Speech
Embargo
6 September 2018, 6.30 pm
After the storm: ten years on, how weatherproof is the Swiss
banking system today?
University of Lucerne
Fritz Zurbrügg
Vice Chairman of the Governing Board*
Swiss National Bank
Lucerne, 6 September 2018
© Swiss National Bank, Berne, 2018 (speech given in German)
Ladies and Gentlemen
Almost exactly ten years ago, on 15 September 2008, Lehman Brothers, the fourth-largest US
investment bank at the time, filed for bankruptcy. The ensuing storm engulfed the global
financial markets with a ferocity and magnitude that took all market observers by surprise.
The collapse of Lehman Brothers made it clear that many financial institutions could not
withstand such a buffeting without government support. The financial crisis spilled over
rapidly into the real economy, resulting in the deepest global recession since the Great
Depression.
We all have our own personal memories of this difficult period. Many of you are probably
thinking of 16 October 2008, the day on which the Swiss authorities stepped in to support
UBS with a comprehensive package of measures. Back then, I was working at the Federal
Finance Administration. The fact that we were obliged to burden the state and the taxpayers
with an exposure worth billions to stabilise a big bank made a lasting impression on me.
The lack of resilience in the banking system forced governments across the world to plough
huge sums into bank bail-outs. It was the only way to protect their economies from the
enormous damage that a banking system collapse would have wrought. The financial crisis
demonstrated in no uncertain terms that the banking system was not sufficiently
'weatherproof'.
The financial crisis also showed clearly that particular risks stem from large, highly
interconnected banks. Owing to their size and market position, such banks cannot exit the
market without severe consequences for the banking system and the real economy. In industry
jargon, they are 'systemically important'. Thus, they enjoy an implicit guarantee that the state
will intervene in an emergency. This form of market failure is now known the world over as
the 'too big to fail' issue.
In my speech today, I will be looking into this issue, one that is particularly relevant to
Switzerland. I will start by discussing the causes and effects of 'too big to fail', and how it
manifests itself in Switzerland, before moving on to the reasons why banking regulation
before the crisis did not sufficiently address the risks posed by 'too big to fail' banks. Based
on this analysis, in the third part of my speech I will describe the wide-ranging regulatory
measures taken at international and national level to resolve 'too big to fail'.
Let me just present our own conclusion up front: In Switzerland, the response was quick,
targeted and, at the same time, cost-effective. On the one hand, the regulatory amendments
strengthened banks' resilience, reducing the likelihood of a bank getting into financial
distress. On the other hand, they introduced measures aimed at ensuring that even a
systemically important bank can exit the market in an orderly way in the event of a crisis.
We are convinced that the Swiss big banks and the Swiss banking system are much more
weatherproof today than they were ten years ago. Many of the planned measures have already
been implemented.
However, we have still not quite achieved our objective. Only once the agreed measures have
been fully implemented will the conditions for resolving 'too big to fail' in Switzerland be in
place.
The 'too big to fail' issue
So what is behind 'too big to fail', and what concrete form does it take in Switzerland?
a) 'Too big to fail' institutions must be bailed out in a crisis ...
As I mentioned at the start, 'too big to fail' means that an individual institution is so important
that the state is under a de facto obligation to bail it out in a crisis.
This state obligation arises under two conditions.
First, if the affected institution provides services that are of crucial importance to the national
economy and which are generally indispensable. Second, if these services cannot be provided
by other market participants at short notice - in other words, they are not substitutable.
How pronounced are these two aspects in the banking sector? First, banks generally provide a
wide range of essential services for the economy, such as lending or payment services.
Second, these services are not easily substitutable, particularly at big banks. Banks are closely
interconnected with each other, and with the rest of the economy. The result is that problems
at one bank can spill over to other banks and the rest of the economy. The larger the bank and
the higher its market share, the smaller the likelihood that other market participants will be
able take over important functions at short notice in the event of a crisis.
