Philipp Hildebrand: Review of the international financial system
Introductory remarks by Mr Philipp Hildebrand, Vice-Chairman of the Governing Board of the
Swiss National Bank, at the end-of-year media news conference, Zurich, 10 December 2009.
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1. Introduction
At the news conference in June of this year we spoke of a gradual calming in the general
financial market environment, although the outlook remains uncertain. Since then we have
seen a majority of banks returning to profitability. The horror stories being reported almost
daily just over a year ago have now disappeared. It is very tempting just to go back to
business as usual.
However, we must not forget that - just over a year ago now - the international financial
system was on the brink of collapse. Support packages of an unprecedented size were being
put together for the banks. Exceptional monetary and fiscal measures were required to
combat the dramatic plunge in the global economy - measures which have had to be kept in
place to the current time. Only by a narrow margin was a complete collapse of the financial
system avoided and the danger of a major depression averted.
This experience has clearly shown us all that the principle of sustainability needs to be a
much more dominant element in the development of the international financial system than it
was previously. This serves the interests of governments and taxpayers; but it is also in the
fundamental interests of the financial system itself, since it is not impossible that a future
crisis could outstrip the resources of monetary and fiscal policy, thus rendering it impossible
to rescue systemically important banks.
2. International approach
Consequently, there is broad international consensus between the relevant authorities on
what the objectives of future regulatory measures should be. The Financial Stability Board
(FSB), in which Switzerland is an active participant, has clearly formulated these objectives.
The financial system must be brought to the point where it contributes to sustained economic
growth. Never again must it be allowed to combine such high risks with such minimal safety
buffers. Moreover, steps must be taken to avoid profits being privatised while losses are
borne by the public at large.
In essence, there are two ways of achieving this goal. The first approach is to adopt
preventative measures aimed at reducing the probability of a bank collapse or a systemic
crisis. This can be done by increasing safety buffers - for example, by imposing higher
capital and liquidity requirements. The second approach is to take steps designed to reduce
the costs of a crisis once it has already occurred.
2.1 Prevention
At the international level, the implementation of preventative measures is already well
advanced, in that the Basel Committee on Banking Supervision - in coordination with
decisions by the G20 and the FSB - has decided on important measures in the fields of
capital and liquidity regulation. The consultation package on this matter will be published in
early 2010.
The measures designed to strengthen capital include stricter calibration of risk weights to
determine the regulatory capital, improvement in the quality of this capital buffer and a direct
limitation on the level of debt (leverage ratio). The combined effect of all these measures will
be analysed by the Basel Committee during the course of 2010 in order to calibrate the
overall capital requirements.
Liquidity regulation measures are aimed at securing financial institutions' flow of liquidity,
particularly during times of crisis. The Basel Committee is proposing a global minimum
standard for liquidity regulation. This is to ensure that financial institutions build up a liquidity
buffer which allows them to remain liquid in short-term and medium-term stress scenarios.
In line with the decisions of the Basel Committee, we have already implemented stricter
riskweighted capital requirements in Switzerland, supplemented by a leverage ratio. The capital
requirements are designed to be anticyclical, i.e. in good times, banks are required to build
up a capital buffer in excess of a given minimum level. By contrast, in bad times, the capital
buffer is permitted to fall below that level. A new liquidity regulation is currently in the test and
calibration phase. This regulation takes into account all balance-sheet and off-balance-sheet
items that are of relevance in liquidity considerations, and is based - as far as possible - on
internal bank liquidity management principles. It makes the big banks more resilient to
disturbances in the interbank market or larger-scale withdrawals of deposits. It promotes
longer-term financing as well as higher-rated securities that are capable of generating
liquidity even in a stressed market environment. The new regulation is due to come into force
in the second quarter of 2010.
These advances and the broad consensus achieved at the international level can certainly
be regarded as positive achievements. However, so far they only apply to preventative
measures. As mentioned previously, these measures serve to reduce the probability of a
crisis, but cannot always prevent its occurrence. Another crisis is inevitable and we must be
prepared for it.
3. Resolution measures needed; "too big to fail" is biggest challenge
Consequently, we need tools that will substantially reduce the costs of a crisis. The legacy of
the current crisis is a banking system with large international institutions that now enjoy a
virtual state guarantee. The fact that systemically important banks enjoy such a guarantee is
now openly recognised to be a problem by the banking sector, too. A guarantee of this kind
contradicts the basic principle of the market economy and presents us with a situation that
cannot be tolerated. It must be possible for any financial institution, even a large one, to fail,
without threatening the future of either the financial system or the real economy.
