TBTF-regulation in Switzerland – quo vadis?
On Friday, the report of the group of experts on banking stability was published. In May 2023, an expert group was nominated by the Swiss government to evaluate the strategic implications of the Credit Suisse rescue, with a specific focus on the Swiss “Too-big-to-Fail” (TBTF) regime and the collaboration between the Swiss National Bank (SNB), the Swiss Financial Markets Authority (FINMA) and the Federal Department of Finance (FDF).
In this article, we discuss the key findings of the report and add the views of Orbit36 on the improvements necessary after the Credit Suisse demise.
The expert group makes four main recommendations:
- Switzerland should improve in crisis preparation and crisis management
- The liquidity supply available to banks in a crisis situation needs to be improved
- FINMA requires additional instruments to ensure more effective supervision of banks
- The transparency on the quality of capital should be strengthened
Reforms of the Swiss TBTF framework should explore the following aspects:
Why was TBTF not applied?
According to the experts, the TBTF regulation improved the situation compared to the 2007/2008 global financial crisis, but the practicability of the resolution regime remains unproven since the Swiss authorities have decided a merger with UBS, the supposedly less risky alternative.
When Credit Suisse collapsed in March 2023, a total loss-absorbing capacity of around 100bn CHF was available to support a resolution of the bank. The expert group mentions that the amount is large, but leaves open whether it was sufficient to cover the estimated losses under a resolution scenario. Orbit36 believes that the appropriateness of the available (but not used) bail-in capital needs to be further examined before any further increases in capital requirements are considered for systemically important banks.
The resolution plans for UBS and Credit Suisse assume that FINMA would stabilize the entire banking group through a bail-in conducted at the top holding level. The independent resolution of individual legal entities is only foreseen as a fallback option. Solutions involving bridge-banks or the like as commonly used in the US are not available under the Swiss recovery and resolution regime. The experts regard this lack of flexibility as a possible reason why the Swiss authorities might have decided against a bailout of Credit Suisse, presumably coupled with concerns about contagion risks for the global financial system.
The experts additionally conclude that a bail-in would have been associated with operational and legal risks. It was not sure whether the US Securities and Exchange Commission (SEC) would have been willing to grant exemptions from registration duties for the bailout, which could not have been completed over a single weekend. In the absence of a precedent for a bailout of a G-SIB, it was unclear whether a bailout decision by Swiss authorities would have been legally enforceable in the US and other jurisdictions.
Better access to central bank liquidity facilities needed
The liquidity crises incurred by some banks in the US have shown that sight deposits are much more volatile than generally assumed.. Also in the Credit Suisse case, the observed deposit outflows were significantly higher than assumed for the Liquidity Coverage Ratio (LCR). The expert group argues that increased withdrawal rates are not solely a cause of the increased use of digital banking products, but also the long period of negative interests. Consequently, they recommend a conservative re-calibration of the LCR.
Orbit36 believes that a simple increase of the LCR requirements does not sustainably solve the problem. The LCR failed the stress test. It needs to be acknowledged that the banks’ business model of collecting short-dated deposits to finance long-term loans causes a structural liquidity risk. This unavoidable structural risk would in our view be better addressed by a more flexible availability of central bank liquidity, which is not limited to systemically relevant banks. Ideally, all solvent banks could temporarily exchange a broad range of assets against central bank funds as part of their normal business operations, provided they can pledge sufficient assets as collateral.
The expert group finds that the SNB follows a rather restrictive policy for emergency liquidity loans, both in terms of collateral requirements and eligible institutions. The group of experts recommend the SNB to accept a wide range of collateral that can be used by all solvent banks facing a liquidity crisis, following the practices of central banks in other large jurisdictions. In our view, this recommendation makes a lot of sense, as it partly addresses the structural risks mentioned above.
While the experts emphasize the need for the implementation of a Public Liquidity Backstop (PLB), they recommend this instrument only to be used for systemically relevant banks. Yet, it remains unclear why. The PLB was implemented in a number of jurisdictions to ensure sufficient liquidity is available to support the resolution of a failed bank on an uncollateralized basis. It addresses a problem which occurs for all banks in resolutions, not only the systemically relevant ones.
Orbit36 regards it therefore as crucial that access to central bank funds is available to all banks, provided that the banks are solvent and can pledge the central bank loan with eligible collateral. As already mentioned, the list of SNB eligible collateral needs to be significantly widened and should also include banking assets which are illiquid by nature, like mortgages, loans an investment grade securities. The current limitation on highly liquid debt securities of the highest credit grade is impracticable, since such assets are likely already encumbered to market counterparties in an emergency situation.
To reduce the risks for the SNB from lending against lower quality collateral, we believe that access to central bank funds could be conditioned to the availability of bail-in bonds or surplus regulatory capital. The write-down of these liabilities could be used to absorb the potential losses of the SNB in case a bank is unable to repay a liquidity assistance loan. In such setting, the failure to repay the SNB would automatically trigger a bailout and/or the write-down of the surplus capital. In our view, this would be an efficient and flexible instrument, since it would only require a bail-in or write-down of AT1 when needed. Nonetheless, the SNB would have more safety than for the uncollateralized ELA+ facility, a newly implemented instrument to resolve the Credit Suisse crisis.
Capital was not the issue, but the regulation for the parent bank needs improvement
Credit Suisse was until its end well capitalized. The bank failed because of a lack of trust. The crisis escalated despite affirmations of SNB and FINMA, that the bank’s regulatory liquidity and capital adequacy requirements were met at all times. Among different possible explanations, the experts consider the possibility that regulatory measures could provide an incomplete picture (since capital and liquidity ratios are to a certain extent backward looking) and that various transitional arrangements (e.g. on RWA calculations, valuation of participations in subsidiaries) possibly undermine the quality of capital.
We share the view of the expert commission that the Credit Suisse case did not point to insufficient capital requirements for systemically relevant banks. Increasing the unweighted leverage ratio requirement (as proposed by politicians and academics) would provide problematic incentives. It bears the risk that banks reduce their low risk assets and engage in more risky business activities in order to optimize their return on capital.
The expert group also discusses the challenges associated with the capital adequacy measurement at the legal entity, the parent bank and group level. There exist various transition regimes, regulatory filters, double leverage, as well as valuation methods for subsidiaries and deferred tax assets. The valuation of subsidiaries in the parent bank is in certain constellations determined by valuation models based on discounted future cash flows and can therefore be volatile. In addition, the exit of certain businesses caused in the case of Credit Suisse AG some capital impacts on deferred tax assets recognized as capital. The experts conclude that some market participants questioned the quality of Credit Suisse’s capital, which may have accelerated the crisis.
Orbit36 shares the view that the valuation method for subsidiaries can have a significant impact on the capital ratios reported by the parent bank. The bank’s disclosure reports show that Credit Suisse AG had to impair their participations in foreign subsidiaries by more than 50bn CHF over the last years, which steadily eroded the parent bank’s capital. In autumn 2022, FINMA had to allow Credit Suisse AG to temporarily operate below the 10% CET1 requirement to support the planned strategic transformation. We believe that the capital adequacy treatment for the parent bank and the valuation method for subsidiaries should be thoroughly reviewed, as it contains some pro-cyclical elements, creates inconsistencies with the consolidated group capital adequacy and can undermine the trust in the entire bank.
Orbit36 has the competence to support banks, regulators and policymakers in their demanding task of further enhancing the regulatory framework. Please reach out to us to discuss.