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Containing the systemic risks from exceptionally large financial institutions.

The Swiss financial system has weathered the international financial crisis despite the severe losses of its two largest banks and a considerable loss of one of its insurance companies, in part because the authorities moved quickly when the crisis broke in the fall of 2008. However the comparatively large magnitude of the losses of its two largest banks in relation to capital has underscored the systemic risks to the economy posed by the institutions' large size relative to Swiss GDP and their extensive cross-border and cross-currency activities. While the Swiss financial regulatory apparatus has been greatly improved during this decade, further steps need to be taken to better contain the systemic risks. Prudential standards for the two largest Swiss banks will need to be above the average maintained by their peers in other countries. Macro-prudential oversight needs to be further strengthened and broadened. The existing co-operative arrangements with financial authorities in other countries need to be expanded for the largest Swiss banks and insurance companies and for crisis management in the event of future problems.


The strains that hit the Swiss financial system in the wake of the international financial crisis in 2007 have been contained for the present. The capital positions of the two major banks, UBS and Credit Suisse Group (CSG) have been buttressed from private and public sources and the banks are undertaking internal reforms to remedy the serious weaknesses in their risk assessment and management that their losses have revealed. The repercussions of their problems on the remainder of the Swiss financial system have been limited, due in part to the timely actions of the Swiss authorities. Significant risks remain in the near-term, particularly if turmoil were to return to international financial markets or the economic downturn were to worsen or is more prolonged than now expected.

The crisis has underscored the considerable systemic risks to the Swiss economy posed by the exceptionally large size, in relation to GDP, of its major financial institutions, particularly the two biggest banks (Big-2), and their extensive cross-border financial activities (Box 3.1). Although the losses of the two major banks were not exceptional in absolute terms, they were very large in relation to their capital and in relation to the overall economy. The Swiss financial authorities have taken important steps over the past two years to improve oversight of the largest financial institutions and to strengthen prudential norms. As discussed in this chapter, containing the systemic risks posed by these institutions will also require greater emphasis on macro-prudential oversight and enhanced co-operative arrangements with financial authorities in other countries.

Origins of the Swiss financial crisis and its repercussions

Strains on the Swiss financial system began to be felt in 2007 as the credit quality of United States collateralised debt obligations (CDOs) based on sub-prime mortgages steadily deteriorated and the effects spilled over to major interbank markets. Strains on Swiss markets were comparatively moderate until the fourth quarter of 2007 when the first major announcements of write downs by the two largest banks revealed higher exposures to the afflicted assets than previously expected by financial markets.(1) Pressures mounted further during 2008 in the wake of several more major financial institution failures in the United Kingdom and the United States and announcements of further write downs and losses by the Swiss Big-2 and other international banks. Tensions reached a crescendo following the failure of Lehman Brothers in September 2008. Although financial market conditions have improved noticeably since then, they remain strained and vulnerable to further shocks.

The losses from write downs, mainly from CDOs, of the Big-2 Swiss banks have turned out to be very large, particularly for UBS which took cumulative write downs of USD 53.1 billion through the second quarter of 2009(2) (Table 3.3). The Big-2 losses were not exceptional compared to those of major US banks, three of which each took write downs nearly twice as great as those of UBS. The UBS write downs were larger than for any major EU bank, although those of CSG were more in line with those of the worst affected in the United Kingdom and Germany. However the UBS write down was exceptional in relation to its capital: by this standard, UBS losses were greater than for any surviving United States financial institution and well above the ratios for any other EU bank. For CSG they were, by this standard, closer to the ones of other European banks.
Box 3.1. Distinctive features of the Swiss financial system

The Swiss financial system is characterized by several distinctive
features that have an important bearing on the risks it poses to
the domestic economy (Table 3.1). First, the banking system is
large. Swiss bank financial assets were nearly 7 times the level of
GDP at the end of 2007, compared to about five times GDP at the
beginning of this decade, and were still nearly six times GDP at
the end of 2008 despite considerable downsizing of bank portfolios
during the present crisis (Table 3.2). The Swiss ratio is
substantially higher than that of other OECD countries except for
Iceland prior to the crisis in 2007. The Swiss insurance sector is
also quite large. Banking and insurance business are major
contributors to domestic economic activity, accounting for nearly
11% of GDP and 5% of total employment. Value added from wealth
management commissions alone contributed nearly 4% of Swiss GDP.

The large size of the financial system reflects the presence of
several very large internationally focused institutions that make
Switzerland a major international financial centre. Domestically
booked assets of Switzerland's two largest banks, UBS and Credit
Suisse Group (CSG) account for about 60% of total Swiss bank assets
or over 3 1/2 times Swiss GDP at the end of 2008 while their total
worldwide assets (including those of subsidiaries) were 6 times
GDP. The Big-2 are among the world's largest international banks,
ranking 5th and 27th respectively in terms of total assets at the
end of 2008. Their focus is on wealth and asset management and
investment banking conducted through an extensive network of
foreign branches and subsidiaries predominately located in Europe
and North America. Interbank and other wholesale financial markets
supply most of their funding. Switzerland's role as an
international banking centre is also manifest in an extensive
presence of foreign banks at the end of 2008. The insurance sector
is likewise dominated by two very large internationally focused
institutions, Swiss Reinsurance (Swiss Re) and Zurich Financial
Services (ZFS), two-thirds of whose prernia arise from foreign
business. Swiss Re alone accounts for nearly 15% of global
reinsurance premix, and Switzerland ranks only behind the United
States and Germany in the scale of its reinsurance business.

Switzerland's prominence as an international finance centre goes
beyond its largest institutions. Swiss domiciled institutions
account for an estimated two-thirds of cross-border wealth
management (IMF 2007a). This wealth management is carried out
through an extensive network of private banks organized as
partnerships and by foreign banks in Switzerland as well as the
Big-2. Switzerland is also a major player in the international
hedge fund business, ranking second to the US as a market for such
funds. Hedge funds have grown very rapidly in Switzerland since the
beginning of this decade, from 39 funds registered domestically in
2001 to 256 at the end of 2007 (IMF 2007a). The Big-2 have been
extensively involved in hedge fund activities and their exposures
have been closely monitored by the Swiss banking authorities.

The international orientation of the largest Swiss financial
institutions and large presence of foreign banks has led to a
comparatively high level of foreign-currency denominated assets and
liabilities relative to the overall size of the financial system
and in relation to Swiss GDP. Foreign currency denominated
instruments--predominately interbank and other wholesale--accounted
for nearly 60% of total Swiss banking system liabilities in
December 2008, more than 3 times GDP, and nearly 80% of liabilities
to banks. This concentration makes the Swiss financial system and
economy particularly vulnerable to liquidity shortages in foreign

Most of the other Swiss financial institutions are primarily
focused on domestic lending and other activities. The 24 cantonal
banks play a major role in lending to domestic businesses and
households, and together with the other domestic banks account for
nearly two-thirds of domestic lending. The domestic banks engage
mainly in traditional mortgage and commercial lending: securities
and other trading activities as well as foreign currency holdings
are limited. Deposits account for a much larger portion of funding
of the domestic banks (about one-quarter of total liabilities)
compared to the Big-2. Apart from the three largest, Swiss
insurance companies are likewise focused on domestic customers.

Several features of the Swiss financial regulatory system are also
distinctive. As in other countries, major segments of the financial
system have until recently been subject to separate financial
regulators. Cantonal authorities play a key role as owners of the
Cantonal banks, whose liabilities are guaranteed by the cantonal
government and which are subject to mandates on their local
lending. Cantonal authorities also have a key role in pension fund
regulation. Switzerland's regulatory system is also distinctive in
the importance of self-regulatory bodies, such as the Swiss Bankers
Association, and in its reliance on external auditors to conduct
examinations of financial institutions.

The international orientation of the largest Swiss financial institutions and large presence of foreign banks has led to a comparatively high level of foreign-currency denominated assets and liabilities relative to the overall size of the financial system and in relation to Swiss GDP. Foreign currency denominated instruments--predominately interbank and other wholesale--accounted for nearly 60% of total Swiss banking system liabilities in December 2008, more than 3 times GDP, and nearly 80% of liabilities to banks. This concentration makes the Swiss financial system and economy particularly vulnerable to liquidity shortages in foreign currency.

The Swiss bank write downs were also larger as a ratio to GDP than for any other OECD country except Iceland. The losses of Swiss Reinsurance from its exposure to sub-prime mortgages and credit default swaps (CDS) were also relatively large compared to most other international insurers, although much smaller in absolute terms than those of the Big-2.

Market assessments are broadly consistent with the severity of the write downs. Measured by credit default swap rates (CDSR), UBS has until recently been viewed as among the most at-risk of major European banks, although somewhat less risky than the worst-affected US banks for much of the crisis (Figure 3.1). The perceived risk of CSG has remained noticeably below that of UBS throughout the crisis and is now lower than the average of the US and European banks. Both banks have undergone several downgrades by the major credit rating agencies since the beginning of the crisis. Overall ratings for UBS are among the lowest of the major banks hardest hit by the crisis, although those for CSG are somewhat better. (3)


Weakness in internal controls was a contributor but not the fundamental cause of the write downs

Weaknesses in the internal risk management of the Big-2 were a significant proximate factor behind their heavy losses on sub-prime and other securitized assets. A UBS special report to its stockholders issued in March 2008 and a subsequent report of the Swiss Federal Banking Commission (SFBC) cited serious weaknesses in internal reporting of risk exposures to sub-prime assets to senior management, inadequate control of the bank's trading inventory of securitized assets, and insufficient attention by senior officials to the risks entailed by the rapid growth of the overall balance sheet (UBS, 2008a; SFBC, 2008). Such weaknesses were hardly unique to the Big-2 and do not appear to have been exceptional in relation to the other major United States and EU banks that suffered most heavily. While better internal controls probably would have reduced the losses somewhat, the internal idiosyncratic weaknesses of the Big-2 were not the fundamental problem.

The basic source of the Big-2 losses was their adoption of a strategy (in their investment banking component) involving pursuit of rapid growth in revenues through the trading of complex structured instruments based on mortgages and other assets whose individual risk was supposed to be hedged through diversification. Profits were driven by highly leveraged financing of the trading through borrowing in shorter-term markets. This strategy was shared by the major international bank peers of the Big-2 in the US and the European Union (EU) and began to develop during the 1990s although it became much more aggressive during this decade. The Big-2 along with Swiss Reinsurance began to increase their emphasis on this strategy earlier in this decade in order to augment the profits they were receiving from their traditional (and generally more conservative) wealth management and other core businesses. (4)

The Big-2 also shared the weaknesses of other major international banks in seriously underestimating the risks entailed by their activities in the structured instruments business. The probability of credit deterioration in the assets underlying the structured instruments was understated, the ease with which the banks would be able to reduce their risk exposure in times of market turmoil was overstated, and too much reliance was given to ratings of the major credit rating agencies. These misperceptions were widely shared, by market analysts outside the banks as well as among financial supervisory authorities in Switzerland, the rest of Europe, and the United States.

The Big-2 did go further than most banks in leveraging their balance sheets to boost revenue. The average ratio of Tier I capital to book-value assets for the Big-2 fell from nearly 7% in 1995 to just above 4% in 2000 and dropped further to about 2% in 2005-2006. The UBS ratio of tier I capital to total assets at the end of 2007 was the lowest of any major European bank except for Deustche bank and well below the levels of the major United States banks; while the CSG ratio was also relatively low (5) (Figure 3.2).

Despite their comparatively high leverage, the Big-2 were (and largely remain) relatively well capitalized on a risk-adjusted basis. The tier i CAR of CSG and UBS were among the highest of major international banks before the crisis. Two of the other banks taking the largest write downs, Citigroup and Royal Bank of Scotland, also had comparatively high CAR. The combination of high CAR with high leverage is characteristic of those banks which most aggressively grew their leveraged trading activities in complex structured instruments. (6) The high CAR encouraged a sense of confidence that risks were being contained, but the low ratios of capital to book-value assets proved to be the better measure of vulnerability during the crisis.