In the last two years, the risks presented by systemically important banks to the stability of
the financial system and the economy in general have become only too evident.
First, in principle, systemically important institutions have an incentive to enter into excessive
risks (moral hazard). Should these risks materialise, this can lead to losses of unimaginable
dimensions, as has indeed occurred. Second, the potential costs of supporting systemically
important banks are enormous. Third, the larger the systemically important institutions
compared to the size of a country's economy, the greater the likelihood that the costs in
question will exceed the capacity of that individual country to bear them (the "too big to
rescue" issue).
The leaders of the G20 countries were quick to recognise the significance of these risks and
they asked the Financial Stability Board to elaborate proposals before the end of October
2010 on how the "too big to fail" and "too big to rescue" issues could be addressed.
In its interim report on this matter published at the beginning of November 2009, the FSB
focuses on three elements. At the same time, it is closely monitoring the development of
additional proposals at national and international level.
From the point of view of the FSB, the possibility of conducting an orderly resolution of a
failing cross-border financial institution is an important element in finding a solution to the
"too big to fail" and "too big to rescue" issues. Effective communication between the relevant
supervisory authorities as well as forward-looking elaboration of emergency procedures are
indispensible in this process. Internationally recognised regulations for the dissolution of
systemically important institutions that can be enforced under any jurisdiction are no doubt a
splendid objective. In the real world, however, different national regulations will continue to
exist in this field. From our point of view, reciprocal recognition of national regulations that
are mutually compatible, and the associated adjustment of structures and processes, are a
more realistic objective.
The second element proposed by the FSB is to supplement the increased capital and
liquidity requirements with various measures that address the organisational structures of
systemically important financial institutions. Measures of this kind could, for instance, create
the possibility of extracting operations that were important for the economy and liquidating
the remaining operations.
The third element in the solution envisaged by the FSB is a financial market infrastructure
whose design ensures that, as far as possible, it minimises destabilising effects in the event
of a bank collapse. Central counterparties can play a special role in this respect. Thus, in
markets cleared through a central counterparty, all market participants have just one single
counterparty, rather than numerous bilateral business relationships, and the complexity of
the financial system is significantly reduced. What is even more important, however, is the
fact that, in the event of a bank collapse, a central counterparty guarantees that it will fulfil
the commitments it has entered into with respect to the other market participants, thereby
eliminating the traditional domino effect. That is why, together with other central banks and
supervisory authorities, the SNB is supporting the banks' ongoing efforts to clear a larger part
of the enormous over-the-counter derivatives market through central counterparties. These
central counterparties come at a cost, since it goes without saying that they must run a very
sound risk management system. For even a central counterparty could be threatened with
failure. Since the consequences of such an event would be catastrophic, central
counterparties need to command sufficient financial resources to ensure that they can
withstand the failure of the largest market participant, even in extreme market conditions.
4. Political responsibility
The SNB is investing substantial resources in actively carrying forward the approaches to
solving the "too big to fail" and "too big to rescue" issues that have just been outlined - not
just in international bodies like the FSB or the Basel Committee, but also at the national level,
in conjunction with FINMA. The reasons for this are obvious. Given the particular importance
of the banking sector, with two big banks which hold a key position in the domestic loan and
deposit market, the "too big to fail" and "too big to rescue" issues have particular significance
for Switzerland.
Consequently, we need to be very conscious of the fact that measures may be needed over
and above any international standard. For this reason we are dependent upon political
support in order to make our financial system more resistant and more stable with regard to
the "too big to fail" and the "too big to rescue" issues. If this succeeds, the competitive
position of the Swiss banking sector will be reinforced in the long-term as a result of
increased safety, reliability and credibility. The fact that the Swiss Federal Council has
appointed a commission of experts on the subject of "too big to fail" is an important step,
which we welcome. The willingness of the big banks to participate actively in elaborating
solutions to the "too big to fail" and "too big to rescue" issues is also welcome. These latest
developments clearly show how urgent the problems are.
Ladies and gentlemen, if we do not manage to fundamentally reform the financial system, it
is to be feared that a future crisis of even greater dimensions will trigger such a strong
protectionist and regulatory reaction that the damage done will extend even to the market
economy to which we owe our prosperity. We owe it to future generations to take action
against this danger. Doing nothing is not an option.