Thomas J Jordan: Financial Stability Report - potential risks and actions
Introductory remarks by Mr Thomas J Jordan, Vice Chairman of the Governing Board of the
Swiss National Bank, at the half-yearly media news conference, Berne, 16 June 2011.
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In my introductory remarks today, I would like to present the most important points from our
recently published Financial Stability Report, in which we consider potential risks to financial
stability and identify where action may be needed.
General economic and financial conditions for the Swiss banking sector improved further in
2010. Overall, global economic growth was stronger than expected last year, despite the
expiry of fiscal stimuli. In Switzerland, too, economic development was robust and growth
was high in an international comparison. Against this background, the profitability and capital
situation of both big banks improved further, and remained good for banks with a domestic
focus.
However, the economic environment remains fragile, and a renewed, sharp deterioration
over the next twelve months cannot be ruled out. In the short term, the prevailing uncertainty
primarily affects the two big banks, which are still exposed to considerable credit and market
risk relative to their loss-absorbing capital. For domestically focused banks, by contrast, the
risks are largely of a medium-term nature, and are related to potential adverse developments
on the Swiss real estate and mortgage markets.
In view of these risks, all Swiss banks should ensure that they have a broad and high-quality
base of loss-absorbing capital. For the big banks, in particular, it is crucial that a sufficient
capital base be laid down as soon as possible, so that losses can be fully absorbed. The
SNB welcomes the fact that, in 2010, both big banks already took important first steps in this
regard, and we would like to encourage them to keep up the pace of their capital expansion.
The capitalisation of most domestically focused banks is good by historical standards.
However, a combination of high interest rate risk exposure and strong mortgage lending
growth has been reported by a number of banks. In order for these banks to bear the risks in
the medium term, it is important to ensure that their capital base is strong enough.
I would now like to take a closer look at the situation of the two big banks, before turning my
attention to the situation of the domestically focused banks.
Situation of big banks
Compared to 2009, the two Swiss big banks saw a marked improvement in their profitability
and capital situation last year. In 2010, these institutions reported combined net profits of
around CHF 13 billion, as opposed to roughly CHF 4 billion in 2009. This positive
development was driven by UBS, whose situation improved further over the course of last
year. In addition, both UBS and Credit Suisse continued to increase their regulatory capital
ratios (ratio of Tier 1 capital to risk-weighted assets), which were already very high by
international standards. Moreover, their financial strength ratings also improved. According to
rating agency assessments, the big banks' intrinsic financial soundness improved
significantly last year.
However, two aspects should be borne in mind when assessing the big banks' situation:
First, their exposure to credit and market risk relative to their capital remains considerable.
Although credit quality abroad has improved slightly, it still remains at historically low levels,
particularly in the US and Europe. In view of this, lower-than-expected economic growth or a
deepening of the debt crisis in Europe could potentially lead to a further deterioration in the
creditworthiness of individual countries. Yet, the big banks' exposures to sovereign debt in
peripheral euro area countries are only moderate. Should the debt problems in the already
vulnerable international banking system or in other sovereigns become amplified, however,
these banks could face considerable losses.
Second, the big banks' economic capital situation is less comfortable than their very high
regulatory capital ratios under Basel II might suggest. A considerable portion of both
institutions' regulatory capital is made up of capital components that proved to be not fully
loss-absorbing during the recent crisis. These include, for instance, deferred tax assets,
which are only realised if a bank is profitable, or certain hybrid Tier 1 capital instruments,
which only become loss-absorbing in the event of bankruptcy. Thus, such capital
components will no longer be recognised under Basel III and will be phased out by 2019. The
transition period granted to banks gives them sufficient time to meet the new requirements.
However, in view of the risk exposures and the prevailing uncertainties in the economic
environment, it is crucial that the big banks build up a sufficient base of loss-absorbing
capital as swiftly as possible during this transition period.
After adjusting for the not fully loss-absorbing components, the big banks' remaining capital
buffers are still thin in light of the aforementioned risks. Despite some improvement, leverage
for both UBS and Credit Suisse is still high by international standards. Taking only fully
loss-absorbing capital into account, the average capital ratio of both big banks amounted to
less than 2% of total assets.
