Update: On Sunday 20 March 2023, the Federal Council decided, using emergency legislation, to support the sale of Credit Suisse to UBS. In this context, the to-big-to-fail provisions described in this article must be considered inapplicable, although they are still legally valid.
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In the financial crisis of 2007/2008, UBS was in danger of going under. On 16 October 2008, the then President of the Confederation, Pascal Couchepin, informed about rescue measures taken by the Confederation and the Swiss National Bank (SNB) to prevent a conflagration on the entire Swiss economy.
Today, a similar scenario is hardly conceivable after a multitude of measures were taken to stabilise the Swiss financial centre. In this article we look at the measures taken and explain at what point losses would occur for the individual stakeholders and how they would be affected in the event of bankruptcy.
Too-big-to-fail provisions
UBS was rescued while some financial institutions abroad went under in the financial crisis. The financial crisis had a global dimension due to contagion effects. The response to the crisis was new regulations, which were introduced in many countries to strengthen security and stability in the financial sector. In Switzerland, so-called “too-big-to-fail” provisions were introduced. The specific regulations are largely set out in the Capital Adequacy Ordinance (CAO), the Liquidity Ordinance (LiqO), the Bank Insolvency Ordinance-FINMA (BIV-FINMA) and in other FINMA circulars.
The Swiss Financial Market Supervisory Authority (FINMA) divides banks into five different categories, which are supervised with varying degrees of intensity. The categorisation is based on the measurable criteria of total assets, assets under management, privileged deposits and required capital.
- Category 1: Very large, significant and complex market participants. Very high risk.
- Category 2: Very significant, complex market participants. High risk.
- Category 3: Large and complex market participants. Significant risk.
- Category 4: Medium-sized market participants. Average risk.
- Category 5: Small market participants. Low risk.
Financial institutions are systemically important if their failure would significantly damage the Swiss economy and the financial system. Internationally active systemically important banks are UBS and Credit Suisse, which are subject to the strictest requirements and highest monitoring intensity (close and ongoing monitoring). Domestically oriented systemically important banks are PostFinance, Raiffeisen and Zürcher Kantonalbank.
Recovery and resolution planning
The big banks are obliged to develop contingency plans so that systemically important functions can be continued without interruption in the event of a crisis. Recovery is the term used in connection with stabilisation in the event of a crisis. Measures such as waiving distributions to investors and reducing bonuses are considered if business is not going in a good direction. Afterwards, partial sales of business units, conversions of bonds if the capital requirements fall below defined levels and other measures can be considered as stabilisation measures. If all these measures are insufficient, FINMA will intervene or, more specifically, stabilise and restructure and/or orderly wind-down a bank, which is called resolution.
As systemically important banks, the big banks must submit comprehensive recovery and resolution plans to FINMA, which approves these contingency plans.
What happens in the event of an over-indebtedness crisis?
The terms underbalance and overindebtedness are familiar from Art. 725 of the Code of Obligations (CO). If a company has used up more than half of its equity capital, restructuring measures must be initiated. If the entire equity capital has been used up, this is referred to as over-indebtedness and bankruptcy can hardly be avoided.
Banks have created an instrument that can save a slipping financial institution in the event of a crisis. In the event of a crisis, hardly anyone is prepared to provide further money in the form of equity capital. So-called convertible capital and bail-in bonds are the solution. This means that current bonds can be converted into equity capital in the event of a crisis. There are different categories of these bonds, which can be converted into equity capital depending on whether they fall below defined key figures. If restructuring measures and the conversion capital, which is automatically converted if capital requirements are not met, are not sufficient to meet the regulatory requirements (CET 1 core capital ratio), FINMA intervenes. This is referred to as a “point of non-viability”, at which point a restructuring and/or orderly resolution is to be carried out by FINMA.
In practice, in such a case, the equity capital would first be written down to zero. This would amount to a total loss for the shareholders. At the same time, bail-in bonds would then be converted into equity. For the bail-in bonds with higher risks of conversion into equity, a higher interest rate has to be paid. The investors of such bonds want a higher compensation for having to bear a higher risk.
With bail-in bonds, an effective instrument was created through which significant losses could be absorbed and systemically important banks remain capable of acting. Firms without bail-in bonds would be forced to negotiate a restructuring with lenders in the event of over-indebtedness. This is usually a challenging process with an uncertain outcome.
What are the maximum losses a bank can bear?
In technical language, a distinction is made between “going concern capital” and “gone concern capital”. Going concern refers to the view that a bank will continue to operate. Gone concern capital refers to the view that a bank will continue as a going concern.