Thus, a bank's size and market position are important indicators for assessing its systemic
importance. Specific parameters are the bank's share of domestic lending and deposit
business, and its importance for payment transactions. Another widely used measure of
systemic importance is the ratio of balance sheet total to GDP, as this is a good indicator of
the bank's interconnectedness and the (lack of) substitutability of its services.1
b) ... as their failure would come at too high an economic cost
If a 'too big to fail' bank gets into distress, it jeopardises not just itself but also the stability of
the financial system as a whole and, as a direct consequence, the real economy. The high
economic costs can be illustrated using two mechanisms.
The higher the bank's market share of lending business, the greater the probability that the
economy will not be provided with enough liquidity if that bank gets into difficulties. First,
finding alternative credit providers will take time. Second, in the event of the failure of a
systemically important bank, the assets of households and companies will - at least
temporarily - be frozen, with the attendant negative impact on consumption and investment.
Here too, the maxim applies: the higher the institution's market share of deposit business, the
greater the fallout in the event of a crisis.
The second mechanism is based on the fact that, as I have already mentioned, banks are
closely interconnected. Within this network, systemically important banks provide essential
services for other banks. For example, they play a key role in system-wide liquidity provision
and adjustment between banks. Normally, this takes the form of short-term interbank lending.
If a key player in this network gets into difficulty, this interbank market can seize up, causing
problems for other, otherwise sound banks, too.
c) The result is false incentives and high risks for society as a whole
A systemically important bank can expect to be bailed out because the cost of failure for the
real economy would be extremely high. In other words: the bank benefits from an implicit
state guarantee.
The consequence of this are far-reaching, as it provides significant false incentives for a
bank's shareholders, management and creditors.
On the one hand, shareholders and management of a 'too big to fail' bank benefit from
unjustifiably low capital borrowing costs, compared to other banks. The state guarantee is
tantamount to a subsidy worth billions.2 It allows shareholders and managements to take on
more debt and greater risk.3
On the other hand, the state guarantee means that creditors have less incentive to make sure
that the bank does not take on excessive risk. If all goes well, they will benefit from virtually
risk-free interest income. If, however, things do go wrong, the state will have to intervene and
the creditors will not be held liable for any losses that may arise.
The mere assumption that a bank is too big to fail can be a self-fulfilling prophecy.4 On the
assumption that it will be bailed out if necessary, the bank may take on excessive risk much
more readily, and focus its business model too heavily on debt-based growth. Thus, the bank
becomes even bigger, thereby increasing the likelihood that the state will have to intervene in
a crisis, so that the original assumption proves to be correct. Given this increased likelihood
of a bail-out, the bank can now take on even more risk, and the de facto bail-out obligation
becomes even more acute - a vicious circle.
This bail-out obligation can result in very high and unforeseen costs to the state. The scale of
these costs was highlighted by the global financial crisis, which at the time saw announced
state support for the financial sector in advanced economies amounting to some 20% of GDP
(cf. slide 2).5
State budgets, which are already under strong pressure from the recession associated with a
financial crisis, can be overstretched by the cost of state support measures. And indeed, during
the crisis, a number of countries did find themselves having to shoulder costs well in excess
of their financial capacities. Ultimately, they coped by resorting to external support.
d) The 'too big to fail' issue is especially pronounced in Switzerland
As I've mentioned, in Switzerland, too, a package of state support measures for UBS in 2008
was unavoidable. The capital injection of around CHF 6 billion from the Confederation
amounted to some 10% of federal receipts, while the distressed assets of up to USD 60 billion
that the SNB was willing to take on represented some 10% of GDP.6 In its 2011 dispatch on
the 'too big to fail' (TBTF) legislation, the Federal Council noted that this commitment was
associated with considerable risks for taxpayers, and that future rescue packages might not be
financially sustainable for Switzerland.7
This is because the 'too big to fail' issue is especially pronounced here in Switzerland.
