Thomas J Jordan: Approaching the finishing line - the too big to fail
project in Switzerland
Speech by Mr Thomas J Jordan, Vice Chairman of the Governing Board of the Swiss
National Bank, at the International Center for Monetary and Banking Studies, Geneva,
17 May 2011.
* * *
I would like to thank Dr. Claudia Strub and Till Ebner for their valuable support in drafting this speech.
Introduction
Eighteen months ago, we here in Switzerland tackled a major challenge: the search for a
solution to what is known as the "too big to fail" problem in the current financial system. "Too
big to fail" means that the state has no choice but to rescue a company because its demise
would seriously affect the entire economy. In good Swiss tradition, a broad-based committee
of experts1 presented the Federal Council with a proposal supported by all involved parties
and the implementation of which would significantly alleviate the "too big to fail" problem.
This proposal was, in essence, approved by the Federal Council and has been put before
Parliament in the form of a draft law.
At this point, I should like to deliver an important message. The package of TBTF - too big to
fail - measures is not intended to hurt the big banks or the banking sector in Switzerland.
Rather, it aims to protect state and taxpayer from incurring an unwanted and unacceptable
risk, while also creating the necessary framework conditions for the banking sector to be able
to develop sustainably and successfully over the long term.
The decision is now up to the politicians. In the coming weeks and months, Parliament will
decide whether the proposed measures will actually be implemented. The final, decisive
phase of the project is thus underway - we are approaching the finish line!
In the Swiss system of direct democracy, the electorate essentially also has the final word in
the legislative process. It is therefore important to ensure that the public clearly understands
such a complex topic as the regulation of systemically important financial institutions. The
SNB has the statutory mandate to contribute to the stability of the financial system. It thus
played a significant role in drafting the solution put before the Federal Council. Allow me to
explain the considerations behind the proposed legislation.
The cost of financial crises
The latest crisis highlighted the fact that big, globally interconnected financial institutions
present a particularly large risk to an economy. If they fail, systemically important functions
vital to the smooth running of the economy - such as the lending business or executing
payment systems - can no longer be carried out. It is for this reason that an economy cannot
afford to allow such an institution to fail. In a crisis, the state - in other words the taxpayer -
has no choice but to rescue the bank. Big banks of this kind therefore possess an implicit
state guarantee and benefit from artificially low borrowing costs. From an economic point of
view, this equates to a state subsidy. This is not in line with the basic principles of a free
market economy. (cf. chart 1)
This problem is particularly acute in our country, with its two very big banks. Although they
have reduced their balance sheets significantly since 2008, the balance sheet totals of both
big banks still amount to around four times the gross domestic product. Even though this is
only a rough yardstick, it nevertheless gives an indication of the risk to an economy. As the
crisis has demonstrated to us, this risk can have dramatic consequences if it turns into
reality. The cost to the state of rescuing a TBTF bank may be enormous. In extreme cases,
the state may even need to ask for international help, which can would greatly jeopardise a
country's independence. (cf. charts 2 and 3)
In order to massively reduce the likelihood of this nightmare scenario suddenly coming true,
we must put our financial system back on a more stable footing. There is no doubt that this is
in the interest of Switzerland as a whole. Indeed, having enough capital and hence being
considered robust is - undoubtedly - also in the interest of the banks themselves. Although
we dealt with the crisis competently - here, I am referring to the successful bail-out of UBS in
autumn 2008 - there is unfortunately no guarantee that our country will come off so lightly in
future crises.
The Swiss TBTF proposal
As the above remarks make clear: big, interconnected financial institutions can destabilise
the financial system and an entire economy, with dramatic consequences. How can they be
made more secure? And how can the problem of the implicit state guarantee be reduced?
The package put together by the Federal Council in Switzerland is precisely targeted at these
two questions.2
A central component of the Swiss approach is that systemically important banks should
markedly improve their capital base and liquidity positions, both qualitatively and
quantitatively, and reduce their risk exposure to other banks.3 This will make systemically
important banks more stable in future and reduce the likelihood of them running into
difficulties. Furthermore, organisational measures aim to ensure that systemically important
functions can continue to be performed during a crisis, while simultaneously liquidating the
big bank in an orderly manner. This reduces the need for state intervention.