Against this background, both big banks have already made major strides towards expanding
their loss-absorbing capital base. To this end, Credit Suisse issued contingent convertible
bonds (CoCos), while UBS retained its earnings. These important first steps have already
significantly strengthened the big banks' loss-absorbing capital base. They also show that
the big banks should be in a good position to build up the necessary, additional capital buffer.
Situation of domestically focused banks
Allow me now to discuss the situation of banks with a domestic focus.
The capitalisation of domestically focused banks was almost unchanged in comparison to
2009. The short but sharp recession in Switzerland in 2009 did not have any noticeable
impact last year either. Write-downs and provisions were at a historical low. In a long-term
comparison, profits remained at a high level overall. Likewise, the capitalisation of
domestically focused banks hardly changed in 2010 and remains good in relation to both
risk-weighted assets and total assets.
However, the fact that capitalisation is high overall does not take into account that the
regulatory capital requirements do not fully capture certain risks. For example, the interest
rate risk and credit risk associated with potentially adverse developments in the real estate
and mortgage markets are not taken into account, or only partially accounted for. Yet these
risks are especially pronounced in the current environment.
On the one hand, interest rate risk for all domestically focused banks continues to remain at
a historically high level. Since there is a maturity mismatch between assets and liabilities, a
rise in interest rates would result in losses for the banks. The overall high level of interest
rate risk is driven by Raiffeisen and cantonal banks.
On the other hand, credit risk at domestically focused banks continued to increase. This is
because the mortgage lending volume, which is closely linked to developments in the real
estate market, continued to grow.
The situation in the Swiss real estate market has deteriorated slightly since last year's
Financial Stability Report was published. Even though they varied widely, most real estate
price indices suggest that prices also rose substantially in 2010. There is still no indication of
a general overvaluation based on the current price level, yet several indicators suggest that
overheating is already becoming apparent in the owner-occupied apartment and apartment
building segments. There are also considerable regional differences, although there are
signs that, already now, real estate prices in some regions are no longer justified by
fundamentals.
Should real estate prices continue to rise at the current pace and move away from the level
justified by fundamentals, a significant price correction is more likely in the medium term.
Such a price correction, together with a significant rise in mortgage loan defaults, would pose
a threat to financial stability.
Overall, however, there is some uncertainty about banks' risk exposure. Given this
uncertainty and signs of potentially adverse developments in the real estate and mortgage
markets, there is a need for action in many respects.
Therefore, the SNB and FINMA have already taken the first steps and intensified their
monitoring of the mortgage market. For this purpose, at the beginning of 2011, the SNB
launched a comprehensive quarterly survey of banks. In this survey, detailed information is
collected on key risk indicators such as loan-to-value ratios and affordability criteria in the
granting of mortgage loans. The survey results, which are expected from the autumn of this
year, should contribute to a better analysis of the vulnerability of the Swiss banking sector
and close existing gaps in data.
Moreover, a detailed analysis should be made as to what extent banks with a combination of
high interest rate risk exposure and high mortgage lending growth are able to bear those
risks. This is mainly a microprudential task, which is performed by FINMA.
Furthermore, a revision of the self-regulation guidelines for mortgage-backed loans by the
Swiss Bankers Association might make a substantial contribution to preventing the
development of significant imbalances in the real estate and mortgage markets. It might be
worth considering the inclusion of quantitative "best practice" standards as a complement to
the qualitative guidelines.
Ideally, microprudential supervision and self-regulation will prevent the build-up of systemic
risk. Should the growth momentum currently being observed in mortgage lending and real
estate prices continue, or even accelerate, further measures would have to be considered.
Such measures should be countercyclical, thereby making a preventive contribution to
financial stability.
At best, the SNB's monetary policy can only make a minor contribution to financial stability in
this respect. First, monetary policy's primary objective is to ensure price stability. Second,
monetary policy always affects the economy as a whole. Thus, its effect cannot be directed
only at specific areas of the economy.
However, additional macroprudential tools, which would be much better suited to targeted
intervention are currently not at the disposal of the Swiss authorities. In the recent past, both
the SNB1 and the International Monetary Fund (IMF)2 have emphasised that there is a need
for action in this area. For this reason, the SNB welcomes the Federal Department of
Finance's decision to set up a commission of experts to draw up proposals on
macroprudential oversight and to determine the associated institutional responsibilities.