Other Swiss financial institutions have experienced adverse consequences from the international financial crisis, but in most cases these were moderate. Swiss Re recorded substantial write downs, amounting to nearly 3% of its total assets (mainly) from its exposure to sub-prime mortgage related instruments and credit default swaps and was forced to seek a capital infusion from an outside investor (Berkshire-Hathaway fund). Neither its losses nor those of the other major Swiss insurers have posed significant systemic risks by themselves. However they probably added to market concerns over the Swiss financial system and economy and increased the potential costs to the Swiss government in the event that a broader financial rescue was to be become necessary.


The problems of the major Swiss financial institutions have led to a significant increase in market assessments of Switzerland's sovereign risk. The risk premium on Swiss sovereign debt--as measured by the credit default swap rate (CDRS) on government debt--rose sharply along with those of other affected economies during the surges in 2008 and early 2009 although it has since fallen back below that of the United Kingdom (Figure 3.3). Movements in the Swiss bank and sovereign CDRS have been closely synchronised, more so than for the United States or the United Kingdom, and the difference between sovereign default swap rates and bank debt default swap rates has been smaller. This pattern suggests that the financial institutions' problems are perceived to be more closely linked to Swiss sovereign risks than for other countries. The reliability of the CDS Market as an indicator for the sovereign risk of Switzerland may be questioned. The CDS market for Swiss bonds is not transparent, because their prices are negotiated between the parties concerned ("over-the-counter market"), as is generally the case for CDS contracts, so price discovery may be unreliable. For small euro area countries, differences in interest rates on government debt from different countries are tracked quite closely by corresponding differences in the CDS prices, suggesting that CDS prices on government debt may reflect how investors price their perceptions of risk of government debt even in small countries. (7)

Spillovers from the Big-2 problems to the rest of the Swiss financial system were limited

The cantonal and other domestically oriented Swiss banks seem to have been little affected directly by the international turmoil and Big-2 problems although they have been affected indirectly through the downturn in the Swiss economy. Domestic banks received substantial inflows of funds from the Big-2 banks in 2008, although these were subsequently relent back to the Big-2, facilitated by measures taken by the SNB noted below. Non-performing loans of cantonal and the regional and savings banks have not risen appreciably. While their profits have fallen, they remained positive through 2008 (Table 3.4) (SNB, 2009a). The portfolios of insurance companies have fallen markedly in value as a result of the decline in asset prices on international and domestic markets, although their immediate ability to meet their obligations has not been impaired. Coverage ratios of pension funds' assets to the discounted value of future obligations have fallen. As discussed in Chapter 1, the authorities have mandated remedial actions that will restore coverage ratios to more normal levels in the near-term.


A number of factors help explain the relatively limited damage experienced by Swiss domestic financial institutions and markets. The relatively early decision (October 2008) to transfer toxic assets from UBS to a dedicated fund also helped restore confidence. Real estate markets in Switzerland did not go through the marked cycle in the years prior to the crisis that occurred in the United States, the United Kingdom and a number of other European countries. Swiss housing prices rose only moderately, at an annual average rate of 4.2% over 2000-2006, and have continued to rise since then. The stringent mortgage lending standards adopted by Swiss domestic banks after the severe real estate market downturn in the early 1990s have largely been maintained both before the present turmoil and after (SNB 2009a). As a result, Swiss domestic banks have experienced little deterioration in the quality of their mortgage loan portfolios or losses from defaults. Domestic banks' concentration on traditional lending and limited trading activities has insulated them from the direct impacts of the declining financial market prices. (8)

The comparative robustness of the Swiss franc as the crisis unfolded also helped in containing the spillovers from the problems of the largest financial institutions and in preventing a much greater meltdown such as that experienced by Iceland. The franc appreciated against the dollar during the latter half of 2007 (although it changed much less versus the euro) and again in the first quarter of 2008 following the Lehman Brothers failure. The Swiss franc's traditional status as a "safe-haven" currency probably contributed to its robustness, although there are indications that carry trade also played a role (see Chapter 2). Other factors, notably Switzerland's long record of macroeconomic stability, current account surpluses, fiscal prudence, and the previously high reputation of its major financial institutions were probably as least as important. The fact that the banking problems were widespread and not simply confined to Switzerland may also have helped avoid downward pressures on the franc. None of these factors can be expected to provide any guarantee against a currency crisis, in the future, however. There were some indications before the crisis that the decline in the role of the Swiss franc as a reserve currency and the advent of the euro might have eroded its safe haven status (IMF, 2007d).

... due in no small part to effective actions taken by the financial regulators and the SNB

Measures taken by the Swiss banking authorities and SNB since the crisis began have played a critical role in limiting its impact on the domestic economy, notably through significant easing of monetary policy as well as injections of dollar liquidity. These actions were essential to ensuring that Swiss financial institutions could obtain the dollars needed to fulfill their obligations (Chapter 2). The SNB also played a key role in alleviating pressures on the Big-2 banks resulting from the outflow of funds by brokering the issue by the Big-2 of mortgage backed ("covered") bonds to domestic banks.

These actions, along with statements by the Swiss authorities that further measures, including direct government guarantees of bank obligations, would be taken if necessary helped to stabilize confidence in the overall financial system and probably to calm concerns over the viability of the Big-2. The actions may well have raised longer-term moral hazard that will have to be addressed at some point, but the immediate systemic risks posed by the Big-2 were, at that point appropriately, the overriding consideration. Moreover, the regulator moved quickly after the outbreak of the crisis to bolster prudential capital requirements on the large banks (see below).

The support measures for UBS announced by Swiss authorities (the SNB, Swiss Federal Banking Commission, and Swiss Federal Government jointly) in October 2008 have insulated UBS from further losses on a significant portion of its most impaired assets while preserving its capital (Box 3.2). (9) The original shareholders of UBS paid an up-front cost of 10% of the value of the assets transferred. The Bank had to pay a significant risk premium on the notes purchased by the Swiss Federal Government. The risk of the assets held by the Stability Fund is shared between UBS and the SNB and both share in the gains if the assets rise in value. The agreement also provided for assessment of the acquisition prices for the assets by an independent panel of experts. These prices were established quite close to the valuation on the UBS trading book at the end of September 2008.

The agreement had the advantage of decisively removing a large portion of the impaired assets that were undermining confidence in the viability of UBS. A notable feature of the scheme is that it limited moral hazard by making incumbent shareholders bear part of the losses while at the same time ensuring that such losses born by shareholders would not weaken the capital base of the bank. The maximum losses to be born by incumbent shareholders amount to the initial 10% as well as any SNB profits from exercising its option to acquire UBS shares in case there are further losses (about another 5% of the assets transferred at a share price of USD 20). Greater up-front costs could have been imposed on UBS shareholders, which would have further limited moral hazard on future shareholders. This would have required a larger stake in UBS from the Swiss government. The offer to transfer toxic assets out of UBS' balance sheet without public intervention in the bank's management exposed the public sector to incentives of the bank to sell only assets for which it could expect to make a profit at the expense of the public sector. The "all or nothing" rule for transfer of assets within designated categories helped to limit these adverse selection risks to some extent. The provisions making incumbent shareholders bear part of the losses that may build up in StabFund, as noted above, also reduced these adverse selection incentives. The costs of the package so far have been mixed. In August the Swiss government sold its stake in UBS for a profit of CHF 1.2 billion. The assets in the StabFund have fallen below the original equity by about CHF 600 million, but this loss would be more than offset if the SNB exercised its option to acquire shares (as of September 2009). By contrast, losses have been incurred by the public sectors in the United States, the United Kingdom and Sweden (OECD, 2009b).
Box 3.2. Terms of the support package for UBS

Under the agreement announced on October 16, 2008 (SNB, 2008b), a
special investment vehicle (the SNB Stability Fund- StabFund) was
created to acquire up to CHF 60 billion of sub-prime and other
seriously impaired structured assets from UBS. Designated
categories of assets were defined, with UBS required to either
transfer all assets within a given category to the fund or to
retain the entirety on its books. The vehicle was financed in part
by equity provided by UBS equal to 10% of the value of the assets
acquired and which was subsequently written down. The remainder was
agreed to be financed by a non-recourse US dollar loan from the SNB
at an interest rate of 250 basis points above the one-month LIBOR.
(Given that the assets acquired were denominated in dollars, the
SNB initially funded its loan by borrowing on its swap line with
the United States Federal Reserve, and later by issuing Swiss
National Bank notes denominated in dollars). The Fund has a maximum
life of 8 years (extendable to 12 years), allowing for considerable
time to sell the assets in more favourable market conditions.

The other component of the arrangement was a purchase by the Swiss
Federal Government of CHF 6 billion (0.1% of GDP) in mandatory
convertible notes issued by UBS. Together with the write down and
transfer of the UBS equity injected into the fund, the plan--as
originally conceived--effectively restored UBS capital to its
original level and gave the federal government the option to claim
an ownership stake in the bank of 9.3%. The injection represents
13.6% and 5.6% of UBS market capitalization at the end of 2008 and
at the end of 2007 respectively. The notes carried an interest rate
of 12.5%. The notes had to be converted into equity no later than
30 months after the original sale, although the government was
given the option to sell the notes before conversion.

The UBS potential loss is thus capped at its 10% contribution of
the value of the assets required. Moreover the SNB will receive
partial compensation in the form of UBS shares (up to 100 million
units) in case its loan is not fully repaid upon termination of the
Fund. Moreover, the SNB is entitled to the first CHF I billion of
the value of the fund at maturity above the loan amount, with gains
above that amount shared equally between SNB and UBS.

Changes in accounting rules toward the end of 2008 allowed UBS to
transfer a portion of the assets originally designated to be
acquired by the StabFund (mainly assets based on United States
student loans) from the trading book to the bank book. This
transfer provided a less expensive means to UBS of eliminating
future market risk from the assets although, as noted in the text,
it leaves the bank with residual credit risk on the assets. The
remaining assets transferred to the fund amounted to just under CHF
38 billion.

Conditions have improved but the financial system is likely to remain vulnerable for some time

Financial strains have eased noticeably since their peak in the first quarter of 2009 as markets have become somewhat more optimistic about the prospects of the major international banks, including the Big-2. Financial conditions of the Big-2 and the major insurers have improved noticeably since mid 2008 (Table 4.4). Substantial capital injections from private and other sources, amounting to nearly USD 28 billion for UBS (excluding the capital from the Swiss government) and about USD 12 billion for CSG, have restored their overall CAR to above pre-crisis levels. Both banks have been reducing their exposure to their most risky assets and shrinking their trading activities. This has led to a substantial drop in their total assets that largely accounts for the decline in the total assets of Swiss banks relative to GDP in 2008. Lower interbank lending also contributed, while exchange rate effects played a minor role. The downsizing of balance sheets continued in the first 6 months of 2009. Declining assets along with additional equity injections have also led to significant improvement in leverage ratios, particularly for CSG. After recording a first net loss in the first quarter of 2008, profits of CSG have been positive since the first quarter 2009. Swiss Re has also improved profitability. UBS continued to record net losses but these fell noticeably in the first quarter of 2009. Profits have been depressed by the write-offs and other charges on impaired assets. The improvements are reflected in the two banks' credit default swap rates, which by the end of the second quarter of 2009 had fallen by about one-third from the peaks they reached in the first quarter.

Significant risks to the Swiss financial system are likely to remain for some time, however. Despite the write downs and downsizing of their trading portfolios, the largest financial institutions, particularly the Big-2 banks, retain sizeable trading risk exposures, particularly in their off-balance sheet activities and their exposures to certain emerging market economies. The USD 21 billion of UBS holdings of United States originated securities transferred from the trading book to the banking book earlier this year is still vulnerable to credit losses should those securities become further impaired. Market observers continue to be wary about the prospects of the Big-2. The Big-2 and other Swiss banks also faced uncertainties about their wealth and asset management business engendered by the intensified controversy over Swiss bank secrecy rules. UBS reported outflows from its wealth and asset management divisions of CHF 39.4 billion in the second quarter of 2009. (10) These appear to have been offset by inflows to other Swiss wealth managers.

