Thomas Jordan: The Swiss banking sector and the next steps in
resolving the "too big to fail" issue
Introductory remarks by Mr Thomas Jordan, Vice-Chairman of the Governing Board of the
Swiss National Bank, at the half-yearly media news conference, Geneva, 17 June 2010.
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Introduction
A year ago, the financial system was still in an extremely fragile state. Crisis management
was at the centre of our efforts. Yet even then, we were emphasising the urgent need to
alleviate the "too big to fail" issue. Much has happened since that time. The financial sector,
hit hard by the crisis, has recovered considerably, and on a national and international level,
politicians, supervisory authorities and central banks are working intensively to ease the "too
big to fail" issue. The goal is clear: in future, the public and the taxpayer should not have to
shoulder the responsibility for rescuing banks.
Based on our latest Financial Stability Report, I would like to review first the situation in the
banking sector, and second, the next steps in resolving the "too big to fail" issue.
Conditions in the Swiss banking sector
Conditions in the Swiss banking sector have improved. Following a catastrophic 2008, the
situation at UBS stabilised over the course of last year. With regard to Credit Suisse, it is now
even possible to speak of a return to normal. Large-scale support measures deployed by
governments and central banks played an essential role in ensuring that the global economy,
the financial markets and thus also the banks recovered sooner and more vigorously than
had been anticipated a year ago. For the banking sector alone, the major industrial nations
committed funds amounting to almost 20% of gross domestic product. As a result of the
different measures to support the economy and the banking sector, there has been a
considerable rise in the indebtedness of many countries, and also, in some countries, in
sovereign credit risk.
The international big banks - including the Swiss big banks - benefited substantially from
these support measures, and were able to increase their profitability in 2009. At the same
time, the Swiss big banks reduced their balance sheets by approximately a quarter.
Compared to the previous year, their capital situation improved substantially. Their
riskweighted capital ratios, in particular, have increased markedly, and are high also by
international standards. This is a very positive development. However, it should not be
allowed to conceal the fact that the leverage of both big banks is still high - both per se and
when compared with banks in other countries. The big banks are still a long way from
meeting the leverage target that will apply in Switzerland from 2013. With this in mind, a
further strengthening of the capital situation and - in conjunction with this - a further
realignment of the business model in order to achieve sustainable profitability, are still central
challenges facing the big banks.
The profitability and the capital situation of the banks with a domestic business focus - the
cantonal, regional and Raiffeisen banks - were significantly higher in 2009 than the
longterm average. The dip in GDP from mid-2008 to mid-2009 has so far barely had any effect on
these banks, with the result that the provisioning requirement for credit risk continued at a
low level in 2009. Nevertheless, in our estimation, the position of these bank categories is
less comfortable than may appear at first glance. First of all, the capital situation of the
Raiffeisen banks and the state-guaranteed cantonal banks needs to be put into perspective:
the Raiffeisen banks can count the additional funding obligation required of members in the
cooperative as capital until the end of 2011, and the cantonal banks are entitled to a
reduction in required capital due to the state guarantee. In the absence of these
concessions, the capital ratios - particularly for the Raiffeisen banks - would be markedly
lower. Second, according to our assessment, the risk exposure of the domestically focused
banks is higher now than it was in 2009. For one thing, the interest rate risk of cantonal and
Raiffeisen banks is at historically high levels. For another, the sharp increase in loan volumes
- especially for mortgages - against a backdrop of persistent economic uncertainty and the
substantial rise in real estate prices points to higher credit risk. In addition, for first mortgages
on residential properties, banks are required to have less capital backing under Basel II than
they did under Basel I - before 2007 (i.e. under Basel I), a mortgage had to be backed with
4.0% capital; since then (i.e. under Basel II), that figure is only 2.8%. This not only gives
banks an incentive to grant more mortgages, but also enables them to reduce the capital
buffer used to absorb loan losses.
In view of the increased interest rate and credit risk, we urge the domestically focused banks
to be prudent. They must be prepared for interest rates to rise. Besides the direct effect on
the interest rate margin, particular attention also needs to be given to the indirect effect of an
interest rate increase, namely that if loans are granted without sufficient attention being paid
to borrowers' financial situations, a rise in the interest rate will inevitably result in higher loan
losses. As I have mentioned, the domestically focused banks are well capitalised by
historical standards. But in view of the risks and uncertainty, they will also need to maintain a
large capital buffer.
The jump in domestic mortgage lending and in property prices in an environment of
historically low interest rates prompted us in the first quarter of this year to conduct a survey
among the major banks in the Swiss mortgage industry. We must not forget the lessons
learned from previous crises. The property bubble of the 1990s, with its dire consequences
for the Swiss banking sector, but also the most recent example - the sub-prime crisis - serve
to remind us that adverse developments in the mortgage market can threaten the stability of
the banking system, and are thus deserving of the Swiss National Bank's (SNB) fullest
attention. The results of the survey give no cause to sound the all-clear. These may show
that there was no relaxation of internal lending standards by the banks between 2005 and
2009, but for banks with a significant overall market share these standards lack
conservatism. More than a few banks, for instance, are determining the affordability of a
mortgage loan based on an interest rate which is at a historically low level. In addition, based
on statements made by survey participants, in practice, deviations from internal lending
standards occur frequently: banks with a market share of almost 25% reported such
"exceptions to policy" for more than 20% of new mortgage loans granted in 2009.
Furthermore, the banks provided only incomplete data on their actual lending practices. This
could be a sign that some banks are inadequately informed of the risks in their mortgage
portfolios.