These measures may have different starting points and goals, but they all harmonise with
each other. If the provisions for improving stability do not suffice and a crisis occurs anyway,
the mechanisms that guarantee the continuation of systemically important functions will kick
in.4 In their entirety, these measures help to ensure that the banks are again able to bear
more of their risks themselves.
What are the objections to the package of measures?
So why are there still objections to the Swiss package of measures from various quarters, if
the advantages are so obvious? Do these measures have any harmful consequences?
Objections and doubts before the introduction of new regulations or laws are part and parcel
of a thriving democracy. Before implementation, we can never know with absolute certainty
how our economy or society will react to changed framework conditions - there is therefore
always an element of doubt. For instance, one objection to the package of measures is that
the cost of taking such drastic action to achieve the transition to a more stable system would
be too high. In addition, doubts have also been expressed concerning the rapid pace and the
impact of the proposed reforms. Although we can understand such criticisms, the SNB
believes them to be exaggerated and largely unfounded. Allow me to explain.
I would like to begin by making three general preliminary observations. Firstly, regulation is
never free of charge for every participant. However, analysis of the possible costs of
regulation must always differentiate between the private and the social costs: in practice,
regulation is bound to lead to additional costs for those regulated. This is part of the plan and
makes economic sense provided that these additional costs are smaller than the benefits
that regulation brings to the entire economy. If regulation leads to the elimination or reduction
of market distortions - such as subsidies, for example - then an economically more efficient
result is obtained.
Secondly, regulation can be formulated in a more or less cost-efficient manner. Particular
attention was paid to this element in Switzerland. For instance, the additional capital required
here by systemically important banks can largely be held in the form of more cost-efficient
convertible capital. Other, far more drastic measures, such as a strict ban on certain
business activities or the introduction of a bank tax - as discussed in other countries - were
firmly rejected, partly for cost reasons.
Thirdly, the proposed measures are by no means excessive in scope - on the contrary: the
increase in capital would reduce the big banks' ratio of debt, which currently stands at
approximately 98%, by only three percentage points: around 95% of the balance sheet total
could continue to be financed by borrowed capital! Besides, the Federal Council's proposal
merely implies a return to a level of capital that the big banks exceeded up until 1996
(cf. chart 4).
Ladies and gentlemen, let us now take a closer look at the potential negative consequences
of the proposed regulation of the big banks.
Will stricter regulations push up borrowing costs within Switzerland?
Firstly, there are fears that stricter capital adequacy requirements could lead to higher
financing costs for the banks. It is argued that this would above all lead to more expensive
credit for companies and households. Lending would then decline, acting as a brake on
Swiss economic growth.
According to economic theory, the one does not necessarily lead to the other, since an
increase in capital should not have any effect on a bank's overall financing costs.5 Owing in
part to the preferential tax treatment of borrowed funds, the Modigliani-Miller theorem
referred to here, cannot be applied directly in practice, which means that overall financing
costs would rise if capital increases. However, this is exactly what the proposed measures on
convertible capital take into account. They create better conditions, so that capital structure
will have less influence on a bank's financing costs.
Independently of this finding, it is argued that the reduction of the state subsidy - which is
one aim of the new regulation - will lead to an increase in lending rates for clients. There are
various arguments against this. On the one hand, structural factors within Switzerland's
banking sector limit the big banks' scope for setting prices even today: There is a sufficient
number of domestic lending providers in the market, which keeps margins relatively low. On
the other hand, the reduction in the subsidy will tend to lead to even more competition. The
current disadvantage suffered by other banks active in the domestic market is lessened - the
package of measures thus levels the playing field in the Swiss customer business segment.
In this environment, an increase in lending rates by the big banks would lead to a loss of
market share. A reduction in the subsidy is therefore more likely to manifest itself in lower
returns on equity or lower compensation for the bank management than in higher lending
rates.