The decline in the portfolio values of insurance companies and pension funds, although not critical now, poses risks if asset prices were to fall further. A number of life insurance companies experienced large and as yet largely unrealized losses in 2008 from rising credit spreads, higher liquidity premiums, lower interest rates and increased market volatility. For 2S to 30% of Swiss pension funds assets were estimated to be worth less than the present value of their future obligations (less than 100 per cent coverage ratio) as of September 2009, although the funds' ability to meet obligations in the short and medium-term has not been impaired. (11)

Although projections for major economies have been revised upwards in recent months, risks could increase if the current global economic downturn were to prove longer or more severe, than now projected. (12) A prolonged period of negative profits would erode the progress made by the Big-2 in buttressing their capital margins. Swiss banks that have been little affected so far could come under greater strain if the downturn were to lead to an acceleration in business bankruptcies and defaults on mortgage and consumer credit.

Bolstering prudential standards to help contain systemic risk

The global financial crisis has revealed major weaknesses in international norms and practices for financial regulation, including gaps in regulatory coverage, pervasive underestimation of the true risks of complex financial products, and inadequate attention to liquidity needs in times of market tension. In retrospect, too little attention was paid to interdependencies among markets; regulators tended to focus too much on individual institutions; and assessments of systemic risks through stress tests turned out to be insufficiently stringent (Bailey et al., 2008; Brunnermeir et al., 2009; FSA, 2009).

The fact that the crisis itself and its subsequent extent were unanticipated further underscores these weaknesses. The sophisticated internal models used by financial institutions failed to detect the risks they were incurring, in part because they were overly reliant on assessments by outside credit rating agencies and in part because they assumed that positions could be unwound in times of turmoil much more easily than turned out to be the case. While concerns were widely expressed about the growing resort to increasingly complex and opaque instruments and the overall rise in leverage, country supervisory authorities and the major international financial authorities continued to believe up to the onset of the crisis that the largest banks and other financial institutions were sufficiently robust to any likely shocks that might hit the system. (13)

Remedying the weaknesses to prevent future crises will require further changes in prudential norms and supervisory oversight. As discussed in the following sections, financial supervisors need to give greater attention to macro prudential oversight of the financial system as a whole and to develop more effective cross-border co-operative arrangements.

Switzerland needs to continue its efforts towards prudential norms that take account of the systemic risk from the largest institutions

The need to better contain systemic risks is the key priority for Swiss financial reforms over the next several years. The greatest systemic risks are posed by the Big-2. So long as they retain their present size and form, these institutions are individually and collectively "too-big-to-fail" because of the costs their failure would impose on the economy. For example, Switzerland's largest bank is much larger in relation to GDP (328%) than is the case with the largest bank in virtually any other OECD country and its failure even in isolation would pose systemic risk. (14) The costs of rescuing one or more of the institutions in the event of failure would at least severely strain the fiscal resources of the Swiss government and in a worst case could exceed its capacity.

The potential for an accompanying currency crisis under such (or milder) circumstances adds to the risk. Both the likelihood of a currency crisis and the damage it would cause to the economy are magnified by the comparatively large foreign currency assets and liabilities of the largest financial institutions in relation to the overall financial system and Swiss GDP. While financial institutions normally limit their foreign currency exposures by largely matching assets and liabilities in a given currency, they are still vulnerable to substantial losses in the event of serious disruption to market liquidity. The net demand for foreign currency that could arise in such circumstances could exceed the capacity of the resources available to the SNB to supply. The net foreign asset position resulting from Switzerland's history of current account surpluses does not guarantee adequate access to foreign currency in the event of a liquidity crisis. Moreover, while assessments about public finances, which have been prudently managed, can spillover to exchange rate developments, such assessments may, in future, themselves be influenced by the perceived risk of any needed government interventions to rescue banks, as Figure 3.3 illustrates. Should such perceived risks rise in the future, risk premia in domestic interest rates could thus emerge, transmitting a crisis in one of the large, internationally active intermediaries to the domestic economy, and possibly to the exchange rate.

The "too-big-to-fail" status of the largest institutions means that moral hazard is large and inevitable and cannot, even with the best of governance structures, be expected to be fully internalized by the institutions themselves. The challenge facing the Swiss authorities is all the greater in view of the complex cross-border structure of the largest institutions, which as experience during the crisis has underscored, may be beyond the capacity of individual country regulators alone to oversee.

The systemic risks posed by other Swiss financial institutions are less than those of the Big-2 but not negligible. Failure of one of the major insurers might not undermine the stability of the overall financial system but it may cause strains in domestic financial markets and could require substantial government financial support to ensure that the company's liabilities could be paid. A more general deterioration in the financial soundness of the domestic banks, insurance companies, or pension funds would almost certainly require substantial government assistance and, at least in the case of the banks, could adversely affect credit availability to the overall economy.

Given the systemic risks of the largest Swiss institutions capital-asset ratios (CAR) and other prudential standards for the Big-2 should be at least as stringent as those maintained by their soundest international peers and thus above minimum or average industry standards.

Capital requirements need to be more stringent and responsive to the risk cycle ...

The Basel capital adequacy rules are currently under review with consideration being given to changes in the minimum ratios along with revisions to the definition of capital and risk weights on certain assets (BCBS, 2009). Individual country regulations will need to adapt over time to the changes agreed upon by the Basel Committee on Banking Supervision (BCBS), although some country regulatory authorities, notably the Swiss Financial Market Supervisory Authority (FINMA) and the United Kingdom Financial Services Authority (FSA), have already announced some steps.

An international consensus has emerged on at least two points. First, the minimum capital ratios need to be substantially higher than the levels (8% and 4% respectively for total and tier 1 capital) presently specified under the Basel accords (FSA, 2009a; de Larosiere, 2009; Geneva, 2008; see also Hildebrand, 2009). There is less agreement at this point as to how much the ratios should be increased, in part because this will depend on the changes that are made in the definition of capital and asset risk weights. The ratios maintained by the largest international banks before the crisis, including those which have suffered most severely, suggests that their minimum CAR should be at least 50% greater than the current Basel standard. The United Kingdom Financial Services Authority (FSA) has recommended that the Tier 1 ratio be increased by as much as two-fold and that this ratio, rather than the total CAR, be given primary emphasis for systemically important banks (15) (FSA, 2009a; see also Brunnermeister et al., 2008).

There is also general agreement that capital requirements should be specified so that capital cushions rise during market expansions (when risks have tended to be underestimated) and are allowed to fall back during contractions (DeLarosierre, 2009; FSA 2009a; Group of 30, 2009). Pro-cyclical capital requirements would help to ameliorate the tendency of fixed CAR requirements to magnify balance sheet expansion during market upswings, when declining risk indicators free up capital for further investment, while adding to contractionary pressures during market downturns when increased risk induces banks to shed assets to maintain CAR (Brunnermeister et al., 2008; FSA, 2009a).

The revised capital requirements announced by FINMA officials in June 2009 represent an important step toward achieving prudential norms that better reflect systemic as well as individual risks. Under FINMA's implementation of the BIS standard, starting no earlier than 2013, the Big-2 will be required to maintain minimum overall CAR of at least 50% above the Swiss implementation of the current BIS minimum (that is, at least 12%) at all times. This ratio must be increased to two times the BIS minimum (no less than 16%) in "good-times", defined as two successive years in which a bank's profits are at least equal to the "industry standard". As with the prior rules, Tier 1 capital must make up the bulk of overall capital and its dominance will be further increased by the revised FINMA definition of permissible capital, which excludes subordinated debt, scheduled to take effect sometime after 2013 (FINMA, 2009b).

Several considerations suggest that implementation of the new standards could be accelerated and that higher minima may ultimately be needed. The Big-2 now have overall capital ratios above the lower minimum on the basis of the Basel II definitions. The new minimum is roughly at the median of the capital ratios of the largest 2B international banks in the OECD area in terms of assets at the end of 2008 and slightly below the average (12.7). (16) It is also noticeably below the CAR ratios of the Swiss domestic banking segments. Imposing a lower CAR than will be needed in the longer-term while the Big-2 are still vulnerable to further losses is reasonable.

As argued earlier, the appropriate minimum CAR for the Big-2 should ultimately place it toward the top of those maintained by its industry peers. The ratios maintained before the crisis suggest that this is likely to turn out to be closer to the two times the current Basel minimum now mandated for "good times". Once the Big-2 have reliably recovered, the higher ratio should be maintained as the primary standard. The minimum may need to be raised further if the tightening of prudential standards in other countries leads to a further rise in CAR of other major international banks. The adequacy of the current capital requirements for domestically oriented banks also should be reassessed once the revised stress tests that are being developed are implemented (see next section).

The new requirements establish a rudimentary mechanism for varying the capital standard but this could be improved. As indicated earlier, the rationale for pro-cyclical CAR rules is to establish capital cushions that vary with the cycle in markets. The profit criterion specified in the new rules is not a very good measure of this cycle and could have perverse effects. If applied literally, for example, it could lead to relaxation of capital requirements if a bank underperformed the industry due to its own weaknesses. A preferable approach would be to specify a range of variation for the CAR over the cycle. The minimum CAR would be at the top of the range during market upswings and allowed to fall toward the lower end of the range during contractions. Conditions specifying the position of the CAR within the range would be determined by an objective rule incorporating indicators of the market cycle (for example average credit expansion by international banks relative to trend). The rule might also incorporate further indicators of systemic risks to the Swiss financial system (for example, the size of a bank's assets relative to Swiss GDP). Consideration should also be given to raising the present lower bound if this approach is taken, since 150% of the BIS minimum may not be adequate for the Big-2 even in market downturns.

The alternative option would be to require banks to build up a separate buffer of capital-eligible assets during market upswings that could be drawn down in downswings. The minimum CAR would then remain constant at the desired average over the cycle. The "dynamic provisioning" system that has been used in Spain is one example of how such a buffer could be implemented. As with the first option, rules need to be developed to determine the average size of the buffer and its variations. Given the importance market observers often attach to the CAR, this second approach may be marginally preferable to the first since it would limit the risk that fluctuations in the published CAR will be misinterpreted by markets. (17)

... and backed up by a leverage ratio

The problems of sustaining highly leveraged balance sheets that occurred during the crisis strongly suggests that CAR, however refined their calculation, do not provide sufficient protection against risks, especially those arising in extreme circumstances. A minimum leverage ratio--defined as the ratio of capital to the (risk-unadjusted) value of total assets--can be viewed as a "backstop" when, as is virtually inevitable, the risk measures underlying CAR calculations are imperfect (FSA, 2009a; Brunnermeister, 2008). It also limits banks incentives to exploit their superior knowledge of their operations by under-reporting their risks to supervisors and the markets (Blum, 2008). Leverage ratios were widely used prior to the 1980s but were largely displaced by the Basel capital standards because they took inadequate account of differences in risks across asset types and of off-balance sheet exposures. However the experience in the United States and Canada, which have maintained leverage limits, suggests that they can be useful supplements to CAR (Box 3.3).
Box 3.3. Leverage limits in the United States and Canada

Although leverage ratios were replaced in most OECD countries by
the Basel CARs, they have been retained in the United States and
Canada. Commercial banks in the United States are required by the
Federal Deposit Insurance Commission to maintain a ratio of Tier 1
capital to assets of at least 5% to qualify as well-capitalised'
and thereby free of restrictions on the terms they can offer on
their deposits. The ratio is applied at the consolidated group
(bank holding company) level. Investment banks, which are regulated
by the United States Securities and Exchange Commission, are exempt
from the ratio. Canadian banks are required to maintain a ratio of
total capital to assets (including off-balance sheet) of 5%,
although exceptions are allowed in special cases (World Bank,

The largest United States commercial banks maintained substantially
higher leverage (capital to assets) ratios in the run up to the
present crisis than banks in Europe. However the capital to assets
ratios of investment banks such as Lehman Brothers and Goldman
Sachs fell to levels more comparable to those of European banks.

