Philipp Hildebrand: Current state of the financial system in Switzerland
Introductory remarks by Mr Philipp Hildebrand, Vice-Chairman of the Governing Board of the Swiss
National Bank, at the half-yearly media news conference, Berne, 14 June 2007.
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I would like to use today's publication of our Financial Stability Report as an opportunity to share some
thoughts with you on the current situation of the financial system. I will start with the most important
message - the Swiss banking sector and the financial system in general are in very good shape at the
moment. Based on our analysis, the outlook for the future is also essentially positive.
As stated in our report, the favourable situation in the Swiss banking sector comes as no real surprise.
Developments in the economy and the financial markets in recent years have been very positive, both
in Switzerland and abroad. Although economic growth has been strong, it has had practically no
impact on inflation to date. The credit standing of borrowers remained high. In addition, despite
repeated, significant short-term price corrections - as was the case last week - the stock markets rose
sharply overall in an environment of low volatility.
How can these positive developments be explained? And are there any risks involved - in particular
for the stability of the Swiss financial sector?
The good performance is not solely attributable to the favourable economic situation. Structural
aspects have also played a role. With that I mean first and foremost the increased level of efficiency
that has been achieved in the financial system in the past few years. This rise in efficiency can be
ascribed to the innovativeness of financial markets. New financial instruments, such as credit
derivatives, enable banks to separate their credit risk and transfer it either completely or partially. This
facilitates a better distribution of credit risk in the financial system and means that the risk is borne by
those who want to and are able to bear it.
The improved efficiency has resulted in a reduction in the financing costs of companies and
households. Lower financing costs help the economy and stock markets to achieve greater growth.
The increased efficiency also appears to have improved the ability of global financial markets to
absorb shocks. The downgrading of General Motors' credit rating in 2005, for instance, or the major
losses suffered by the hedge fund Amaranth last year had no lasting impact on stock and credit
markets.
All in all, global financial markets are currently better able to absorb shocks, at least small to
mediumsized ones. Accordingly, serious turbulence in the financial system seems less likely today. From a
financial stability perspective, this is a positive development indeed.
However, the greater the stability of the financial markets, the greater the risk appetite of market
participants tends to be. This in turn can increase the likelihood of a crisis and, in the event of one
occurring, the extent of the damage. The greater concentration and interconnectedness in the global
financial system may also have increased the magnitude of a potential crisis.
The greater risk tolerance of market players is ultimately a logical consequence of the exceptionally
long and stable period of calm in the financial markets. Market participants have had no reason of late
to keep their risk-taking in check. Basically, anyone who held back felt they were missing the
opportunity to generate high returns. Even the short-term corrections in the financial markets in
February of this year and May of the previous year did not result in a change of attitude in this regard.
On the contrary, the low impact made by these corrections and the ability of the markets to absorb
them may have served as a confirmation for those operating a high-risk strategy to continue, and as
an indication for the more risk-averse to take greater risks.
The risk appetite is also fairly high in the Swiss banking sector at present. In our Financial Stability
Report, we indicate for instance that the domestically oriented banks - Raiffeisen, cantonal and
regional banks - are currently incurring a relatively high interest rate risk. At the same time, the big
banks have also exhibited an increased risk tolerance in recent years. Although Credit Suisse Group's
overall risk has declined in the past year, following the sale of Winterthur, both big banks have
significantly increased their risk-taking in the banking business; particularly their exposure in trading
and in foreign lending business. As a result, their trading books have virtually doubled since 2003 and
are now clearly in excess of CHF 1,000 billion. This accounts for roughly two-thirds of the assets
managed by the entire hedge fund industry.
The fact that market participants take more risks in a stable environment is in itself not a problem.
What is important is that they correctly assess their ability to bear risks and are able to handle poorer
conditions. Driving 120 km/h along an empty motorway in good weather conditions is generally not
dangerous for an experienced driver. It is a different story, however, if visibility is poor and traffic is
heavy. If the speed is not adjusted accordingly, the chances of having an accident increase. Driving
fast becomes dangerous if the speed is no longer in line with the driver's capability and external
conditions.