The two big banks, UBS and Credit Suisse, have very large balance sheets relative to GDP,
owing to their substantial international activities (cf. slide 3). At the same time, they also have
a significant market share of domestic lending and deposit business, and are major players in
the area of payment transactions.
Moreover, in an international comparison, three other banks which have been designated as
systemically important by the SNB - PostFinance, Raiffeisen Group and Zürcher
Kantonalbank - also have very large balance sheets relative to GDP. For example, Raiffeisen
and ZKB relative to Swiss GDP are about double the size of the largest US banks relative to
US GDP.8
Shortcomings in the TBTF regulations before the crisis
Ladies and gentlemen, the global financial crisis has clearly demonstrated that, not least for
Switzerland, the 'too big to fail' issue is real and the costs and risks for society as a whole are
too high for this state of affairs to be simply accepted.
a) 'Too big to fail' issue: recognised but insufficiently addressed by regulation ...
Looking back today, it is clear that this issue was underestimated before the crisis - both in
general and by the regulators.
For instance, before the crisis, neither the international recommendations on banking
regulation nor the Swiss regulatory provisions contained anything that explicitly addressed
the systemic importance of individual banks and the associated risks.
And this despite the fact that people were aware of the issue before the crisis - both in
Switzerland and elsewhere.9 The term 'too big to fail' itself already featured in political
debate during the 1980s in the US, in the context of difficulties experienced at a number of
financial institutions. The first bank that was referred to as 'too big to fail' was the
Continental Illinois National Bank and Trust Company, at that time the seventh-largest bank
in the US, which sought recourse to state support in 1984.10
So, at this point, one could legitimately ask the question: why didn't legislators, regulators
and supervisory authorities tackle this known problem more vigorously before the crisis? The
short answer is: The risks stemming from ever larger and ever more globally interconnected
banks were underestimated, and as a result, the true magnitude of the 'too big to fail' issue
was likewise underestimated.
The pre-crisis era was dominated by a general mood of self-confidence and optimism. This is
hardly surprising, considering the long phase of comparatively low macroeconomic
turbulence. In such an environment, concerns over the sustainability of economic
development appeared to be misplaced. Thus, the risks attached to the growth and the
globalisation strategies of many banks were ignored.
Moreover, the underestimation of risk was closely bound up with the prevailing regulatory
paradigm at that time, which overlooked the significance of mutual dependencies between
banks. Instead, it was assumed that the stability of the system as a whole was ensured, so long
as each individual bank held enough capital to cover its own risks. Yet this assumption
disregards the fact that, as a bank's size, market share and interconnectedness increase, the
economic costs associated with bank failure rise disproportionately.
Allied to this underestimation of the significance of systemic interlinkages was an excessive
faith in modelling, to which the supervisory authorities also subscribed.11 There was a general
conviction that the commonly used quantitative models for measuring risk captured the actual
risks in the banking system fully and reliably - a dangerous misapprehension. For instance,
these models' risk calculations were based on correlations of price trends in the recent past,
while often disregarding the fact that such correlations can change rapidly and significantly,
for reasons that are not directly apparent from the data. Moreover, the models simply did not
sufficiently replicate certain risks which grew to major proportions over the course of the
crisis, such as the default risk of positions which the banks were holding on the assumption
that they could easily sell them at short notice.12
Since the regulatory capital requirements largely relied on these model-based calculations,
they did not adequately take account of the actual risk exposure.
Against this background, the resilience of many banks proved to be insufficient overall during
the crisis. Relative to their risk exposure, the banks simply did not have large enough liquidity
and capital cushions. They were unable to absorb large outflows of funds and losses.
In short: before the crisis, the practical relevance of the 'too big to fail' issue was
underestimated. At the same time, the belief that the risks in the banking system could be
precisely quantified and monitored by means of sophisticated statistical models led to a false
sense of security. These are key explanations for the inadequacies in banking regulation
worldwide before the crisis.
b) ... in Switzerland too
These aspects also played a key role in Swiss regulatory practice before the crisis.
