Jean-Pierre Danthine: A macroprudential progress report
Speech by Mr Jean-Pierre Danthine, Vice Chairman of the Governing Board of the Swiss
National Bank, at the Society for Financial Econometrics (SoFiE), Lugano, 11 October 2013.
* * *
I would like to thank Till Ebner, Fabian Gunzinger and Patrick Saner for their very valuable support in drafting this
speech.
Introduction
Five years ago, the failure of Lehman Brothers sent shockwaves through the global financial
system. The failure of a relatively small but highly interconnected institution pushed the entire
financial system and, eventually, the global economy to the brink of collapse. This painfully
highlighted the fact that policymakers had underestimated systemic risk. Five years later,
thanks to substantial efforts, we have a better - but admittedly still incomplete -
understanding of what systemic risk is and what we should do about it.
In general terms, systemic risk arises because an optimising financial institution does not
fully account for the cost that its behaviour imposes on other financial institutions. Thus, in
essence, the origin of systemic risk is a negative externality imposed by individual financial
firms on the system. For analytical and regulatory purposes, it is useful to differentiate
between structural and cyclical systemic risk. Structural systemic risk stems from institutions
that are so large or so interconnected that their failure would threaten the stability of the
entire system. These are the institutions that are "too big to fail" (TBTF) or "too
interconnected to fail". The cyclical dimension of systemic risk captures the procyclicality of
financial agents' behaviour which, if left unchecked, can amplify the financial cycle and
increase its instability - a classical collective action problem. Historical evidence shows that
the risk of such instability is particularly elevated in situations that combine rising residential
prices and dynamic credit growth.1
Regulators and policymakers around the world have been working hard on regulatory
measures that aim directly at containing these risks. The Lehman anniversary and the
papers that have been discussed here this afternoon make this conference a good occasion
to reflect on these efforts. In particular, I want to talk about the progress we have made here
in Switzerland in devising and implementing regulatory answers to mitigating systemic risk,
and also about the work we still have ahead of us in this regard. I will address these two
issues in turn.
For a start, let me give you a quick overview of the global reform agenda. On the global
scale, the regulatory reform approach (Basel III) sets minimum capital adequacy
requirements that are more stringent in both quantitative and qualitative terms, and
introduces a global minimum standard on liquidity buffers. At the same time, importantly, the
new framework takes explicit account of systemic risk. First, it imposes a capital surcharge
for systemically important institutions in order to address the structural TBTF problem. This
surcharge amounts to additional loss-absorbing capital of between 1.0% and 2.5% of
riskweighted assets, with the specific requirement depending on the degree to which an
institution is systemically important. Second, it introduces a countercyclical buffer ranging
between 0.0% and 2.5% of total risk-weighted assets, to increase the system's resilience to
cyclical systemic risk. This buffer can be temporarily imposed when credit growth is judged
excessive. These new rules are being phased in over several years and will come into full
effect in 2019.2
Regulation in Switzerland: Framework and progress so far
Switzerland is well advanced in the process of introducing a new regulatory approach in line
with this international framework. There was, and still is, an urgent need to proceed faster
and to go beyond the global minimum standards.
First, the size of Switzerland's two major banks, Credit Suisse and UBS, relative to GDP is
very large by international standards (8:1 in 2007 and 4:1 today). It is worth recalling that,
back in October 2008, in order to prevent a breakdown of our financial system, the Swiss
authorities had to take measures to strengthen UBS, putting a large amount of public funds
- up to USD 60 billion - at considerable risk. Despite the favourable turn of events since
then, we have to take all means necessary to avoid such a situation in the future.
Second, on the cyclical front, the sustained momentum in the Swiss mortgage and real
estate market over several years has already led to imbalances that pose a risk to financial
stability and, ultimately, the Swiss economy.
So, what have we done to address systemic risk in Switzerland up to now?
With respect to the structural dimension of systemic risk - the TBTF issue - Switzerland
already adopted a package of measures back in 2011. This package aims at reducing both
the likelihood of crisis at a systemically important bank and the costs to the economy in the
event of such a crisis.