Empirically, there is no connection between the capital ratio and the credit volume, either. In
the phase of debt-financed balance sheet ballooning seen between 1995 and 2007, the
amount of credit available did not rise accordingly, nor did it decline in the following period
when debts were being cleared. This observation is even more striking, given that, in autumn
2008, the regulatory authorities stated that as of 2013 both big banks will have to have twice
as much capital as the Basel II minimum international standard specifies: According to
current findings, the capital adequacy rules did not have a negative impact on lending levels
nor did they increase lending rates (cf. charts 5 and 6).6
With a view to other possible economic repercussions of tighter regulation of the big banks,
the question also arises as to whether and to what extent employment and value creation in
Switzerland are at all affected. A glance at the statistics covering the period when UBS and
CS saw their balance sheets expanding between 1995 and 2007 shows, among other things,
that there is no clear-cut positive connection between the size of a balance sheet, on the one
hand, and jobs and contribution to value creation at these banks in Switzerland, on the other.
This implies that reducing the balance sheet as a result of stricter regulation would not
necessarily have negative consequences in these respects (cf. chart 7).
To conclude, it appears that there are no theoretical or empirical grounds to indicate that the
Swiss economy will be adversely affected by the proposed regulation. Even though, in the
short term, the transitional phase would generate some costs for those regulated, this is
clearly outweighed by the long-term advantages.
Is international competitiveness being weakened?
The second concern expressed is that tougher banking regulation would have negative
repercussions for the Swiss financial centre if it is stricter or too strict compared with other
countries in relative terms. Critics say that this would be a disadvantage in international
competition, with far-reaching consequences such as a weakening - or even redimensioning -
of the Swiss financial centre. They claim that customer assets and international companies
would move abroad, since the Swiss financial centre would no longer offer a comprehensive
range of banking services. Switzerland would therefore lose jobs and create less added value,
they believe.
Key factors for international competitiveness
One significant aspect of the discussion about the repercussions of regulatory differences is
that other factors are at least as decisive for the international competitiveness of the Swiss
banks. These include favourable tax conditions, political and economic stability, a high
degree of legal certainty, excellent asset management expertise and high standards in the
banking business generally. Overall, this "Swissness" represents a crucial success factor for
the banks when it comes to competing internationally with other financial centres.
Secondly, we should bear in mind that a country-specific difference in banking regulation is
nothing new. Even before the financial crisis began in 2007, both the Swiss big banks were
subject to stricter regulations in terms of capital requirements than their competitors in many
other countries. As already mentioned, FINMA ruled, in autumn 2008, that as of 2013, both
big banks will have to hold double the amount of capital specified in international minimum
standards. The current "Swiss finish" therefore calls for an extra 100%!
However, these regulatory differences do not seem to have harmed the Swiss financial
centre in the past. On the contrary, Switzerland's banks have always had a tradition of a
"Swiss finish". Stability is one of the Swiss financial centre's clear competitive advantages
and has made a significant contribution to attracting customer assets and companies to
Switzerland.
A consideration of regulatory differences in their entirety
Let us now take a closer look at the possible regulatory differences in connection with current
trends in Switzerland and other countries. How significant are these differences?
First of all: the thrust of international capital regulation is the same everywhere - more
capital, stricter risk weighting and systemic importance to be taken into account when
deciding how rigorous the regulation should be. The Basel Committee on Banking
Supervision and the Financial Stability Board have stipulated that banks of international
systemic importance should hold a substantial capital surcharge in relation to risk-weighted
assets, which is over and above the Basel III standards.7 However, this additional amount
does not take national systemic importance into account. Each country, therefore, must
henceforth decide individually on an appropriate additional amount based on the risk. For
example, even if the international capital surcharge was set at a low level of 1%, the "Swiss
finish" would result in only 25% more common equity (cf. chart 8).8
Unlike in the case of risk-weighted capital regulation, however, Switzerland does not play a
pioneering role as regards the absolute indebtedness (leverage ratio) of banks. The United
States and Canada, for example, both introduced a leverage ratio some time ago. These
countries are therefore stricter than Switzerland regarding leverage ratio.