The case for a prudential leverage ratio in Switzerland is especially strong given the exceptionally high ratios the Big-2 maintained before the crisis The SNB has recommended that the ratio of capital to assets for the largest banks should be no less than 5% in "good" times (SNB, 2009a). Under the package of measures announced by FINMA on 16 October 2008, the Big-2 banks will be subject to a minimum ratio of total capital to assets (including derivatives) of 3% at the group consolidated level and 4% for individual units, effective no earlier than 2013. Domestic lending and certain other domestic claims are excluded from the assets used to calculate the ratio. (18)

The new rule should prevent the extreme leverage attained prior to the crisis, particularly as the Swiss authorities expect the Big-2 in practice to maintain leverage ratios significantly above the minimum in good times (SNB, 2009a). Nevertheless, several considerations argue for imposing a somewhat higher floor. First, the specified group-level minimum is only modestly above the level the Big-2 maintained before the crisis and is below the ratio maintained by a significant number of international banks including the two large Swiss banks. Moreover, the Big-2 now have leverage ratios above the minimum proposed. They should be able to meet higher standards in the future.

Equally important, the exclusion of domestic lending from the ratio is inconsistent with its underlying rationale, as FINMA authorities have acknowledged (FINMA, 2009b). Excluding domestic lending could also create confusion in comparing the proposed ratio with the more conventional measures likely to be adopted by other countries. The exclusion also seems unnecessary: domestic lending accounts for a modest portion of total assets (slightly less than 20% for CSG and 10% for UBS). Accordingly, their inclusion would not greatly lower the stated leverage ratios. (19) Together these considerations recommend setting a higher group ratio, of at least 4%, and including domestic lending in the assets used for the calculation. Consideration should also be given to imposing the leverage ratios somewhat earlier than now scheduled, or at least to phasing them in. On the other hand, a prudent aspect of the newly introduced rules is that all assets acquired through investment banking are to be fully included in the leverage ratio.

Improvement in liquidity management and oversight is equally critical

Inadequate liquidity management was a key factor in magnifying the systemic risks that emerged during the crisis. The widely traded short-term instruments that seemed to provide an ample liquidity buffer turned out to be of at best limited protection when the markets for these instruments became paralysed by uncertainty over the financial soundness of the major participants and their counterparties. The elaborate models and other methods used by the financial institutions and their regulators severely overestimated the adequacy of the liquidity provisions, in large part because they were based on disturbances to individual institutions and failed to take adequate account of a generalised deterioration in market liquidity (Baily et al., 2008; Brunnermeister et al., 2009).

It is now acknowledged that liquidity oversight and management need to be given higher priority and that the tools used by financial institutions and supervisory authorities to assess the adequacy of liquidity buffers need to be substantially revised and strengthened (De Larosiere, 2009; Group of 30, 2009; FSA, 2009a). Principles and options for stronger liquidity guidelines have recently been advanced by a number of financial regulatory bodies and associations (BCBS, 2008; CEBS, 2008; IIF, 2007). The BCBS is currently developing revised prudential guidelines for liquidity, based on the principles enunciated in the Committee's 2008 paper on the subject (BCBS, 2008). The reports agree on the need to improve banks' internal accountability and systems for assessing and managing liquidity risks. They also call for financial supervisors to strengthen their oversight of these systems and to take a more active role in independently assessing liquidity risks, both to the overall financial system and to the soundness of individual institutions.

The reports stress several principles for better liquidity regulation for the largest financial institutions (CEBS, 2009; BCBS, 2008):

* The adequacy of liquidity buffers needs to be calibrated to the results of realistic "stress tests" approved by supervisors and carried out with the banks. The scenarios for the tests should include an "idiosyncratic" interruption in external funding for the individual institution only, a generalised severe impairment in access to funding from several key markets, and combination of the two. The tests need to incorporate all the main risks to liquidity, including risks from off-balance sheet instruments and cross-currency exposures.

* Liquidity buffers should consist of cash and other assets that can be expected to remain highly liquid even in periods of heightened market stress and which are eligible as collateral at central bank lending facilities (ECBS, 2009).

* Individual banks need to develop detailed contingency funding plans for emergencies.

* National supervisory authorities need to strengthen co-operative cross-border arrangements for dealing with severe liquidity stress.

The Swiss authorities have intended for some time to strengthen liquidity oversight but implementation was delayed due to demands posed by adherence to Basel II and by the financial crisis (IMF, 2007a). The authorities have worked effectively with the Big-2 in coping with their liquidity strains and through their interventions in the financial markets over the past two years. However the crisis, and the possibility of renewed market turmoil, have underscored the need to improve the framework for liquidity regulation and oversight as soon as possible. Containing the liquidity risks posed by foreign currency denominated instruments is particularly urgent.

The revised framework for the Big-2 introduced by FINMA and the SNB earlier in 2009, which will become operational in 2010, is an important step toward these goals. The new framework incorporates the basic principles enunciated by the BCBS in 2008. Liquidity needs of each of the Big-2 will be evaluated under scenarios specified by the authorities that incorporate both market wide and bank specific disturbances. Each bank is required to evaluate the impact of the scenarios on its liquidity flows, based on "conservative" assumptions (agreed upon with the supervisory authorities) about its internal control systems and must demonstrate its ability to generate sufficient liquidity for at least one month during a time of market distress. The new framework particularly improves on its predecessor in considering liquidity needs arising from off-balance sheet as well as balance sheet exposures and by focusing on "severe" rather than milder disturbances (SNB, 2009). The authorities also plan to reform liquidity management for the domestic banks at some future point. The framework for the domestic banks and other smaller financial institutions need not be nearly as elaborate as that applied to the Big-2 or largest insurance companies. For example, smaller institutions might simply be required to maintain a "standardised" liquidity buffer of suitable assets rather than one based on internal modelling, as has been suggested for the United Kingdom (FSA, 2009a).

The systemic importance of the largest Swiss financial institutions and the large size of their foreign currency assets and liabilities suggest that further options beyond those that emerge as international norms may need to be considered. For example, there have been suggestions that systemically important banks be subject to a minimum ratio of those liabilities likely to be most sustainable over the economic cycle to their assets (FSA, 2009a). The qualified liabilities would include the most stable components of their deposits and marketable obligations, but would exclude money market funds and most wholesale funding sources. Such a "core liquidity ratio", which is analogous to the deposit to loan ratios that were more widely used by regulators in the past, would "backstop" the liquidity buffers determined by liquidity stress tests. It would further restrain the tendency toward excessive leverage during market upswings. There is some evidence that Canadian banks' comparatively high reliance on depository funding may have contributed to their comparative resilience during the crisis (Ratnovski and Huang, 2009).

Even if an overall core liquidity ratio is not deemed appropriate for the Big-2, consideration should be given to imposing analogous limits on each of the major foreign currency components of their portfolios. This would provide a form of "self-insurance" against a sudden deterioration in access to foreign exchange markets, particularly if the resulting need for foreign currency were to prove greater than anticipated by the liquidity stress tests. Such a limit also would help to limit the amount of emergency foreign currency demands on the SNB in the event of a crisis.

Steps also need to be taken to improve financial institution governance and incentives for risk-taking

In addition to strengthening prudential norms, financial supervisors need to ensure that the weaknesses revealed by the crisis in financial institutions capacity and incentives to control risks are remedied. As a number of recent reports have stressed (De Larosiere, 2008, FSA 2009a; Geneva, 2008; SNB 2008b) internal risk controls and reporting need to be strengthened by raising the accountability of senior officers and boards of directors, strengthening the independence of the risk management function within the bank, and by reducing reliance on external risk assessments by credit agencies. Equally important is the revision of performance-based compensation schemes that have encouraged excessive risk-taking. These need to be more firmly based on long-term firm performance, calibrated to the risks involved, and more transparent to shareholders (De Larosiere, 2009; FINMA 2009).

Some promising steps have been taken by the Big-2 banks, with the encouragement of FINMA, to strengthen risk control. The largest bank has buttressed its high-level risk oversight capability by creating an Executive Committee to monitor capital utilisation and risk in each major business line and a dedicated risk committee of the Board of Directors (UBS, 2008b). Risk control monitoring functions have been merged into a single unit responsible for monitoring all major risks across the group's divisions.

FINMA is among the first national financial authorities to take concrete steps toward developing prudential rules for compensation that better encourage prudent risk-taking which apply both to banks and insurance companies. A draft circular was published in June 2009 which is due to come into effect in January 2010. The circular requires that performance based compensation systems be sustainable based on a firm's longer-term performance and take account of the risks incurred (FINMA, 2009). Financial institutions are strongly encouraged to implement deferred compensation arrangements that are subject to downside as well as upside variations depending on the firm's performance. In the circular it is noted that certain tax and labour law issues may result; some of these may require further consideration or clarification by the Swiss legislator or courts. (20) The circular specifies the responsibility of the board of directors for ensuring that compensation principles are implemented and requires it to publish a separate report on compensation so that shareholders are adequately informed. In addition, the circular requires involvement of internal control bodies in procedures in respect of the design and operation of the compensation system. UBS is required to adhere to elements of the guidelines beginning in 2009. For all other major financial institutions covered by the circular the disclosure requirements apply as of the reporting year 2010. Compliance with all elements of the circular is expected of covered financial institutions as of January 2011. The extent to which the principles can be further developed will depend on how far other countries go in reforming their compensation schemes. FINMA has indicated that it is willing to consider strengthening its compensation principles if they were to fall below any agreed international standards. FINMA has indicated that it may loosen its principles if the major financial centers do not implement the principles for sound compensation practices developed by the Financial Stability Board.

Strengthening the supervisory framework and institutions

The Swiss regulatory framework has been considerably strengthened and modernised during this decade and its standards and practices were well aligned with international norms before the crisis (Box 3.4). However, the international financial crisis has revealed serious weaknesses in the capacity of financial supervisors in general to contain systemic risks that need to be addressed throughout the OEGD. These include inadequate monitoring and assessment of risks to the financial system as a whole; excessive reliance by regulators on the judgements of financial institutions and markets even when warning signs of problems arose; and limited ability to oversee the cross-border activities of large complex institutions.

While Switzerland has done much in recent years to strengthen its regulatory system, the recent crisis suggests some basic principles for strengthening future financial supervision in Switzerland:

* Macro-prudential regulation needs to be given greater emphasis, based on strengthened monitoring and assessment of risks to the overall financial system and economy. Financial supervisory authorities and the authorities responsible for macroeconomic stability will need to co-operate to contain systemic risks, as they have in the past, but the arrangements may need to be further elaborated.

* Financial supervisors need to take a more pro-active approach to oversight, particularly of the largest systemically important institutions. This includes more independent analysis by regulators and greater scrutiny of the accuracy of financial institutions' internal models and controls. Resort to more direct controls on the size or activities of very large institutions may be necessary in cases where their systemic risks cannot otherwise be adequately controlled.

FINMA provides a solid foundation for strengthened regulation

Creation of the Swiss Financial Market Supervisory Authority represents a major step forward toward integrated and more consistent regulation and supervision. Care has been taken to ensure that FINMA has the independence, powers, and capacities to carry out its responsibilities. FINMA is not dependent on appropriations from the Federal Government since it is financed by fees on the institutions subject to its jurisdiction. (21) The Authority enjoys some flexibility in deviating from federal government scales in recruiting and setting staff salaries although it is not completely autonomous in this area.

Overall, FINMA has legal and institutional independence at least equal to that of its predecessor agencies. Its formal independence is comparable to that of the United States Federal Reserve if somewhat less explicit in legal terms. Financial regulatory agencies are particularly vulnerable to undue influence ("capture") from those they regulate in part because of the large differential between their staff salaries and those of the financial institutions (OECD, 2009b). Resistance from regulated institutions and their industry associations can make it difficult to impose regulations that are sufficiently stringent to meet macro-prudential requirements. Financial regulators limited resources can also lead them to become overly reliant on the judgements of the institutions they oversee.
Box 3.4. Recent reforms to the Swiss regulatory framework

Major changes in the Swiss financial regulation over the past five
years have resulted in a more coherent, streamlined, and effective
financial supervisory apparatus. While the earlier basic laws
governing the major segments of the financial system remain in
force, there have been some important changes in specific areas.