The SNB is treating this issue as a high priority, and will continue to monitor the mortgage
market carefully. We will analyse the risks in greater detail - in close cooperation with FINMA
and the banks themselves - and examine whether there is a need for action. In any case,
caution should be exercised in lending. When assessing affordability, it must be taken into
account that interest rates are, by historical standards, exceptionally low. It is essential that
loan-to-value ratios be set conservatively, especially for regions and property types that have
seen prices rise sharply in recent years.
Outlook
We expect the global economy to continue recovering this year. This recovery, however, is
fragile, for it has until now been based largely on the support measures deployed by
governments and central banks. Uncertainty is still at an above-average level. Downside
risks have gone up again in recent months due to the financing difficulties faced by some
European countries. Urgently needed cost-cutting measures and rising risk premia could
jeopardise the recovery and trigger another lengthy period of higher credit default rates, and
even renewed turbulence on the financial markets. A development of this kind would present
the Swiss banking sector with a serious challenge: besides an economic slowdown and a
slump in the financial markets, a further destabilising influence could be the spread of
problems throughout the global banking system. Thus indirect risks pose a serious threat to
Swiss banks, even if direct risks - measured by the direct claims on those countries
particularly affected until now - are moderate. In this climate, it seems inappropriate to us
that banks increase their appetite for risk.
Reforming the regulatory framework / "too big to fail"
A year ago, we emphasised the urgency of alleviating the "too big to fail" issue. Where do we
stand today? Allow me to state clearly right now: the "too big to fail" issue will not resolve
itself. Last year, the big banks significantly reduced their balance sheets - a move explicitly
welcomed by the SNB. The "too big to be rescued" issue has thus also receded somewhat.
However, there has been hardly any alleviation of the "too big to fail" issue. Big bank
liabilities, which at the end of 2008 were still almost six times Swiss GDP, were reduced by
the end of 2009 to just over four times GDP. Nevertheless, the big banks' share of markets
relevant to the Swiss economy - and hence their systemic importance - remains just as high
as before: the big banks grant a third of domestic loans and hold a third of domestic deposits.
In other words, Switzerland is still vulnerable, and the need for action remains great. This
opinion is shared by the commission of experts appointed by the Federal Council on "Limiting
the economic risks posed by large companies", of which I am Vice Chairman. It is the
commission's assessment that in their current form and size, the big banks are clearly
systemically important.
The commission of experts published its interim report at the end of April. The "too big to fail"
issue is to be addressed through a package of key measures encompassing special
requirements for systemically important banks in the areas of capital, liquidity and
organisational structure. These key measures are compatible with the approach discussed
by the Financial Stability Board. Besides those proposed by the commission of experts, other
measures being considered at the international level include the breaking-up of big banks,
the prohibition of certain activities such as proprietary trading, and the taxation of balance
sheets and transactions.
The SNB fully supports the proposals put forward by the commission of experts to date. The
overall direction is correct. What is important now are the details of the measures. Our
position is clear. It is essential that capital requirements be significantly increased and that
they rise in line with the degree of systemic importance of a bank. This is the only way to
ensure that the banks internalise the risks which, until now, they have been able to pass on
to the general public, to some extent. Moreover, progressive capital requirements should
create an incentive for banks to reduce their systemic importance, with its associated risk
potential.
Allow me to point out that the tightening of capital regulations and the introduction of a
leverage ratio that occurred at the end of 2008 were not aimed at reducing the systemic
importance of the big banks to an acceptable level. These measures were much more a
response to regulatory shortcomings revealed by the recent crisis, which were insufficiently
conservative backing of risk with capital (particularly in the trading book) and the lack of a
countercyclical component in capital requirements. As regards more stringent liquidity
requirements for systemically important banks, specific measures have already been
implemented. The liquidity requirements have been thoroughly revised by FINMA and the
SNB in collaboration with the big banks, and will come into effect at the end of this month.
The final key measure, which is aimed at organisational structure, is also important. The
organisation and legal structure of systemically important banks must be adapted to ensure
that an orderly liquidation is possible should it become necessary. In particular, it must be
possible for systemically important functions to be maintained without the bank as a whole
having to be rescued. Clearly, this is not easy to achieve. The implementation of this
measure must take into account the challenges posed by the considerable complexity and
cross-border activities of the big banks. It must be credible and robust - both operationally
and legally. An unworkable approach in this area could have fatal consequences in the next
crisis.
The SNB will continue pushing hard for a genuine alleviation of the "too big to fail" issue. We
are confident that the banks in the commission of experts will continue to cooperate
constructively on achieving a solution. We are aware that, for the big banks, the regulatory
measures being discussed are associated with costs. However, first of all, these costs are
primarily a reflection of the fact that a subsidy in the form of a de facto "too big to fail"
guarantee will be reduced. Yet since the cost to the taxpayer is reduced to the same extent,
this does not constitute a cost to the economy as a whole. And second, alternative
measures, such as the prohibition of business activities, would be associated with
considerably higher costs for the banks. In addition, we are convinced that, in the long term,
the big banks will also benefit from more stringent regulatory requirements. The most recent
crisis showed that a stable financial system is a basic prerequisite for the long-term
competitiveness of our financial centre. This is particularly true of wealth management, an
important line of business for Swiss banks. Consequently, an appropriate solution to the "too
big to fail" issue in Switzerland could strengthen our banking system in the long term and
ensure that it is well placed strategically.