Like a lot of big banks in other countries, UBS and Credit Suisse also pursued a growth and
globalisation strategy that focused heavily on investment banking in the decade leading up to
the crisis. UBS, in particular, had set itself the goal of becoming one of the global leaders in
investment banking.13
Such global business activities enabled the big banks to achieve impressive returns for many
years (cf. slide 4). Their financial soundness and strategic direction were thus rarely
questioned.14 The risks taken on by the big banks as part of this development were widely
underestimated.
In the years before the crisis, supervisory authorities and regulators had warned of potential
risks associated with rapidly expanding balance sheets and shrinking capitalisation (cf. slide
5). For instance, the Swiss Federal Banking Commission (SFBC), the predecessor of today's
Financial Market Supervisory Authority (FINMA), had already stepped up its supervision of
Switzerland's two big banks by the end of the 1990s.15 The SNB, in its Financial Stability
Reports from 2003 onwards, pointed out that both big banks were highly leveraged in an
international comparison.16 Together with the SFBC, the SNB was also an early advocate
within the Basel Committee on Banking Supervision of an international tightening of capital
requirements for big banks. However, these calls failed to garner enough support, and, due to
considerations relating to international competitiveness, it was decided that Switzerland
would not go it alone.17
At the same time, the Swiss authorities and banks, like their peers elsewhere, also fell victim
to the widespread over-reliance on models, leading to a distortion of risk assessment. Thus in
2004 the SFBC, for instance, granted UBS permission to use its own adapted risk model to
assess the market risk, i.e. the financial risk, stemming from changes in the market valuation
of the bank's assets. Using the adapted risk model, the maximum assumed risk of loss on the
corresponding positions, and hence the requisite capital requirement, was reduced.18 Granting
permission to use this model was, in the conditions prevailing at the time, a logical step and in
line with international practice. During the crisis, however, it became clear that the
overreliance on risk models was a mistake - something which FINMA (the successor to the
SFBC) has also acknowledged in hindsight.19
Switzerland's regulatory response to the 'too big to fail' issue
The financial crisis vividly exposed the shortcomings of banking regulation. A broad
consensus quickly developed over the need for a thorough overhaul of the regulatory
framework. In Switzerland, the UBS case, in particular, generated strong political momentum
for stricter banking regulations.
a) Extensive adjustment of international regulatory standards
At international level, the Basel Committee and the Financial Stability Board (FSB)
subsequently adopted a number of measures to strengthen banks' resilience and find a
solution to 'too big to fail'.
With respect to banks' resilience, the Basel Committee increased the minimum risk-weighted
capital requirements, in terms of both quality and quantity. It also specified a capital
surcharge for systemically important banks over and above the new minimum requirements
applying to all banks. Furthermore, it revised the calculation of risk-weighted assets with the
goal of restricting banks' freedom to determine capital requirements. At the same time, it
introduced an unweighted capital adequacy requirement - a leverage ratio, to serve as a
nonrisk-based backstop to the risk-based capital requirement for banks.
The FSB measures are aimed at improving the resolvability of systemically important banks.
In particular, requirements have been defined for resolution planning and for the accumulation
of gone-concern loss-absorbing capacity. These measures are intended to ensure that
systemically important banks can exit the market in an 'orderly' fashion in the event of a
crisis.
b) Swiss TBTF regulations rest on two complementary pillars ...
In Switzerland, parliament had already passed a package of legislation back in 2011 that
recognises the special importance of the 'too big to fail' issue and is in line with the
international approach. It is based on two complementary pillars with special requirements for
systemically important banks.
The first pillar defines measures to strengthen the resilience of these banks and thereby reduce
the likelihood of a systemically important bank getting into financial distress.
In particular, the revised regulations impose stricter capital and liquidity requirements on
banks. They have to meet both risk-weighted capital requirements and a leverage ratio
requirement.