Using this analogy, how does the current situation in the global financial markets and Swiss banking
sector compare? As already mentioned, the overall impression at the moment is that we are driving
quite fast. Unlike on the motorway, however, there are three reasons why it is difficult to judge if the
speed is too high or if the market participants would be able to slow down in time were conditions to
deteriorate.
Firstly, it is not clear just how fast the car is going, or rather, how much risk is being entered into. This
not only applies to the less regulated players in the financial system, such as hedge funds, but also to
a certain extent to banks. For instance, the rating agency Moody's came to the conclusion in a report1
Financial Stability
published last year that banks generally do not disclose their risks sufficiently. In our
Report, we also point out that it would be beneficial if Swiss banks were to provide more data in this
regard. By providing more comprehensive data, banks would be helping investors and authorities to
better assess the risks banks take. Banks should, for example, publish more results from their stress
tests. Similar to crash tests, stress tests examine how severely the bank would be affected by a major
crisis.
Secondly, it is difficult to assess how the traffic would react in poor weather conditions. Even though
the braking distance is relatively short on a dry surface, this is by no means a guarantee that the car
will react in the same way on a wet or even icy road. A number of instruments currently in use in the
financial system have not yet had to prove their worth in extreme stress situations. It is therefore not
clear whether the risks for these new and complex products have been adequately assessed. These
products are typically not assessed in a central market, but by using complex models. In other words,
the analysis is not a mark-to-market one, but a mark-to-model one. The reliability of the mark-to-model
approach, however, relies heavily on assumptions and on the availability of reliable data. Data on tail
events (events that occur rarely, but have major repercussions) would be particularly beneficial for the
calibration of models. There is, however, by definition hardly any data on such events. This begs the
question as to whether the dangers associated with tail events are being correctly assessed using the
available models, or whether model risks pose a problem.
Thirdly, it is unclear whether the finance industry's capital buffer - in the form of equity capital - is
adequate to weather particularly bad storms. Like airbags in a car, equity capital is only rarely called
into action. Yet, the more serious the accident, the more generously the bags should be filled with air.
In the current economic environment, many market participants are highly leveraged, in other words,
they have a low ratio of debt to equity capital. Low levels of equity capital can be compared to a thin
airbag - they only protect against moderate shocks. It would only take a loss of 2-3% of the balance
sheet total, for instance, for Swiss big banks to use up all their equity capital. Of course, a loss of this
magnitude is highly unlikely. After all, the Swiss big banks are well-diversified, have sophisticated risk
management models in place and have high risk-weighted capital ratios. This notwithstanding, such a
loss cannot be ruled out. In fact, it represents a classic tail event: a loss of this kind is highly unlikely,
yet would have dire consequences, particularly for the stability of the entire Swiss banking sector. In
view of the aforementioned uncertainties in connection with risk assessment, would it not be justified
to aim to create a somewhat more "well-padded" cushion of security, even if equity capital - like
airbags - comes at a price?
Finally, I would like to point out that central banks do not know better than banks or the market as to if
and when and in what form a major crisis could hit the financial markets. In principle, we believe that
the likelihood of severe disruptions in the financial system has actually declined as a result of
innovations in the financial markets. At the same time, the repercussions of a crisis - should one occur
after all - could be particularly severe given the current situation. With this in mind, I feel it is important
that market participants - including the Swiss banks - should increasingly take tail events into
consideration in their assessments. Stress tests are especially suitable in this regard. In our Financial
Stability Report, we also underline the importance of stress testing. This calls for an intensification of
the cooperation between the authorities and the big banks so as to enhance the transparency and
comparability when evaluating the resilience of the Swiss big banks. Within the context of this
cooperation, it should also be ensured that the cost/benefit ratio of such an exercise remains
adequate.