Furthermore, one thing is often overlooked in the current debate: banking regulation is by no
means restricted to capital adequacy requirements. On an international comparison, it is the
overall package of measures proposed for the regulation of (systemically important) banks
that is decisive. In the US, for example, the Dodd-Frank Act9 severely restricts proprietary
trading by banks that accept deposits. Sweden, for example, introduced a tax on systemically
important banks. A variety of other proposals, such as the establishment of a permanent
bailout fund or new regulations on the organisational structures of banks, are being planned in
the EU (cf. chart 9).10
When comparing regulatory packages at international level, it is therefore important not to
look at capital adequacy requirements in isolation. Additional measures with far-reaching
effects on economic freedom can have grave unintended consequences. They therefore end
up costing considerably more than measures that create targeted incentives to allow market
discipline to operate again.
To sum up, an analysis of international differences in regulation shows that, in the past,
stricter capital regulation was in fact a competitive advantage rather than a disadvantage for
Swiss banks. Furthermore, a look at the various regulatory packages in their entirety shows
that the future requirements for internationally active, systemically important financial
institutions will be designed differently at global level. Ultimately, however, they will differ in
rigour only as far as the respective national regulators deem necessary in response to
country-specific risks.
Is the Swiss package of measures being introduced too quickly?
A third objection concerns the pace of the regulatory reforms. Compared with other
countries, the implementation of the Swiss package of measures is regarded as too hasty in
some quarters. One concern is that significant aspects have not been properly considered
when drafting the package, with the ultimate consequence that the TBTF problem is not
tackled effectively.
First of all, it is important to remember that the latest crisis reached its peak some three
years ago. It is therefore entirely inappropriate to refer to the Federal Council's proposal as
hasty.
On the contrary, the committee of experts worked intensively on drawing up a proposal
supported by all groups involved. The administration conducted a thorough analysis and
carried out an extensive consultative process. The Federal Council has thus been able to put
forward a sophisticated package of measures. This method of proceeding is in keeping with
the Swiss tradition of taking the necessary action while avoiding snap decisions. However,
actually implementing these rules will take some time. Because of the pressing need for
reform in Switzerland, it is not practicable to wait for the international bodies to complete their
work in this area. It would make much more sense to implement the best possible measures
within a suitable time frame, in order to achieve a significant reduction in the risk to our
country as early as possible.
I consider that the best possible measures are those which take account of the specific
characteristics and risks inherent in our banking structure and have a high impact without
incurring too high a cost. The package now before Parliament fulfils these criteria. On the
one hand, the proposed measures are rigorously based on tried-and-tested approaches and
instruments11 which have been in existence in all developed countries for decades and
whose effectiveness cannot be doubted. On the other hand, measures with great potential
for unintended consequences have been decisively rejected by the committee of experts and
the Federal Council, and not included in the package.
Conclusion
I am now drawing to the end of my remarks.
The failure of a big bank would have enormous and incalculable negative implications for
Switzerland - not least because a state bail-out would be unavoidable. This risk is no longer
acceptable. That is why strenuous efforts have been made over the past eighteen months to
find a solution to the "too big to fail" problem. The Federal Council has recently presented a
carefully thought out, balanced package of measures for Parliament's consideration.
Implementing these measures in full will make an effective contribution to significantly
reducing the problem in Switzerland. This package considerably lessens the probability of a
big bank crisis and the ensuing need for state support in such a crisis - which would create
an intolerable strain in terms of regulatory and fiscal policy - and at the same time restores
market discipline.
We need to be aware that regulation is never implemented without some cost to those
regulated. However, fears about the extent of the potential repercussions are in my view
unfounded, not least because consideration has been given to the costs involved during the
drafting of the new rules. In particular, the newly introduced convertible capital will contribute
to limiting the costs of stricter capital adequacy requirements. What is more, the
organisational measures do not constitute excessive interference with the freedom of scope
and responsibility enjoyed by a bank's management. Measures of this kind can only be
subsidiary in nature. This means that the regulatory objective is not exceeded.
The increased stability brought about by this package will help not only Switzerland but also
our entire financial centre to emerge from the latest crisis significantly stronger than before.
What happened to UBS may not happen again. The proposed amendments to the
regulations will also soon create legal certainty for the banks and allow them to plan
concretely, while at the same time promoting the reasonable, long-term development of the
financial centre. There is no doubt about the positive long-term consequences for the entire
Swiss economy in terms of income and employment.
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