Equity capital allows banks to absorb losses, thus protecting them from insolvency. At the
same time, a high capital buffer reduces the incentives for shareholders to take excessive risks
as they would be putting their 'own money' on the line. Liquid assets, in turn, ensure that a
bank is capable of withstanding sudden, unexpected outflows of short-term liabilities without
getting into acute payment difficulties.
The bank-specific level of these requirements is today partly determined by the bank's degree
of systemic importance. In contrast to the pre-crisis era, the regulations now expressly take
into account the risks to the financial system and the economy as a whole arising from the
failure of a systemically important bank. In this way, the regulations also explicitly rein in
incentives for excessive growth in the sector.
However, even the new, stricter capital requirements cannot eliminate the risk of a
systemically important bank getting into existential difficulties. First, the risks are difficult to
assess and they also change over time. Second, the very nature of banks' operations means
that they will always be to some degree susceptible to crises. Absolute security can never be
achieved if, at the same time, we want to safeguard the useful economic functions of banks.
The second pillar of the TBTF regulations comes into play in the event that a systemically
important bank gets into financial distress despite increased resilience. It is intended to ensure
that the bank is resolvable. In other words: Even a systemically important bank should be able
to exit the market in an orderly fashion. Its recovery or wind-down must not be allowed to
jeopardise the stability of the economy as a whole.
For this purpose, the regulations stipulate requirements for resolution planning. For example,
by end-2019, systemically important banks in Switzerland have to prepare 'emergency plans'
demonstrating that they will be able to continue their systemically important functions in
Switzerland without interruption in the event of a crisis.
The second pillar also specifies requirements for loss-absorbing capacity. Systemically
important banks must hold sufficient financial resources to cover losses in a crisis or to
finance the costs of a separation of systemically important functions. Banks can use so-called
'bail-in' instruments for this purpose. These are essentially debt securities which can be
converted into equity or written down in the event of impending insolvency.20
These measures are especially designed to counter the de facto obligation by the state to
provide assistance in the event of a crisis. The organisational arrangements facilitate an
orderly separation of the central functions within a reasonable timeframe. Furthermore,
creditors are to participate directly in the default risk. The intention is to ensure a bail-in by
creditors rather than a bail-out by the state in the event of a crisis by predefining the criteria
for when debt securities are converted or written down.
The Swiss regulatory approach is thus aimed at tackling the fundamental causes of 'too big to
fail'. This was also the conclusion reached by the Federal Council in its 2015 evaluation
report. Its assessment of the Swiss approach was positive, considering it appropriate in an
international comparison.21
At the same time, the Federal Council concluded that further action was needed in relation to
certain parameters. In particular, it stressed that, due to the special significance of 'too big to
fail' in our country, Switzerland should be at the forefront when it comes to setting resilience
requirements. Consequently, it prescribed an increase in capital requirements.
These changes have been criticised in some quarters. Concerns were voiced that some of the
adjustments were unreasonable and would put banks at a competitive disadvantage
internationally.22 How justified is this criticism?
c) ... and are designed to be cost-effective
All regulations inevitably meet with resistance because they create added costs for the
regulated institutions. But it is often the only way to bring about the desired change in
conduct. In any discussion of the costs of regulation, it is important to weigh the private costs
incurred by those subject to the regulations against the costs to the economy as a whole. As
long as the private costs are less than the macroeconomic benefit, then the regulations make
economic sense. Yet such a cost/benefit analysis is complex and fraught with uncertainty.
The literature is unambiguous on the macroeconomic costs and benefits of the post-crisis
increase in capital requirements.23 The benefits far exceed the costs involved. The benefits of
the higher capital requirements are that they reduce the likelihood and the severity of a
banking crisis.24 However, economic costs from stricter capital requirements may arise in the
form of higher borrowing rates, reduced lending and an associated weakening in economic
growth. Empirical evidence shows that these negative effects are minor, particularly if the
capital requirements are increased gradually as planned.25
Cost-effectiveness also needs to be taken into consideration when deciding on specific
regulatory measures. Switzerland made a conscious choice to adopt a lean approach to
resolvability requirements. Consequently, the regulations do not directly impact on banks'
business models or organisational structures. Nor do they distinguish between desirable and
undesirable banking activities or prohibit certain practices. Rather, the Swiss approach is
based on incentives and subsidiarity. Banks 'only' have to demonstrate that they are
'resolvable' in the event of a crisis.
