Banks : must we regulate the regulator?

Is it true that the more capital banks have, the more they lend? In many countries with financial giants, debates are intensifying once again, bringing to the forefront the delicate question of the adequate level of capital banks should have.

Summoned urgently last year for Credit Suisse, the Swiss government is in the midst of analyzing this crucial issue for a country potentially facing four banks with systemic risk: UBS of course, Raiffeisen Group, Zürcher Kantonalbank (Bank of the Canton of Zurich), and PostFinance. Do these institutions need a serious readjustment of their capital ratios to avoid dragging the country into their debacle? An independent firm has just revealed that, to not pose a vital risk to the Swiss economy, UBS may need an additional 10 to 15 billion Swiss francs in capital. In short, executives and regulators of these nations fortunate enough to host “Too Big To Fail” institutions are trying to anticipate the next move. How can they not be blamed when, for example, the size of UBS is twice the Gross Domestic Product of a modern country with a globally integrated economy like Switzerland?

The United States is obviously not lagging behind, as a significant tightening of ratios is under consideration by the Federal Reserve, which is being opposed by large banks deeming any tightening unnecessary. Citi, JP Morgan Chase, and Bank of America even threaten to resort to the courts (which decide everything in the USA) if the regulator ventures into this territory, reiterating the age-old refrain that financing for “hardworking families and small businesses” would be affected.

But what do Credit Suisse and Silicon Valley Bank (barely saved) have in common that sadly made headlines in 2023? The answer is that they both had capital ratios significantly higher than regulatory requirements. This is why focusing solely on a bank’s capital is insufficient, as the other equally fundamental indicator is liquidity, which – if unavailable or scarce – can decimate a financial institution. Capital, and the rules related to it, are not here to prevent a bankruptcy, but to allow the institution to navigate through the rise in risks and attempt to manage them at least catastrophically. Capital is an unreliable, imprecise indicator if the regulator simply scrutinizes it to gauge the health of the bank. Capital is only good for absorbing and reducing the impact of losses. For a bank, risks become major when it seeks to increase its profits through additional leverage by using its clients’ deposits. To return to the example of our two banks, their level of capital only determined the speed at which they collapsed in a context of inevitable liquefaction: Silicon Valley Bank failed to manage interest rate risk, Credit Suisse due to a deplorable business model.

The banking elite also knows perfectly well that their institution’s capital is not a fundamental gauge, but they cling to it because they are fully aware that more capital leads to a lower return on that capital, hence lower bonuses for them. The highly unhealthy caricatural example being Credit Suisse, which managed to distribute 35 billion in bonuses over 10 years, while losing 3.5 billion over the same period. So, it’s not surprising to hear the judicious remark of the Swiss Finance Minister, Karin Keller-Sutter, who recently acknowledged that the 14 million Swiss franc bonus received by Sergio Ermotti, the UBS’s CEO, represented 30 years of her own salary!

To stick with Credit Suisse, beyond its capital ratios, how did the regulator not get alarmed by its miserable governance and the lamentable oversight exercised by its Board of Directors? Because there is another fact that seems hardly contestable, namely that troubled institutions are always those whose Board of Directors is not up to par, with competent experts preferring to avoid such a risky position for meager compensation. The case of Credit Suisse proves that bankruptcy can be attributed to as many quantitative as qualitative factors, and highlights the negligence of the supervisor because, in this case, FINMA (Swiss Financial Market Supervisory Authority) never intervened to rectify the unhealthy greed of its leaders or the miserable governance of this bank.

These regulators, like their American counterparts, could have largely limited the damage if they had simply paid attention to the stock prices of these institutions destined for failure. A simple glance toward real life should have triggered widespread alarm.

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My 5 Points program for the Swiss National Bank