The calculation of the specific capital requirements is complex and depends, among other things, on the business activity carried out. In autumn 2022, Credit Suisse fell deep into the loss zone due to repeated massive write-downs. It was published that a loss of around 3.5 billion Swiss francs is likely to result for 2022. This is after a loss of around 500 million Swiss francs was already reported in 2021. The figures are difficult to classify. And – whether Credit Suisse will succeed in avoiding further larger write-offs in the future remains uncertain.
In order to assess how safe Credit Suisse is, one should compare the figures with the capital that could absorb a loss. Figures from a Credit Suisse presentation to debt investors on December 7, 2022 show the following picture:
- Loss-absorbing capital Going concern: CHF 50.1 billion
- Total loss-absorbing capital (incl. gone concern): CHF 97.4 billion
The magnitude of these figures shows that with the instruments created after the financial crisis of 2007/2008, even very large losses can be absorbed without endangering the security of bank deposits.
Credit Suisse’s high loss in 2022 is likely to hurt shareholders in particular, which is reflected in the share price. It is to be hoped that the damage to the bank’s reputation due to the high losses and negative press will not have any long-term consequences.
Swiss clients are even better protected
Systemically important functions in Switzerland are the deposit business, the lending business in Switzerland (including loans during the year) and payment transactions. These businesses are affiliated with Credit Suisse Schweiz AG and not at group level.
If the Credit Suisse Group were to get into difficulties, FINMA would intervene with coercive measures with the aim of restructuring the bank. In the event of a restructuring, the group could be restructured and transferred to a new business model. FINMA could force a write-off of the bail-in bonds in order to restructure the group. In the event of a restructuring, it is envisaged that all companies in the group will remain open.
If a restructuring at group level does not seem possible or is not successful, a second stage – the Swiss emergency plan – kicks in. Credit Schweiz AG would be separated from the group. Since the systemically relevant functions are already run through Credit Suisse Schweiz AG, continuity and uninterrupted continuation are guaranteed.
Which losses are borne by whom in the event of restructuring?
In the case of a bank restructuring, it is clearly specified who would have to bear losses and in what order. In a loss scenario, the stakeholders would have to pay for a loss in the following order:
- Shareholders of the bank:
The share capital would be the first to pay for losses. In the event of bankruptcy, this means a total loss for the shareholders. - Debt investors:
Outstanding bonds could be converted into share capital in a crisis according to a defined hierarchy (bail-in bonds) or would only be partially repaid or not repaid at all in the event of very high losses. - Other exposures:
Other banks and other counterparties that do business with the bank and have outstanding claims against the bank would have to waive claims if the loss could no longer be covered even by the debt investors. - Bank deposits (account):
Only then could savers be asked to pay up or bank deposits no longer be repaid in full.
Deposit insurance: Deposit insurance offers additional protection for deposits in bank accounts. Deposits per customer of up to 100,000 francs are paid out immediately and outside of the bankruptcy proceedings.
The amount available for deposit insurance in Switzerland is 8 billion Swiss francs (as of 2023). This corresponds to the statutory value of 1.6% of all secured assets in Switzerland.
Bankruptcy privilege: In addition to the deposit guarantee of 100,000 Swiss francs, bank clients benefit from a bankruptcy privilege on the same amount. Claims up to 100,000 that cannot be settled with the deposit protection fall into the second instead of the third bankruptcy class.
In the case of a pension foundation, the privilege applies per client of the pension foundation. The pension foundation is therefore not only considered as one client for the bank, but behind it there can be thousands of clients who individually benefit from the privilege.
Would securities investors with custody account holdings also be asked to pay?
Investments in securities are considered special assets and are not part of the bank balance sheet. In the event of bankruptcy, the securities are protected. In the case of funds, there are points to consider which could lead to a certain loss within a fund:
- The cash balance of the fund: In passively managed funds, this amount is usually very low and negligible, as all receipts are invested bypass. For actively managed funds, the risk is greater and must be controlled by the fund manager.
- Currency hedging or other derivative transactions: If foreign currencies are hedged, gains or losses result from these transactions during the term of the hedge. If a profit could not be claimed from it, a loss would result from it. Risks are minimised by setting profit and loss thresholds at which settlement payments are made between counterparties. In the case of synthetically implemented funds, the risks of losses are correspondingly higher.
- Securities lending: Securities lent to a bank could not be reclaimed in the event of bankruptcy. In practice, substantial collateral is necessary in order to be able to engage in securities lending and to control the risks (collateral).
- Investment risk: If the fund itself invests in securities of a bank affected by bankruptcy, a loss may result on these investments.
The risk of loss due to a bank failure is very low in physically converted passive investments. A closer look is needed for actively managed investment funds.
A bankruptcy of a closely supervised major bank is hardly realistic today. Securities savers with passive investments (physically replicated) would also be practically fully protected and hardly affected even in an isolated and theoretical bankruptcy scenario.