The package consists of four complementary measures: (1) significantly more capital, and
capital of better quality, (2) larger liquidity buffers, (3) rules imposing sufficient diversification
to reduce counterparty risk, and (4) organisational measures. Let me briefly outline some key
elements of this package.
The new capital adequacy regulations for systemically important banks apply to the
riskweighted capital ratio and the leverage ratio. Furthermore, they are designed to be
progressive. Put simply, the bigger the bank, and the greater its systemic importance for the
domestic financial system, the higher the requirement. For institutions similar in size to UBS
and CS at the time the TBTF package was initially defined, the total capital requirement adds
up to 19% of risk-weighted assets (RWA), of which 10% must be held in common equity and
9% can be held in convertible capital (cocos), and the leverage ratio requirement amounts to
about 4.6%.3
The organisational measures require banks to show convincingly - on the basis of
"emergency plans" - that they are organised in such a way as to be able to maintain
systemically important functions in the event of a crisis, thus reducing the need for a public
bail-out. If they are not able to do so, the regulator, FINMA, may impose organisational
measures. In March 2012, these new rules came into law and UBS and CS must fully comply
by the end of 2018. This transitional period was introduced to mitigate potential unintended
side-effects.
Implementation is under way. Specifically, with respect to increasing their risk-weighted
capital ratios, both banks have already made substantial progress. If they continue according
to the plans they have announced, they will be in a position to fulfil the new regulatory
requirements by the end of 2014.4 At the same time, regulators are working on the
establishment of resolution and recovery plans. When finalised, these plans should enable
the regulators to secure the orderly resolution of a global bank in the event of a severe crisis
and, in doing so, to make sure that systemically important functions can be maintained. As
an important step towards this goal, FINMA has been authorised, since November 2012, to
order a bail-in of creditors to generate the financial means necessary for restructuring a
bank.
Turning to cyclical risk, in June 2012, the Federal Council announced a set of measures
consisting of three elements: (1) a permanent increase in risk weights for high loan-to-value
mortgage loans,5 (2) a revision of the banking industry's self-regulation guidelines for
mortgage lending,6 and (3) the legal basis for the activation of a countercyclical capital buffer
(CCB), as proposed in the Basel III framework. This instrument allows for a temporary
increase in capital requirements when imbalances appear to be building up in the credit
markets. It thus aims to increase the resilience of the banking system, and helps to lean
against excessive credit growth. In February 2013, following a proposal by the SNB, the
Federal Council activated the CCB, requiring banks to hold additional capital amounting to
1% of risk-weighted residential mortgage loan positions. Banks have been obliged to comply
with this rule since 30 September 2013.
With the activation of the CCB, Switzerland is among the first countries to implement a tool
advocated by the international community as a means for preemptively dealing with cyclical
risks to financial stability. While our experience with the CCB may thus be of general interest,
we cannot draw conclusive lessons at this point. The CCB took effect only two weeks ago,
and was activated while the other two measures I have just outlined were already in place.
So we are not conducting a controlled experiment here, which makes disentangling the effect
of any single measure very difficult.
Where should we go from here?
Overall, Switzerland has taken significant steps and substantial progress has been made to
better deal with systemic risk, regarding both its cyclical and its structural dimension. Yet, our
journey towards a more resilient financial system is far from over. The risk of a systemic
crisis of either kind remains. The task has yet to be completed.
Let's start with structural systemic risk. Despite the progress in reducing exposure and
strengthening the resilience of the two big banks, the TBTF problem is not fully eliminated as
of yet. On the one hand, the capital cushion planned for 2019 is not yet available and, in
particular, the leverage ratios of UBS and CS are still low, with their loss-absorbing capital
amounting to 2.4% of total exposure.7 On the other hand, the orderly resolution of a
distressed systemically important bank is not yet secured. As a consequence, and given the
potentially huge cost of a disorderly collapse of such a bank for financial stability and the
economy, we cannot yet exclude the need for a public bail-out in a possible future crisis.