The key change was the creation of the Swiss Financial Market
Supervisory Authority (FINMA), which began in January 2009. FINMA
provides an integrated structure to regulate and supervise the
financial markets and major financial institution segments similar
to the Financial Services Authority of the United Kingdom. It
merges three prior regulatory bodies, the Swiss Federal Banking
Commission, the Federal Office of Private Insurance, and the
Anti-Money Laundering Control Authority. FINMA is also responsible
for regulating the stock exchanges, securities dealers, and other
financial intermediaries including hedge funds registered in
Switzerland. FINMA is structured as a public corporation financed
through fees on the institutions it oversees. The FINMA Board of
Directors, which is appointed by the Swiss Federal government, is
responsible for setting the strategic goals of the Authority and
approving major decisions. The Board appoints the Authority's
director, subject to approval by the government. Although legally
accountable to it and required to report regularly on its
activities to the Swiss legislature, FINMA's independence is
guaranteed by the legislation.

Consistent with traditional Swiss regulatory practice, FINMA relies
on external auditors, to a larger extent on the banking side, to
conduct on-site inspections of most banks and other institutions
under its jurisdiction. The auditors provide reports on their
findings that are reviewed by FINMA staff. However a special regime
has been introduced for closer oversight of the Big-2, with FINMA
staff more directly involved in on-site inspections and entailing
regular meetings between FINMA officials and senior management of
the Big-2.

Insurance regulation has undergone major changes, first with the
adoption in 2004 of comprehensive legislation to revise and update
the framework. This replaced the prior regulatory approach based on
product supervision with one based on risk-based supervision and
solvency requirements. The framework was further strengthened in
2006 with the institution of the Insurance Supervisory Law (ISL) to
provide, among other things, for better protection of the insured
and against insolvency. The ISL extends insurance regulation to
groups and conglomerates, expands its scope to corporate
governance, risk management, internal controls, and market conduct
of insurers, and broadens the insurance regulator's enforcement
powers. Standards for corporate governance, risk management, and
internal controls are specified and monitored under the Swiss
Quality Assessment and related efforts. The ISL also mandates the
Swiss Solvency Test (SST), a risk based procedure for assessing the
resources needed by an insurance company to meet its commitments in
adverse circumstances, which is recognized internationally as an
industry standard (IMF, 2007c). A revised version of the test
incorporating market risks became mandatory for the largest
insurance companies at the beginning of 2006 and for smaller
companies in 2008.

FINMA's broader financial responsibilities may help to reduce its vulnerability to undue influence from particular financial segments. Basing prudential standards to the extent practical on pre-announced and publically known rules rather than discretion would further help. Personnel and other policies to ensure strong internal accountability and encourage recruitment and retention of skilled staff are essential to sustain FINMA's independence and objectivity. FINMA's independence also depends on effective oversight to ensure the objectivity of the external auditors used for examinations. This could be further strengthened by expanding the pool of qualified auditors, if and when feasible, and periodically rotating their assignments among the financial institutions. Establishing joint responsibility with the SNB for prudential norms of the greatest systemic importance, as discussed below, could make it easier to overcome resistance from regulated institutions.

FINMA has the legal and regulatory powers, instruments, and enforcement tools of the agencies whose functions it has assumed. It has sole responsibility for issuing regulations and other decrees governing licensing of institutions, prudential regulations, and qualifications of senior officials, and shares responsibility with the major exchanges for rules governing issuance and trading. It can intervene to force corrective actions in financial institutions that fail to meet basic regulatory standards and to close failing institutions. Its powers in this area have been further strengthened by the recent amendment to Swiss law governing bankruptcies of banks and securities firms. Overall FINMA's powers appear comparable to those of financial authorities in other OECD countries and consistent with international best practices in most respects (IMF, 2007a). The agency's enforcement capabilities would be further improved if it were given the authority to impose administrative fines for serious violations of its rules. (22)

The establishment of FINMA has not formally altered the "dual character" of Swiss regulation in its comparative reliance on external auditors for examinations (to a larger extent on the banking side) and the participation of industry self-regulatory authorities in certain areas. FINMA is responsible for mandating qualifications and other rules governing the self-regulatory bodies and has recently issued a circular detailing such rules. As with the SFBC, FINMA applies a special oversight regime to the Big-2, involving much closer and direct oversight than for other financial institutions subject to its jurisdiction. Staff from the FINMA division responsible for the Big-2 participate in on-site examinations (including offices in other countries), meet regularly with senior officials of each bank, and review a wide range of information from all the major control and business areas. Events have demonstrated the importance of this close oversight, not only to manage crises but to contain risks outside of a crisis. A comparable oversight regime needs to be maintained for the largest insurance companies, while taking into account the differences between banking and insurance and the specific risks of each.

The demands on FINMA have increased considerably as a result of the crisis. The ongoing efforts to monitor and contain risks in the near-term while upgrading and extending regulatory capabilities will continue to pose heavy, and possibly even greater, demands. It is essential that the financial supervisor have sufficient resources to effectively carry out its responsibilities and that these resources be increased as needed. FINMA's current staff and resources do not appear to be overly generous compared to those of regulators in other countries, given the scale of its financial system. The Authority plans to increase its staff, now about 320, to 355 (13%) as suitable qualified recruits become available. However, given the possibility that the demands on the authority will increase by even more, staff and other resource needs will need to be reviewed regularly. The Authority may need further flexibility in setting its compensation policies in order to be able to attract and retain the highly qualified staff needed for its effective functioning.

Macro-prudential oversight needs to be broadened

The vulnerability of the Swiss economy to distress of its major financial institutions makes macro-prudential regulation and oversight especially important. The basic goal of such regulation is to "... limit the distress of the financial system as a whole in order to protect the overall economy from significant losses in real output..." (De Larosiere, 2009). The key elements of macro-prudential regulation are (OECD, 2009b): establishment of effective means for information exchange and co-operation between financial regulators and the authorities responsible for macro stability, most importantly the central bank; institution of early-warning mechanisms to signal the need for crisis prevention and preparation; and means to translate changes in macro-prudential risk into changes in prudential norms such as capital and liquidity requirements.

A basic framework for macro-prudential oversight has been established that makes the SNB and FINMA jointly responsible for its execution. The current division of responsibility is specified in a 2007 memorandum of understanding (MOU) between the SNB and the Swiss Federal Banking Commission, and which now applies to FINMA (SFBC, 2007). Under its terms, the SNB is responsible for monitoring developments in the banking system as a whole as they affect the overall economy and the conduct of monetary policy and for oversight of the interbank and securities clearing systems. FINMA is exclusively responsible for setting prudential standards.

The MOU specifically provides for the sharing of information on macro risks, risk exposures of the banks as a whole and their major segments, and their capital adequacy. It also provides for periodic joint discussion at a senior level of financial risks to the economy and actions to deal with them. (23) Such discussions take place regularly and were intensified during the recent financial crisis. Further initiatives for better co-operation are under consideration. Pursuant to its responsibilities, the SNB publishes an annual report on financial stability summarising major financial developments and their macroeconomic context and providing an assessment of the main risks.

The current framework has been a valuable resource for collaboration and effective action during the present crisis. Recent prudential actions taken by FINMA, including the new CAR and leverage requirements, were developed in close consultation with the SNB, whose public endorsement probably helped to bolster their credibility. Still, the framework needs to be elaborated in three areas.

First, the framework should be explicitly broadened to include all the major financial segments, including insurance companies and pension funds. This change is consistent with FINMA's status as an integrated regulator of the main financial segments and would facilitate sharing of a broader set of information concerning their conditions than is provided for in the existing framework. The framework needs to include monitoring of exposures among the major segments of the financial system, including the pension funds. FINMA has intensified its oversight of the exposures of domestic insurance companies to the Swiss banks. Direct insurance companies are subject to a limit with respect to counterparty risk exposure to individual banks of 5% but aggregate risk exposure of direct and reinsurance businesses concerning the Big-2--including exposures through insurance claims, such as against their default--are not currently being specifically monitored in this manner. Consideration should be given to measuring the aggregate exposure of individual insurers, including both direct insurers and reinsurers, to one or more of the banks, particularly to the Big-2, and ensuring that insurance companies have appropriate limits. Such limits could help prevent that any potential risks emanating from the two large banks spread to the insurance sector.

Second, a more formal decision mechanism to link assessments of macro-financial risks to macro-prudential instruments should be established. Prudential standards with important systemic implications, such as the CAR for the Big-2 and rules for determining cyclical variations in capital requirements, need to be based both on the circumstances of Swiss financial institutions and the macro risks they pose. Consideration should be given to extending the informal consultation arrangements between the SNB and FINMA. In conformity with its legal mandate to contribute to financial sector stability, the SNB should lead, together with FINMA, which should remain the enacting body, the elaboration of macro-prudential standards and make its views public.

Third, system-wide stress tests of the ability of financial institutions to withstand both financial and macro-economic shocks are a critical tool in macro-prudential oversight but the experience of the past two years shows that they need to be improved. The SNB has developed a sophisticated framework for "top-down" stress tests for the banking sector as a whole that evaluate the effects on banks' financial performance of various external and internal financial and macroeconomic disturbances. The disturbances are chosen based on historical experience and current economic conditions (see SNB, 2008a). These tests have proved useful in identifying potential vulnerabilities of the banking system and its major components. However, as in other countries, the tests greatly overstated the resilience of the financial system in the run up to the crisis. This is partly because they did not anticipate the precipitous declines in credit quality and interruption in market liquidity that were critical in the crisis. In retrospect, however, the "adverse" scenarios examined turned out to be overly mild. (24) Insufficient attention was given to more severe scenarios that, while very unlikely, would cause great damage if they were to occur.

The Swiss authorities acknowledge the need to improve the stress testing framework and FINMA plans to develop "building-block" tests at the institutional level to supplement the SNB's top-down tests. The framework also needs to be broadened to explicitly incorporate other major components of the financial system, including insurance companies and pension funds. To the extent possible, the top-down tests need to be more forward-looking and include the types of disturbances underlying the international financial crisis, including a severe decline in liquidity in key markets. The impact of a sudden deterioration in financial soundness of one or more of the major financial institutions should probably be included among the tests.

Several issues concerning smaller financial institutions should be addressed

In addition to the measures being taken for the largest institutions, several steps to strengthen the current regulatory framework for other segments would further help to contain financial risks.

The recent change in the deposit insurance system is an important step toward closing the gap between Switzerland's guarantees and those of other countries that has heightened the vulnerability, particularly of domestic banks, to deposit flight. The maximum amount guaranteed under the new arrangement, CHF 100 000 (about USD 92 000), is closer to the norm in other European countries than the previous ceiling. However a large gap remains with several important countries that have also recently increased their maxima, notably the United States (where the limit is now USD 250 000) and Germany (where there is no maximum) (Schich, 2008). The guarantee applies to deposits held at all banks domiciled in Switzerland, including deposits in foreign currency or owed to foreigners, with the total amount guaranteed amounting to 60% of 2008 GDP. Domestic banks other than those owned by the cantons (which have provided their own guarantees) are likely to benefit most from the new arrangement. The Big-2 probably benefit less since their "too-big-to-fail" status already provides some assurance to their depositors.

The guarantee system remains unfunded, although it has been somewhat strengthened by a requirement that banks hold liquid assets, which must be issued by Swiss creditors, amounting to at least 125% of the amount insured. As the authorities have acknowledged (DFF, 2009), this ex post funding has significant disadvantages. It could result in delays in repaying deposits and impose costs on the government in the event of generalised banking distress since the banks may not be able to provide the funds required (Schich, 2008; OECD, 2009b). In September 2009, the Swiss authorities issued a draft of a new proposed law on deposit insurance to institute partial ex ante funding. The proposed law contains a two-stage guarantee system. The first stage consists of a deposit insurance guarantee fund with an eventual capital of CHF 9.75 billion, amounting to about 3% of the deposits guaranteed. Two thirds of the funding is to be provided by the banks through annual contributions levied over a period of several years until the amount is reached. The banks will cover the remaining funding by pledging securities. In case the fund was not sufficient to repay the amount insured, a second stage would cover the difference. Currently, there are two propositions for this second stage: An advance or guarantee by the federal government, which both would have to be compensated by yearly payments of additional insurance premia by individual banks. The law provides for the contributions and the premia paid by banks to be based on indicators of their risk, including capital adequacy and leverage. The law, if adopted, will significantly strengthen the effectiveness of the Swiss deposit insurance system and bring it more closely into line with international best practices. However further arrangements may need to be made with financial supervisors in countries hosting branches of Swiss domiciled banks, since the deposits with these branches are not guaranteed by the Swiss system.

