Financial intermediation, systemic risks, and “too big to fail”

U.S. Fed Governor Daniel Tarullo testified on Dodd-Frank Act implementation

In the next parts of the series, we’ll discuss the implications of Governor Daniel Tarullo’s update to the Senate Committee on Banking, Housing, and Urban Affairs in Washington D.C. In this part of the series, we’ll walk you through some of the issues that financial institutions are facing. We’ll explain why it’s important for financial regulators—like the U.S. Federal Reserve—to monitor the issues closely.

Financial intermediation and systemic risks

Financial intermediaries are market-makers for the sources and uses of capital in the economy. They pool funds from savers and investors—for example, through checking accounts and deposits. These funds are lent to businesses and individuals.

When financial intermediaries allocate funds, they assess the risks—credit risk, duration or interest rate risk—and returns that come from various risky claims. They sell some of the risks to investors and individuals who are willing to bear it. Intermediaries help allocate resources and risks throughout the economy. Financial intermediation can result in concentrated risks. The risks increase the financial system’s fragile state. These risks are called systemic risks.

Financial regulators that provide supervision include the U.S. Federal Reserve, Financial Stability Board (or FSB), and the Federal Deposit Insurance Agency (or FDIC). They monitor and reduce systemic risks. They do this without interfering with the healthy function of the financial markets and institutions.

Global Systemically Important Banks (or GSIBs)

Very large financial institutions are usually designated by regulators as GSIBs. A bank-run or bankruptcy in these institutions can trigger a major financial crisis. Some major GSIBs include Bank of America (or BAC), JPMorgan (or JPM), State Street (or STT), and Goldman Sachs (or GS).

These institutions can have a massive impact on financial markets worldwide. They’re sometimes referred to as “too big to fail” (or TBTF). Some market participants have argued that financial stress in TBTF institutions makes a compelling case for a government bailout. Other market participants maintain that market forces should get rid of the riskier firms.

Financial markets impact of intermediation

Financial intermediaries play a critical role in supporting other economic sectors. Systemic risks come from large financial intermediaries. They can spread across markets. This increases volatility (VXX) and affects long-term returns on exchange-traded funds (or ETFs). Examples of ETFs include the iShares Core S&P 500 ETF (IVV), the Vanguard Total Bond Market ETF (BND), the SPDR S&P Regional Banking ETF (KRE), and the iShares U.S. Real Estate ETF (IYR).

You’ll read about the impact on systemic risks on financial markets in the next part of the series.