This state of affairs is still unsatisfactory, and has led to renewed debates on how to further
regulate global banks. Specifically, voices have been raised in favour of a substantial
increase in the minimum non-weighted capital requirement, the leverage ratio. Moreover,
demands for an outright separation of investment banking from commercial banking, along
the lines of the Glass-Steagall Act, have gained political clout.
While these proposals have merits - and, given the difficulty of the task, one should keep an
open mind - qualifying remarks seem appropriate at the current juncture. We are in the midst
of implementing a complementary and balanced package of measures. As we have seen,
tangible progress has already been made. When it is fully implemented, this package will
substantially reduce, and possibly eliminate, the TBTF problem. It is unlikely that a sudden
change in strategy would lead to a faster elimination of the underlying risks.
Rather than changing the regulation strategy midway, it is imperative that we press on with
the full implementation of the TBTF package. We will then be in a position to assess its
effectiveness and decide whether further measures are necessary. Full implementation
entails, necessarily, further progress on the following four issues:
First, the big banks must stay on track, and must fully and consistently implement the tighter
risk-weighted capital and liquidity requirements as currently planned. This will, importantly,
lead to a significant improvement in their leverage ratios.
Second, the quality of the banks' own risk assessment methods must be improved.
Increasingly, doubts have been raised on the reliability of the internal models which banks
use to compute their risk-weighted assets (RWAs). A stable financial system cannot be
based on questionable and opaque risk assessments. To regain confidence in these
calculations, banks should make sure that their RWA calculations are transparent and
traceable. In particular, they have to ensure that changes in RWAs over time, and differences
in published RWAs between institutions, can be explained and economically accounted for.
Third, the ongoing work on recovery and resolution plans should be pursued with total
determination. If required for the guaranteed maintenance of systemically important
functions, changes in the current organisational structure should be explored and initiated
without delay.
Fourth, on the regulatory side, further progress in defining the key elements of a viable
resolution and recovery strategy for globally active banks is needed. In the absence of global
bank insolvency legislation, this necessitates close coordination among regulators across
borders. Specifically, further steps are necessary to guarantee that resolution measures -
such as a bail-in - ordered by the home regulator are mutually recognised by foreign
authorities. In this regard, it is encouraging that the resolution and recovery plans for our big
banks are being developed in close collaboration with the foreign regulatory authorities
concerned.
Let me finish with some words regarding the cyclical risks. Mortgage volumes and real estate
prices continue to grow at rates significantly above those justified by fundamental factors
such as income and population growth. This means that the imbalances, which are already
large, are increasing further. At the same time, indications of a possible slowdown in
momentum became visible during the course of 2013.8 Taken together, these developments
make it difficult to judge precisely where we are in the credit cycle or the direction in which
we are heading. This situation is an example of the fundamental identification difficulty
pertaining to the analysis of the financial cycle. Further academic advances in the
development of new tools to help identify cyclical risks would be highly welcome.
The lessons are clear, however. In the current environment of significant uncertainty and
persistent risk, prudent behaviour on the part of all actors is called for. For banks, this means
applying conservative lending criteria in terms of both loan-to-value ratios and affordability.
For borrowers, it means bearing in mind that real estate prices are already at elevated levels
and ensuring that, even if interest rates were to rise sharply, they could afford to service a
loan. And finally, for regulators, it means continuing to monitor the situation very closely and
being ready to take further regulatory measures, if the hopes of a soft landing are not fulfilled.
References
Bank for International Settlements (2011). Basel III: A global regulatory framework for more
resilient banks and banking systems.
Borio, C. (2012). The financial cycle and macroeconomics: What have we learnt? BIS
Working Paper No 395.
Commission of Experts for limiting the economic risks posed by large companies (2010).
Final report. www.sif.admin.ch/dokumentation/00522/00724/00725/index.html?lang=en.
Schularick M., and Taylor, A. (2012). Credit booms gone bust: Monetary policy, leverage
cycles, and financial crises, 1870-2008. American Economic Review, American Economic
Association, Vol. 102(2), pages 1029-61.