Domestic banks were under significant profit pressures earlier in this decade, although their situation had improved significantly by the eve of the crisis as a result of consolidations and other measures. The banks may face increased competition in coming years as the largest banks reorient their business toward their more traditional core competencies. Evidence suggests that domestic banks as a group compare reasonably favourably with counterparts in other European countries, but that some segments operate at less than fully optimal cost-efficiency (IMF, 2007b). Creation of a more level playing field among the banks by abolishing or at least reducing current regulatory and other preferences would help to facilitate necessary adjustments to sustain their competitiveness.

Authorities have taken an important step in this direction by abolishing, effective in 2011, the preferential lower reserve requirement for cantonal banks compared to the other commercial banks. However the continued guarantee on their liabilities by the cantonal governments along with their mandates to lend to local customers tends to blunt their incentives and their ability to operate as effective commercial institutions. The combination can also encourage excessive risk taking. Consideration should be given to abolishing the guarantee, particularly as the reformed deposit insurance system renders it largely redundant. The special mandates should also be abolished or, if maintained, financed from government revenues rather than bank resources. Further diversification of the ownership of the cantonal banks (most of which are entirely owned by their canton) could also help to strengthen their commercial orientation and facilitate consolidation in cases where it would be beneficial.

The previous OECD Economic Survey of Switzerland in 2007 recommended keeping the setting of key parameters defining the level of pension payments away from the political process (see Table 1.A1), which may facilitate the adjustment of benefit entitlements to demographic and financial market developments. The case for such reform is now even greater than in 2007.

Further steps to contain the risks from the largest institutions may need to be considered

More stringent prudential controls and strengthened supervisory oversight will reduce the likelihood of a catastrophic failure of one or more of the largest Swiss financial institutions. Steps discussed in the next section to improve cross-border co-operation and sharing of responsibility for supervision of large cross-border financial institutions (LCBFIs) and crisis management will also help, in part by reducing the damage if a failure occurs. However the steps may not be adequate to reduce the risk sufficiently for Switzerland given the exceptionally severe damage the largest financial institutions could cause to the economy in a worst case scenario. If so, further steps may need to be taken. Several possible approaches have been suggested (see Hildebrand, 2009). Each would pose significant legal and other challenges to implement and in some cases could affect the competitiveness of the LCBFIs and impose costs on the Swiss economy.

One approach would be for the financial authorities to impose limits on the scope or size of those institutions posing the greatest systemic risks (Hildebrand, 2009). One possibility would be to impose a direct limit on the aggregate size of the group, for example through a ceiling on total assets in relation to Swiss GDP. An important potential drawback is that the risks incurred by LCBFIs are determined not only by their aggregate size but also by the nature of their activities and their connections with financial markets and other financial institutions. For these reasons, it would be difficult to determine an appropriate size limit.

Another approach would be to directly restrict the business scope of a systemically critical institution. For example, divestment of the investment banking divisions of the Big-2 banks into legally separate businesses with no claim on the original institution would greatly reduce systemic risk. This would change the Big-2's character as universal banks, although it would retain the wealth, asset management and much of the business financial service activities that used to be their main focus.

Another possibility would be to shift some of the more risky group activities to subsidiaries that were structured so that they had no legal claim on the Swiss parent or the group's most systemically important components. It has been suggested, for example, that large financial institutions adopt a non-operational holding company structure similar to that developed in the United States and which has also been adopted by a number of other OECD countries (OECD, 2009b). This structure provides for commercial banking to be conducted in a subsidiary that is legally separate from subsidiaries involved in investment banking and other more risky activities. In theory, such a structure can insulate the most systemically important components of the group from losses in its other subsidiaries to a degree that is not as possible for a universal bank. However it is not clear that such separation of financial businesses would be feasible or appropriate for Swiss or other European financial systems that have long been based on universal banking (FSA, 2009) or that such a structure would be permissible under existing Swiss law. Moreover, experience during the crisis has shown that legal separation of businesses may not be sufficient protection against contagion in a crisis, since reputational considerations can spread problems among components of a group even when there is no legal responsibility.

Less drastic measures include placing a limit on the size of the trading book relative to total assets; or limiting (or prohibiting) trading or holding of certain classes of instruments whose risks were deemed to be especially high and difficult to assess. This approach could achieve a more certain and precise means of limiting the systemic risk of institution than aggregate size limits. However, effective limits are more difficult to design given the complex interrelations among activities of a large financial institution.

Aggregate size limits or restrictions on business scope of the Big-2 could impose costs on the Swiss economy. The restrictions could directly lower the profitability and growth potential of the banks and might lead to a transfer of some business now conducted in Switzerland to subsidiaries in other countries. This would directly lower employment and value-added in the Swiss financial services sector. A reduction in the market prominence of the Big-2 might also reduce the attractiveness of the overall Swiss financial system to foreign investors.

The overall size of these costs is difficult to estimate. For example, evidence is mixed on the extent to which very large financial conglomerates actually benefit from scale economies or synergies among their activities (See Berger et al., 1999). There also could be positive effects. Reduced systemic risk from the Big-2 should reduce risk premia in international markets for Swiss obligations. In any case, the overall costs of such restrictions would need to be weighed against the much greater damage that would be incurred in the unlikely but not impossible event of failure of one or more of the largest financial institutions as well as the costs of perceptions of the risk of such an event.

Strengthening cross-border arrangements for crisis prevention and management

The Swiss authorities' effective co-operation with foreign central banks and financial supervisors over the past several years both underscores the importance of such arrangements and the need to strengthen and extend them further. This means developing cross-border frameworks in respect of the supervision of LCBFIs and to facilitate resolution in the event of a failure is especially important for Switzerland.

Fiduciary standards are high

Rigour in protecting client interests has been a key factor sustaining Switzerland's prominent role as an international financial centre, particularly its dominant position in international wealth management. Switzerland's reputation stems from its maintenance of strict fiduciary standards. These include not only protection of the confidentiality of client information but at least as importantly stringent standards governing funds custody and management. Switzerland's laws and regulations on fiduciary responsibilities of financial institutions and their employees and civil and criminal sanctions for violations are among the most stringent in the OECD. Switzerland has laws against money laundering, bribery, insider trading, and most other illicit financial transactions. Financial institutions in Switzerland are required (under pain of potential criminal prosecution in the event of violation) to determine and maintain records of the source and beneficiaries of funds placed with them.

Stronger cross-border arrangements are essential to effective supervision of the largest institutions

The Swiss authorities have developed a range of cross-border arrangements to help in supervising the largest financial institutions and for crisis management. These include regular information exchanges and discussions with United States and United Kingdom regulatory authorities; the co-operative arrangements for insurance company supervision established with EU member states in 2006; and the currency swap lines with the United States Federal Reserve and similar facilities with the Bank of England and the European Central Bank. Such arrangements are both bilateral and multilateral, though mainly confined to several major countries. Also in place are more multilateral supervisory college arrangements in respect of the largest banks and insurance groups. In some cases ad-hoc arrangements are also used and these also have proved to be quite useful in managing the strains from the turmoil in international markets.

Nevertheless, the experience of the past two years has shown that stronger and broader multilateral arrangements need to be developed to strengthen crisis management capabilities, provide for expeditious and orderly wind-down of LCBFIs in the event of their failure, and to clarify the respective responsibility of each supervisor. Switzerland especially may need such arrangements to contain the systemic risks from its LCBFIs and may be able to benefit from co-operating in the arrangements now being developed by the EU authorities (OECD, 2008).

There is now broad consensus that it can be helpful to have explicit arrangements to clarify the respective responsibility of LCBFIs among home country and authorities in foreign countries where they have significant presences (De Larosiere, 2009; Turner, 2009; Group of 20, 2009). Switzerland has been using such "colleges of supervisors" as indicated above and similar ones have been in place for some time in the Nordic region and the concept has been under consideration by EU financial authorities for some time (Wajid et al., 2007; European Financial Services Roundtable, 2004; OECD 2008). At its meeting in March 2009, the G20 agreed that supervisory colleges should be developed for each of the 30 largest LCBFIs and set a target date for the completion of the establishment of those not already set up of mid-2009 (G20, 2009).

The purpose of each college is to ensure coherent consolidated supervision of the institution as a whole by co-ordinating oversight of its units. Under the arrangements now being developed for the EU, the home country supervisor of one of the designated LCBFI invites supervisors from other EU countries where the institution has subsidiaries or branches with systemic importance to participate. Participation is voluntary and based on consensus (OECD 2008). Responsibilities can be allocated among the participating supervisors in a number of ways so that the powers of the home country supervisor need not be altered. Effective colleges need to overcome difficult challenges arising from differences in standards and practices among countries and are no substitute for strong home country supervision. But they can be highly beneficial by improving information sharing and ensuring co-ordinated and mutually reinforcing regulation.

"Core" colleges with banking supervisors from the United States and the United Kingdom have been in existence for the Big-2 since 2000 and separate bilateral regional colleges with banking supervisors from major Asian economies (China, Japan, Singapore, and Hong Kong, China) have more recently been established. Colleges have also been instituted for the major Swiss insurance companies. The colleges have largely focused on information sharing although those for the Big-2 have begun to consider collective actions in certain areas. The colleges could be a valuable resource for improving the oversight of the major Swiss institutions and for crisis management in the event of future problems. However their effectiveness might be improved through a more collective approach involving the participation of representatives from other major European and major Asian countries in the core colleges for the Big-2. The focus of the colleges' efforts should also be broadened over time to include discussion of major regulatory issues and contingency planning for future problems.

Supervisory colleges could also provide a venue for crisis management in the event that systemic threats emerge. The Financial Stability Forum has outlined a set of key principles for preparing for and managing threats to the solvency of systemically important institutions (FSB, 2009). These include: regular information sharing among involved parties, including details on LCBFI group structure and intergroup dependencies and their important linkages to markets and other financial institutions; and development of contingency plans for funding the LCBFI in case of market turmoil, including especially plans to ensure adequate access to foreign currency. The responses of the authorities in the event of a crisis need to be explicitly considered. These include potential impediments such as restrictions on the ability of subsidiaries to lend or transfer funds to their home parents ("ring-fencing"). Participants in the arrangements need to include central bank representatives as well as the financial supervisors. This could be accomplished by inviting central bank representatives to participate in the colleges.

The difficulties encountered in winding up Lehman Brothers have demonstrated the need to develop an explicit cross-border framework for resolving insolvency of LCBFIs (De Larosiere, 2009; FSA, 2009) Home country bankruptcy regimes, such as the bank resolution framework in Switzerland, are adequate for purely domestic institutions. However, they are insufficient for LCBFIs, given that home country regimes cannot be applied to foreign subsidiaries. Ideally, a cross-border insolvency framework should provide mechanisms expediting the sale or liquidation of a failing institution's components, repayment of its depositors and other creditors, and sharing of risks and costs among national authorities. The framework also needs to include development of contingency arrangements by each systemically important financial institution for its unwinding in the event of failure ("living will")--a principle most recently endorsed by the September 2009 meeting of the Group of 20. At least in some cases, this may involve changes to the legal structure of the institution to facilitate the sale or winding down of its components. This in turn may require changes in tax laws (if the change in structure would unduly increase the group's tax liability) or other legal provisions.

A cross-border insolvency framework would complement stronger regulation and oversight of LCBFIs and would not in any way diminish the need for it. Establishing the framework is likely to be a lengthy process, involving multi-country negotiations over division of the responsibilities and burden sharing and also revisions to national regulations and, possibly, laws. But a framework is essential to contain contagion from a failing LCBFI and to reduce the costs imposed on the home country economy. The Swiss authorities have emphasised the critical importance of such arrangements to limiting the risks posed by their largest financial institutions (Hildebrand, 2009). To this end, the authorities should encourage the Big-2 and major insurance companies to begin the process of developing orderly ways to deal with potential financial stress and distress situations, including bankruptcy threats to any part of their group.
Box 3.5. Summary of main recommendations
for strengthening financial regulation

General principles

* Regulation should incorporate an explicitly macroeconomic
perspective, in which prudential standards for financial
institutions are based on their systemic risks to the economy as
well as their micro-prudential risks.

