No Financial Institutions Are Systemically Important

The postmodern regulatory approach to banking relies on the idea of systemically important financial institutions.

The Financial Stability Board defines these creatures as financial institutions whose "disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity."

The FSB lists a few dozen global systemically important financial institutions. Disagreement in this new postmodern world seems to center on better working definitions of systemically important, questions of process and authority as to who shall make the final determination, and quibbles about specific entities and their designations. Only a few bother to ask whether this entire approach is useful or not. And essentially nobody considers the possibility of complete deregulation of the banking sector, including allowing competing currencies.

Let's take a heterodox tack on this issue and consider the hypothesis that no financial institutions are systemically important.

The standard definition above of SIFIs is essentially useless – just like the modern interpretation of the Commerce Clause of the Constitution is useless as a limit on power. What was intended to be a limited Congressional power has expanded into a blank check to act in any case where there is an aggregate effect on economic activity. Congress doesn't even need to explain how the effect aggregates, which would be a low enough hurdle; there only needs to be a "rational basis" for thinking there could be such an effect. In other words, as the Institute for Justice, a libertarian public-interest law firm, argues, as long as the judge's imagination is creative enough, virtually any law can be authorized under the prevailing interpretation of the Commerce Clause.

Similarly, just about any institution can be deemed systemically important under the standard definition. Economic activity in the free market naturally encourages complexity and interconnectedness. That is how the magic of mutual benefit and prosperity spreads throughout the world.

But what is the wider financial system that we are so worried about? People invest in assets and securities with the understanding that they could lose all their money. That's why they don't usually put all their eggs in one basket. People trade with counterparties with full knowledge that in the event of distress or default, some of the money may not be recoverable. That's why they insist on collateral.

To be sure, there are critically important companies and industries in America. If the power goes out, we expect the electric company to be working round the clock. Other critical crews such as firefighters, ambulances, hospitals, and police are also available every hour of every day in the year.

But other businesses that are useful but not critical are not always open. The post office is closed on Sundays. Many museums are closed on Mondays. Most regular office businesses are closed all weekends.

On the other hand, many seemingly "unimportant" businesses are also open every day, often 24 hours a day: fast food restaurants, bookstores, supermarkets, and pharmacies. So it's not necessarily the case that every round-the-clock establishment is in some political sense important, but it does seem reasonable that any establishment that is in some political sense important better be open round-the-clock.

Are banks open round-the-clock? Famously, no. They are closed for every federal holiday observed by the Federal Reserve: Ten holidays a year including Labor Day, Columbus Day, Veterans Day, Martin Luther King Jr.'s birthday, Washington's birthday, and five more. By and large, banks are closed Sundays. They are closed at night. And when they are open, they work, by definition, banker's hours. (The seven-days, open-late model of a handful of community and regional banks is the exception that proves the rule.)

Yet economic activity continues to function even when banks are closed. Credit cards still work. ATMs dispense cash. Checks are accepted. The markets that people are willing to pay to be open are open.

If a crazy calendar somehow had several federal holidays in a row, and banks were closed for a full week, would anybody even notice?

We in the banking and finance community like to think of ourselves as central and critically important to an economy, but perhaps banks are not that important after all. Their major function of clearing and moving money can obviously be postponed indefinitely without major ramifications. And of course that entire functionality can be replaced with electronic services such as PayPal or electronic currencies such as Bitcoin. Is PayPal a systemically important financial institution? Is Bitcoin, or Visa, or MasterCard? Not according to the FSB.

No financial institution is truly systemically important. I worked at Long Term Capital Management when the Federal Reserve twisted arms to orchestrate a private rescue. Would the world have been so much worse if LTCM had simply been allowed to fail or find its own solution? Perhaps it would have been better, given the implied sanction the event gave to future moral hazard.

The only times in history when the collapse of a company threatened an entire nation's economy were when the nation was intricately tied up with the company: The South Sea Company of the 18^th century, a public-private partnership closely supported by the British government; the Mississippi Company, established under the auspices of King Louis XV by economist John Law; Fannie Mae and Freddie Mac. What else needs to be said?

Designating certain companies as systemically important accomplishes nothing more than putting them into a closer relationship with the government, making the designation itself a self-fulfilling prophecy. Without the excessive government interference that forces innocent people to be responsible for the failures of others, no financial institution would be systemically important.

Philip Maymin is an assistant professor of finance and risk engineering at NYU-Polytechnic Institute.