the direct impact relates to size and the degree of
substitutability, while the magnitude of the indirect impact depends on the strength of
interconnectedness. The criteria apply to both markets and institutions. Size and
 9

interconnectedness are the most frequently cited criteria in the responses to the survey, and the
importance of these criteria is also illustrated by the experiences with the recent financial crisis.5

 Size: The importance of a single component for the working of the financial system
generally increases with the amount of financial services that the component provides.

 Lack of substitutability: The systemic importance of a single component increases in

cases where it is difficult for other components of the system to provide the same or
similar services in the event of a failure.

 Interconnectedness: Systemic risk can arise through direct and indirect interlinkages
between the components of the financial system so that individual failure or malfunction
has repercussions around the financial system, leading to a reduction in the aggregate
amount of services.

The three criteria provide a useful analytical device to structure the assessment of systemic
importance, but their relevance is often greatest when they are combined in different ways.

Institutions

13. The link between the size of an institution and the systemic impact that its distress
or failure will bring about is generally accepted as a key factor in the assessment of its
systemic importance. The size of the balance sheet and off-balance sheet exposures of the
institution, the volume of transactions it engages in and processes, the volume of assets it
warehouses or manages are all indicative of the extent to which its clients will be starved of
funds, its business with other institutions will be disrupted and the magnitude of losses its
counterparties may face. While size can be important in itself, it is much more significant when
there are connections to other institutions. The relevance of size will also depend on the
particular business model and group structure, and size may be of greater systemic concern when
institutions are complex (see below). 6 A more subtle aspect of size has to do with clusters of
institutions that can be individually small but collectively significant because they tend to fall
into distress at the same point in time or have similar behavioral responses to a given shock. This
can happen if the institutions are exposed to common risk factors (for instance through similar
business models or exposure to correlated assets or liabilities). Hence, strong commonality can,
in some cases, have a similar effect to large size from a systemic point of view.

14. Some institutions lack immediate substitutes for the key role they play in the
economy. They are systemically important not so much because other institutions are financially
exposed to them but because other financial market participants rely on them for the continued

5
See Background Paper, Chapters 1 and 2.
6
It has been noted, for example, that well capitalized large institutions with simpler business models and exposures
can be a source of stability in times of stress.
 10

provision of key specialized services. This would describe, for instance, institutions charged with
providing systemically important infrastructure services, such as clearing, payment and
settlement of trades, or custodial services. Limited substitutability is likely to be much more of a
concern when the services provided are large in volume, or where they provide a key link in
connections among financial institutions. The criterion can also apply to groups of institutions
that perform a specialized function.

15. Interconnectedness captures situations when financial distress in one institution

materially raises the likelihood of financial distress in other institutions because of the
network of contractual relations in which the institution operates. This chain effect operates
on both sides of the balance sheet, i.e., there are inter-connections on the funding side as well as
on the provision of funds. The larger the number of links (the larger the number of creditors and
clients), the higher potential to cause spillovers onto either clients and/or creditors. In addition,
the larger the size of the individual exposures (the “thickness” of the links), the greater the
potential that these effects will be magnified. Moreover, the complexity of the connections
within a network, as well as confidence factors when a core element of the system comes under
stress, can add to the uncertainty of participants in situations of stress, further increasing the risk
that distress may take systemic proportions.

Markets and Instruments

16. The assessment of systemic importance of markets presents more conceptual

challenges than for institutions. The reason being that the market is a more abstract notion that
lacks precise delineation. A market is the combination of traded instruments, transacting
counterparties (market participants) and the trading infrastructure that includes rules,
conventions, settlement processes and information. By consequence, the systemic importance of
a market derives to a certain extent from the systemic importance of the institutions that
participate and use this market.

17. The link between size and systemic importance in the case of markets is analogous
to that in the case for institutions. The size of activity in a market, measured either by the
volume of transactions or by the number of participants, is a key determinant of the potential
economic costs in the case of malfunction. The transactions volume metric is a proxy of
aggregate (gross) exposures of participants in this market while the number of participants points
to the number of institutions that will be affected.

18. If the economic function of a stressed market cannot be easily replicated by other
means the effect on the economy at large can be very significant independently of the size of
the market. Network effects and economies of scale may concentrate trading of a specific
security in a particular market, which when disrupted becomes the source of systemic distress.
The existence of substitutes can be examined with respect to the different functions that markets
perform: provide a platform for raising funds by private and public sector borrowers, provide
facilities for trading securities and for taking positions or hedging, and enhance the liquidity of
portfolios. Typically the lack of alternative channels for trading a particular type of security or