* Stronger cross-border arrangements with financial authorities in
other countries will be essential to ensuring effective regulation
of the largest Swiss financial institutions, given their extensive
and complex structures, and to prepare for a future crisis should
it occur.

Prudential standards

* Authorities should require the Big-2 banks to maintain a minimum
overall capital adequacy ratio (CAR) of at least 150% of the
current BIS minimum in the near-term. This should be raised to
twice the current BIS minimum once the banks' financial strength
has been restored, if possible before 2013. Further adjustments
should be made as necessary to ensure that Big-2 CAR remain among
the most stringent of major international banks.

* A rules based mechanism mandating cyclical capital buffers that
rise during market expansions and are permitted to be drawn down
during contractions should be established. The buffer should be
determined by objective and publicly disclosed rules based on
indicators of the market cycle and risks, rather than on bank
profitability. * The leverage ratio of capital to the book-value of
Big-2 assets now envisaged should be raised to at least 4% for the
consolidated level and implemented at the same time as the revised
CAR. Domestic lending should be included in the assets used to
compute the ratio. * Consideration should be given to measuring the
aggregate exposure of individual insurers, including direct
insurers and reinsurers, to one or more of the banks, particularly
to the Big-2, and ensuring that insurance companies have
appropriate limits.

Supervisory framework

* Macro-prudential oversight needs to be given greater emphasis and
broadened to include monitoring of all the major components of the
financial system.

* The respective roles of the SNB and FINMA for macro-prudential
oversight should be further elaborated and formalised. In
conformity with its legal mandate to contribute to financial sector
stability, the SNB should lead, together with FINMA, which should
remain the enacting body, the elaboration of macro-prudential
standards and make its views public.

* FINMA should be given the authority for imposing administrative
penalties for serious violations of its regulations.

* FINMA's personnel and other resources should continue to be
reviewed in the near-term and regularly thereafter to determine if
they are adequate to the authority's responsibilities.

Supervisory policies

* The largest insurance companies should be subject to a close
oversight regime similar to that now applied to the Big-2, while
recognizing the differences between the two sectors and relative
risks of each.

* Consideration should be given to periodic rotation of the outside
auditors responsible for particular financial institutions, and, if
and when feasible, widening the range of authorized external
auditors, as a means to sustain the objectivity of the oversight

* Strengthening of FINMA's liquidity regulation and oversight of
the largest institutions needs to be given high priority in the
near-term and extended in simplified form to other financial
institutions over time. Consideration should be given to inclusion
of a core liquidity ratio applied to foreign currency denominated
assets as part of the liquidity regulation.

* Top-down stress tests of risks to the financial system need to be
broadened, elaborated to include disturbances based on recent
market stress, and include very low probability scenarios that
would entail exceptional damage.

* Timely adoption of the proposed deposit insurance law will
significantly improve the effectiveness of the system. The present
ceiling on insured deposits should be revised as necessary to keep
in line with any further changes in other countries.

Regulation and supervision of domestically oriented financial

* Remaining preferences for cantonal banks, notably the guarantee
on their liabilities, should be phased out and their mandates
explicitly funded from government sources, in order to strengthen
their commercial orientation.

Strengthening cross-border arrangements for crisis prevention and

* Consideration should be given to broadening the core colleges of
supervisors for the Big-2, in order to facilitate a more collective
approach to their supervision. As part of these arrangements and
supplemented as necessary by other measures, co-operation of Swiss
authorities with foreign counterparts to develop contingency plans
to deal with future crises should be developed. The major financial
institutions should be encouraged to formulate arrangements to
facilitate their winding down in the event of failure.

* The authorities should continue to implement the decision to
endorse the OECD standard on transparency and the exchange of
information in tax matters as rapidly as possible.


Baily, Martin N., Martin E. Litan and Matthew S. Johnson (2008), The Origins of the Financial Crisis, Brookings Institution on Public Policy, Washington, November.

Banker Magazine (2009), "Top 1000 World Banks", June.

Basel Committee on Banking Supervision (BCBS; 2008), Principles for Sound Liquidity Management and Supervision, Basel, June.

Basel Committee on Banking Supervision (2009), Enhancements to the Basel II framework, Basel, July.

Berger, Alan N., Rebecca S. Demsetz and Philip E. Strahan (1999), The consolidation of the financial services industry: causes, consequences, implications for the future, Journal of Banking and Finance, 23.

Blum, Jurg M. (2008), Why "Basel II" may need a leverage ratio, Journal of Banking and Finance, 32, pp. 1699-1717.

Brunnermeister, Markus, Andrew Crockett, Charles Goodhart, Avinesh D. Persaud and Hyun Shin (2009), The Fundamental Principles of Financial Regulation, Geneva Reports on the International Economy, Geneva.

Committee of European Banking Supervisors (2008), Second part of CEBS's technical advice to the European Commission on liquidity and risk management, September.

Committee of European Banking Supervisors (2009), Position paper on a counter-cyclical capital buffer, July.

Credit Suisse Group (2007, 2008, 2009), Annual Report, Zurich.

Credit Suisse Group (2009b), Financial Release 2Q2009, Zurich.

Departement Federal des Finances (DFF; 2009), Rapport explicatif relatif a la loi federale sur la garantie des depots bancaires, Bern.

European Financial Services Round Table (2004), Towards a lead supervisor for cross border financial institutions in the European Union: Recommendations of the European Financial Services Round Table, June.

Financial Institutions and Market Authority of Switzerland (FINMA) (2009a), Key points of the circular on remuneration systems, Bern, 3 June.

Financial Institutions and Market Authority of Switzerland (FINMA) (2009b), The Swiss regime for large banks: setting the pace for international capital regulation, Bern, 9 March.

Financial Services Authority of the United Kingdom (2009a), The Turner Review: A Regulatory Response to the Financial Crisis, Financial Services Authority, London, March.

Financial Services Authority of the United Kingdom (2009b), A Regulatory Response to the Financial Crisis, Discussion Paper 09/02, Financial Services Authority, London.

Financial Stability Forum (2009), Principles for cross-border financial co-operation on crisis management, June, Basel.

Financial Stability Forum (2009), Report of the Financial Stability Forum on.

Addressing Procyclicality in the Financial System, April, Basel.

Group of 20 (2009), Final Report of the G20 working group on reinforcing international co-operation and promoting integrity in financial markets, March.

Group of 30 (2009), Financial Reform: a Framework for Financial Stability, Washington DC, January. Hildebrand, Philipp (2009), Introductory Remarks, news conference 18 June, Bern.

Hildebrand, Philipp (2008), Is Basel II enough? Benefits of a leverage ratio, Financial Markets Group Lecture, London School of Economics, December, London.

International Banking Federation (2008), Colleges of supervisors, London.

Institute of International Finance (2007), Principles of Liquidity Management, March.

International Monetary Fund (2009a; 2007d), Switzerland: Staff report for the 2009 Article 4 consultation, May, Washington.

International Monetary Fund (2009b), Switzerland: Financial Sector Assessment Program--Detailed assessment of observance of financial sector standards and codes, August, Washington DC.

International Monetary Fund (2009c), Global Financial Stability Report, Washington DC, April.

International Monetary Fund (2007a), Switzerland: Financial System Stability Assessment Update, June, Washington DC.

International Monetary Fund (2007b), The Swiss bank system: structure, performance, and medium-term challenges. Technical Report for the Financial Sector Assessment Program, Washington DC, June.

International Monetary Fund (2007c), Factual update--insurance sector market and regulatory developments, Technical Report for the Financial Sector Assessment Program, Washington DC, June.

de Larosiere, Jacques (2009), Report of The High Level Group of Financial Supervisors of the EU, Brussels, 25 February.

OECD (2007), Economic Reviews: Switzerland, Chapter 3, Paris.

OECD (2008), Economic Review: Euro Area, Paris.

OECD (2009a), Economic Review: Iceland, forthcoming, Paris.

OECD (2009b), Finance, Competition and Governance: Priorities for Reform and Strategies to Phase out Emergency Measures, report prepared for the June 2009 meeting of the OECD Ministerial Council, Paris.

Ratnovski, Lev and Rocco Huang (2009), Why are Canadian Banks more Resilient?, International Monetary Fund Working Paper 09/152, Washington DC, July.

Schich, Sebastian (2008), Financial Crisis: Deposit Insurance and Related Social Safety Net Issues, OECD Financial Market Trends, Paris.

Swiss Federal Banking Commission (2008), Subprime Crisis: SFBC Investigation into the Causes of the Writedowns of UBS AG, Bern, 30 September. Causes of the Write-downs of UBS AG and the Swiss National Bank (2007), Memorandum of Understanding between the Swiss Federal Banking Commission and the Swiss National Bank in the Field of Financial Stability, Bern.

Swiss Financial Market Supervisory Authority (FINMA, 2009), Key points of the circular on renumeration policies, June, Bern.

Swiss National Bank (2007, 2008a, 2009a), Financial Stability Report (issues for 2007-2009), Bern.

Swiss National Bank (2008b), Swiss National Bank finances transfer of illiquid assets of UBS to a special purpose vehicle, Press release, 18 October, Bern.

UBS (2007, 2008 restated), Annual Report, Zurich.

UBS (2009), Quarter Report, Q2-2009, Zurich.

UBS (2008b), Shareholder report on UBS's writedowns, April, Zurich.

Wajid, S. Kal, Alexander Tieman, May Khamis, Francois Haas, Dirk Schoenmaker, Planman Iossifov, and Kalin Tintchev (2007), Financial integration in the Nordic-Baltic Region: Challenges for financial policies, International Monetary Fund, 2007.

World Bank (2009), Background Note: Banking and the Leverage Ratio, Note prepared by the Financial Systems Division of the Financial Policy Division.


(1.) The Big-2 took a comparatively large portion of their total cumulative write downs relative early--the fourth quarter of 2007 and first quarter of 2008. Write downs by UBS and CSG during the two quarters were nearly two-thirds and one-half of the cumulative totals incurred through the second quarter of 2009. Most of the other heavy losers among European and United States Banks reported considerably less than half of their ultimate write downs during the two quarters (The Banker, 2009). This may have contributed to an impression that the Swiss banks' losses were more exceptional than they ultimately turned out to be.

(2.) Most of the write downs for the UBS group were attributable to the investment bank, with the bulk of the remainder to losses, also mainly in CDOs and derivatives, of Dillon Read Capital Management. See UBS 2008b.

(3.) As of August 2009, UBS individual bank strength was rated B- by Moody's Investor Services, above that of Bank of America, Barclay's Bank, and Royal Bank of Scotland but below Citigroup, Deutsche Bank, and CSG, all of which have a B rating. The UBS rating was under review for possible further downgrade.

(4.) For example, until fairly recently, UBS had pursued a relatively less aggressive strategy than other major investment banks due in part to its traditional specialization in wealth management. Beginning around 2003-2004, the bank made a strategic decision to give greater emphasis to its investment banking division, with a goal of achieving very rapid growth to become an industry leader (SFBC, 2008a).

(5.) The differences between the ratios for European banks and the US banks are also somewhat overstated by differences in accounting conventions used to calculate their total assets. US bank assets are calculated using the Generally Accepted Accounting Principles (GAAP) specified by the United States Financial Accounting Standards Board. These specify that derivatives be valued on a net basis. Assets of European banks are calculated according to the International Financial Reporting Standards (IFRS) applied in the EU and which value derivatives on a gross basis. CSG uses the United States GAAP standards, which partly accounts for its higher Tier 1 capital to assets ratio compared to UBS.

(6.) Indeed, average Tier 1 CAR ratios for the five banks suffering the largest losses were above the average for their other peers in the top 25 by total assets (10.3 and 9.8 respectively).

(7.) Interest rate spreads between euro area countries are instructive because they are not affected by currency risk perceptions.