Of course, the calibration of the capital requirements takes international competitiveness into
account. The Federal Council's 2015 evaluation report gives great weight to the comparison
of the Swiss regulations with those of other countries. We are convinced that the improved
regulations contribute to the good framework conditions that characterise Switzerland in
general. This in turn is an essential prerequisite for the sustainable and successful
development of the Swiss banking sector. A robust, well-regulated banking system is a key
locational advantage in international competition. It attracts clients and businesses, and is
therefore desirable not only in the interests of financial stability, but also from the perspective
of the globally active banks themselves.
d) Implementation of the TBTF regulations is already well under way
Thus, ladies and gentlemen, the Swiss regulatory approach targets the fundamental causes of
the 'too big to fail' issue and is cost-effective. We are therefore confident that full
implementation by the end-2019 deadline will create the conditions necessary for resolving
the 'too big to fail' issue in Switzerland.
What is our current status regarding fulfilment of the TBTF requirements? In our latest
Financial Stability Report published in June, we stated that implementation is already well
under way. In terms of the resilience requirements - the first pillar of the regulations - both
big banks are on track. They already fully meet the requirements for risk-weighted capital that
will apply from end-2019.
As far as the second pillar - resolution - is concerned, the two big banks have made further
progress. Here too, they already meet some of the requirements in full, namely those relating
to gone-concern loss-absorbing capacity.
Nevertheless, the finish line has not yet been reached. More progress needs to be made in
increasing resilience with regard to the leverage ratio.
Moreover, the work that still needs to be done under the second pillar should not be
underestimated. The resolution of a bank, especially a globally active big bank, is highly
complex. It needs to be planned in a thorough and prudent manner. To ensure that a bank can
be resolved in an emergency, further progress is needed in three areas in particular. First,
resolution funding plans need to be drawn up, which FINMA, as the competent authority, is
currently in the process of doing. These aim to ensure that a bank has sufficient liquidity to
implement a resolution. Second, loss-absorbing capacity must be ensured at the level of each
individual entity within the big banks. Previously, the focus was on loss-absorbing capacity at
consolidated group level. Third, both big banks must further reduce the financial and
operational dependencies within the group.
In addition, the two banks need to finalise the required emergency plans for Swiss institutions
with systemically important functions by end-2019.
Today, all market participants are well aware of the significance of 'too big to fail' in
Switzerland, and the present environment is propitious for completing the final phase towards
full implementation of the regulations. It is important to avoid the mistakes of the past and
ensure that, in a favourable environment, we do not turn a blind eye to the costs and risks of a
crisis or view the necessary regulatory measures as excessive. Full implementation of all
requirements is essential if the Swiss financial system is to be better equipped to weather
future storms.
Conclusion
Let me now sum up.
The global financial crisis ten years ago made us only too keenly aware of how serious a
problem 'too big to fail' is. It also revealed just how inadequate the regulations were for
dealing with this issue. This was especially true for Switzerland with its important financial
sector.
Huge efforts have since been made to improve regulations, both internationally and
nationally. The reforms are aimed at enhancing the resilience of systemically important banks
to weather future storms and at reducing the risk of extensive storm damage at a
macroeconomic level.
In Switzerland, we have opted for a cost-effective regulatory approach. Many of the agreed
measures have already been implemented. We are therefore confident that the Swiss big
banks and the Swiss banking system in general are much more weatherproof today than they
were ten years ago.
Equally, we are confident that full implementation of the Swiss 'too big to fail' regulations
will reduce the false incentives that underlie the issue and create the necessary conditions for
resolving the issue here in Switzerland. The state should no longer be obliged to use
government funds to bail out a bank.
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