(8.) According to calculations by the SNB (SNB 2009a), market risk accounted for 3.5% of total capital requirements of cantonal banks in 2007, less than 0.5% for regional banks, and 9.5% for the Big-2.

(9.) The Swiss approach of creating a "bad bank" for impaired assets with specified and strictly limited ex ante maximum costs to the bank is most suitable for dealing with an identifiable set of impaired assets. The approach can be more effective than alternative options (e.g. liquidity support or guarantees) in decisively and transparently improving balance sheet quality but also can (although not certainly) entail higher costs

to the government (IMF, 2009c).

(10.) "UBS remains cautious after Q2 loss, big outflows", International Business Times, 4 August 2009, articles/20090804/ubs-remains-cautious-after-q2-loss-big-outflows.htm.

(11.) Swiss regulatory policy requires prompt corrective action if assets drop below 90% of discounted future obligations, but that point has not been reached.

(12.) See, for example, the recent warning by a high official of the ECB ("ECB fears bank crisis in 2010 as the recession drags on", London Daily Telegraph, 10 June 2009 ( 5498989/ECB-fears-bank-crisis-in-2010-as-recession-drags-on.html).

(13.) The IMF Financial Sector Assessment of Switzerland published in June 2007 assessed the Swiss banking system overall as "... resilient to shocks ...", with stress tests "... confirming their resiliency to the most relevant macroeconomic stress events" (IMF, 2007a, p. 12). The Financial Stability Report published by the Swiss National Bank in that same month stated that its "expectations regarding the stability of the Swiss banking sector are essentially positive" (SNB 2007, p. S). Similar positive assessments of the overall robustness of financial systems despite concerns about certain developments were common in reports by financial regulators in other OECD countries.

(14.) By comparison, total worldwide assets of Citgroup, the largest US banking conglomerate, were 13.8% of 2008 US GDP. Comparable figures for Germany (Deutsche Bank) and the United Kingdom were 93% and 113% respectively.

(15.) Higher Tier 1 capital requirements help to restrain excessive leverage and limit the need to shed assets during severe downturns. See FSA, 2009a.

(16.) According to data provided by Euromoney.

(17.) It would also reduce the related risk that the banks would come to view the upper end of the range as the de facto minimum over the entire cycle and be unwilling to allow it to drop (FSA, 2009a). This would undermine the effectiveness of the measure in remedying the tendency of fixed CAR to amplify market swings.

(18.) The exclusion of domestic assets is ostensibly to avoid unduly inhibiting the lending by the Big-2 to domestic Swiss entities. Derivatives are included but the banks are permitted to adjust their valuation of derivatives to the US GAAP conventions.

(19.) Including all assets would have lowered the UBS stated leverage ratio for Q4 2009 to 2.2 from 2.5%; while the ratio for CSG for Q2 2009 would have been lowered to 3.2% from 4.0%. See UBS Annual Report, 2008, p. 162; and CSG Financial Report, Q2, 2009.

(20.) Under current law, compensation is taxable when paid into a deferred fund, even if the value of the payment is subsequently reduced. The circular suggests revising the law to base the tax liability on the value when the funds are withdrawn. The circular also indicates labor law issues that would need to be addressed.

(21.) FINMA's budget is incorporated in the Federal Budget rather than separated, as, for example in the United States (IMF, 2007a) and is subject to audits by the Federal Audit authority. However this does not appear to entail any explicit government oversight over the budget and the audit arrangement is typical of other countries. Remuneration of FINMA staff and officials is linked to the salary scales of the Swiss Federal Government, but FINMA is allowed some special exemptions that give it greater flexibility in setting composition.

(22.) This authority now rests with the Ministry of Finance. See IMF 2007a. FINMA is authorized to confiscate monetary gains arising from serious violations of regulations, such as insider trading.

(23.) Issues concerning macro-financial risks and macro-prudential policies are subject to discussion at the (semi-annual) meetings of the joint standing committee of the two bodies and at the semiannual joint meetings of their governing boards, which has the responsibility for resolving disagreements. See SFBC 2007.

(24.) The "adverse" scenario reported in the SNB Financial Stability Report for 2008 assumed a decline in year-on-year decline in real GDP of 0.2% and 1.2% for the United States and Switzerland respectively, a 30% drop in global equity prices, and a 75 basis point rise in credit spreads. Except for the decline in Swiss GDP, these were considerably milder than the outcomes since 2006.
Table 3.1. Financial system profile

                                 Number of        Total    Assets as %
                                institutions     assets    of 2008 GDP

Banks                                324          3 124         587.2
  Big-2                                2          1 890         355.3
  Cantonal banks                      24            389          73.1
  Regional and savings banks          76             88          16.5
  Raiffeisen bank                      1            132          24.8
  Foreign owned or branches          130            356          66.9
  Private banks                       14             41           7.7
  Other banks (1)                     77            228          42.9
Insurance companies (2)              114            881         165.6
  Life                                24            287          53.9
  General                             90            594         111.7
Pension funds (2)                  2 543            605         113.7

World-wide assets of major Swiss financial institutions, 2008 (3)

                                CHF billion,    % of 2008
                                    2008           GDP

  UBS                              2 015          378.8
  CSG                              1 170          219.9
  Swiss Re                           225           42.3
  Zurich financial services          307           57.7
Foreign currency assets and
liabilities as per cent
of total assets/liabilities        Per cent for end-2008
All Swiss banks (3)                Assets      Liabilities

  All currencies                      71            71
    Denominated in USD                27            28
    Denominated in euros              13            14

(1.) Trading banks, stock exchange banks, and other banks.

(2.) Figures for end-2007.

(3.) Consolidated level (including subsidiaries abroad).

(4.) Swiss booked assets only.

Source: Swiss National Bank, Monthly Report on Banking
Statistics; Annual Reports of UBS and CSG for 2008, IMF 2009a.

Table 3.2. Banks' assets relative to GDP, per cent (1)

       area   Iceland (2)   Iceland   Switzerland (3)

1998   231
1999   243
2000   247
2001   250
2002   249
2003   253        172
2004   263        320
2005   281        528
2006   294        726
2007   318        878         750           705
2008   331                                  595

       Switzerland (4)   Kingdom

1998         512           294
1999         553           285
2000         499           322
2001         512           335
2002         514           338
2003         508           365
2004         550           392
2005         614           441
2006         661           474
2007         681           497
2008         587           548

(1.) Data for the assets of domestically registered banks (excluding
foreign subsidiaries' assets) except where indicated otherwise.

(2.) Consolidated assets of the three largest banks in Iceland; data
include foreign subsidiaries' assets.

(3.) Consolidated total assets of the two largest banks in
Switzerland; data include foreign subsidiaries' assets.

(4.) The series has a break in 2006 due to changes in the number of
banks included in the series' reference panel.

Sources: SNB, Monthly Bulletin of Banking Statistics; Central Bank
of Iceland, Accounts of the credit system; Bank of England, Monetary
financial institutions' balance sheets; European Central Bank,
Monetary and Financial Institutions balance sheets (2009).

Table 3.3. Writedowns of sub-prime and related assets by major
international banks

                                        Cumulative loss
                                         from Q2 2007
                                        through Q2 2009
                                         (billion USD)

Swiss banks
  UBS                                        53.1
  CSG                                        17.7
United States banks
  Citibank Group                            101.8
  Wachovia Bank                             101.9
  Merrill Lynch Bank                         56.0
  Bank of America                            99.3
  Washington Mutual                          45.3
  JP Morgan Chase                            41.2
  Wells Fargo Bank                           22.9
United Kingdom banks
  HSBC                                       42.2
  RBC                                        31.4
  Barclays Bank                              19.9
Other European banks
  Deutsche Bank                              18.8
  BNP Paribas                                14.1
  Bayerische Landesbank                      16.4
  ING                                        15.8
Write downs by major Swiss insurance
companies (through 012009)                USD billion
  Total                                       9.7
  Swiss Re                                    6.4
  Zurich Financial Services                   2.9

                                        Loss as per cent
                                        of total assets
                                          or end-2008

Swiss banks
  UBS                                         2.8
  CSG                                         1.6
United States banks
  Citibank Group                              5.3
  Wachovia Bank
  Merrill Lynch Bank                         90.6
  Bank of America                             5.5
  Washington Mutual
  JP Morgan Chase                             1.9
  Wells Fargo Bank                            1.7
United Kingdom banks
  HSBC                                        1.7
  RBC                                         0.9
  Barclays Bank                               0.7
Other European banks
  Deutsche Bank                               0.6
  BNP Paribas                                 0.5
  Bayerische Landesbank                       2.8
  ING                                         0.9
Write downs by major Swiss insurance
companies (through 012009)
  Swiss Re
  Zurich Financial Services

                                        Loss as per cent
                                        of Tier 1 capital
                                          for end-2008

Swiss banks
  UBS                                         182.6
  CSG                                          59.2
United States banks
  Citibank Group                               85.5
  Wachovia Bank                               234.3
  Merrill Lynch Bank                        1 302.3
  Bank of America                              82.1
  Washington Mutual                           374.4
  JP Morgan Chase                              30.3
  Wells Fargo Bank                             26.5
United Kingdom banks
  HSBC                                         44.4
  RBC                                          31.1
  Barclays Bank                                36.9
Other European banks
  Deutsche Bank                                43.7
  BNP Paribas                                  24.3
  Bayerische Landesbank                       104.5
  ING                                          35.4
Write downs by major Swiss insurance
companies (through 012009)
  Swiss Re
  Zurich Financial Services

Source: Banker, Top 1000 World Banks 2009, June 2009; International
Monetary Fund Country Report--Switzerland; Annual Reports of UBS
and CSG (for Tier 1 capital figures).

Table 3.4. Bank soundness indictators (1, 2)

                                2006     2007     2008    Q1 2009
Total CAR
Big-2                           12.4     10.7      12.6
Cantonal banks                  15.1     15.7      15.6
Regional and savings banks      13.7     13.7      14.5
Raiffeisen banks                16.5     18.7      18.8
Leverage (3) %
Big-2                            2.5      2.5         3
Cantonal banks                     8      8.1       7.5
Regional and savings banks         8        8       7.8
Raiffeisen banks                 8.4      8.7       8.8
Gross profits (CHF million)   29 912   24 218     8 612
Big-2                         15 068    6 925    -4 586
Cantonal banks                 4 265    4 277     3 646
Regional and savings banks       908      915       793
Raiffeisen banks                 981      964       883
Total CAR        UBS              15      127        15     14.7
                 CSG            18.4      145      17.9     18.7
Leverage ratio   UBS            2.54      2.6       3.5
                 CSG            3.14      3.8         4
Net profits      UBS          11 527   -5 247   -21 292   -1 854
                 CSG          11 367    7 760    -7 687    2 006

                              Q2 2009
Total CAR
Cantonal banks
Regional and savings banks
Raiffeisen banks
Leverage (3) %
Cantonal banks
Regional and savings banks
Raiffeisen banks
Gross profits (CHF million)
Cantonal banks
Regional and savings banks
Raiffeisen banks
Total CAR        UBS            17.1
                 CSG              20
Leverage ratio   UBS
Net profits      UBS          -1 402
                 CSG           1 571

(1.) Figures for the Big-2 aggregates and other bank groups are
from the SNB. Figures for UBS and CSG are for the consolidated
worldwide group as reported in the banks' annual and quarterly
reports. The SNB definitions for the Big-2 are not strictly
comparable with the worldwide data reported by the individual banks.

(2.) Figures for 2007 onward are based on Basel II standards. The
ratios under the Basel I definitions were 12.3 and 12.7 respectively
for 2007 and 2008 for UBS and 12.9 for 2007 for CSG (2008 Basel I
figure not available).

(3.) Tier 1 capital as ratio to total assets. UBS and CSG figures
based on (adjusted assets, excluding domestic lending and other

(4.) Figure for end-2008.

Source: SNB Financial Stability Report, 2007 and 2008; Annual
Reports of UBS and CSG for 2007 and 2008; Quarter Report of
UBS for Q2 2009; Financial Release of CSG for A2 2009.
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Title Annotation:Chapter 3
Publication:OECD Economic Surveys - Switzerland
Geographic Code:0IMF
Date:Dec 1, 2009
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