Banking regulation: it’s up to the banks, not the state

Swiss banks should take on the responsibility of ensuring financial stability in Switzerland far more than the regulator or lawmakers, argues economist Adriel Jost, Fellow at the Institute for Swiss Economic Policy (IWP) and President of the think tank Liberethica.

Banking regulation is often subject to the fundamental error of wanting to treat banks like market economy companies. But banks are not in that category.

At their core, they are dependent on the state in our economic system. Why? We need to take a step back: as a currency, the Swiss franc is a state-owned, public good. Bank notes, coins and sight deposits at the Swiss National Bank (SNB) are legal tender in Switzerland. However, the actual means of payment consists primarily of the money in commercial bank accounts.

This money in turn finances the banks. In other words, banks are effectively financed by their customers with a state-issued means of payment!

However, customers only do this because the SNB provides the banks with the necessary liquidity when required, and thus implicitly guarantees that this money is also safe. Otherwise, customers would not invest their savings, which they do not want to lose under any circumstances, in a bank – i.e. a company with hardly any equity.

Bail-in bonds don’t work

This not only emphasises the state’s dependence on banks, but also the fact that banks cannot go under like other companies. Normal companies go under when their equity is exhausted. Whatever value remains is divided up among the creditors. If banks were to go under in the same way, losses incurred by creditors would jeopardise state money – something that should be avoided because systemic repercussions would be guaranteed.

Firstly, it is therefore no surprise that the state is much more involved than with other companies when banks run into problems. It is hardly politically possible to tell the banks’ lenders that they must give up their money. This would break the implicit promise that our means of payment, the franc, is safe.

Secondly, this also makes it clear that banks’ borrowed capital cannot simply be written off. If the state no longer guarantees a bank’s debt capital, this also undermines the confidence of other banks. The risk that other banks will also lose confidence, and therefore sources of financing, is high by definition.

This is important to correctly categorise the benefits of so-called “bail-in” bonds. These were introduced in the aftermath of the financial crisis with the aim of strengthening the capital base of systemically important banks. If a bank gets into difficulties, the regulator can decide to convert this debt into equity.

Because the value of a struggling bank would fall massively, its lenders (bond holders) would have to absorb greater losses. They now hold shares, but these are no longer worth much. However, banks are only based on trust that the state will protect their debt capital. If it fails to do so and debt capital loses value, there is a high risk that other banks will be caught up in the maelstrom. Bail-in bonds are therefore not a panacea.

The authorities also realised this when Credit Suisse went under. As was to be expected, debt capital was heavily protected. The SNB ensured that all depositors were able to withdraw their money by securing Credit Suisse’s liquidity and even crossing its own red lines to do so.

Bail-in bonds, on the other hand, were not triggered because this would have caused great uncertainty. In the words of SNB Chair Thomas Jordan at a press conference on March 19, 2023, Credit Suisse “going into resolution” would have been “anything else but helpful” in the fragile market environment prevailing at the time.

Moral hazard looms

Hoping that this will be different in the next crisis is naive. The conversion of bail-in bonds into equity, a centrepiece of the existing “Too Big to Fail” regulation, is associated with such major risks that the responsible decision-makers would again look for other alternatives that are potentially costly for the taxpayer – in addition to the provision of liquidity, the risks of which would again have to be borne to a large extent by the state.

So what can be done? Swiss politicians are faced with a decision on the direction to take: more government or more personal responsibility for the banks? Those who favour industrial policy see the benefits of a major global bank and argue that the state should assume further risks to strengthen confidence in the bank.

This includes the proper introduction of a public liquidity backstop – which is the federal government’s guarantee to assume losses if the SNB provides the bank with liquidity in an emergency, even without collateral. This also includes giving the financial regulator, FINMA, more powers so that it can intervene more effectively before problems arise.

The problem with this is that if responsibility is delegated further to the state, moral hazard will increase, for example incentivising banks to take greater risks or continue to promote foreign business.

Cut excessive debt

Further crises with even greater state involvement in rescue operations will therefore only become more likely. From a liberal perspective, this cannot be the way forward.

Making managers more accountable, as the senior management regime and fining powers desired by FINMA intend to do, sounds good in theory. However, it would be unrealistic to expect that banks will no longer make mistakes as a result and that bank resolutions will never happen again.

It is therefore more important that banks invest in their own stability first. And if state involvement in the mismanagement and resolution of systemically important banks cannot be avoided, it should at least come with hardly any risks.

Firstly, banks can achieve both by no longer taking on excessive debt at the expense of the state. Massively more (hard) equity would therefore be appropriate. This would make banks more resilient to shocks. And if equity falls below a minimum level, triggering an automatic resolution mechanism, there would also be sufficient equity to finance the resolution.

Secondly, there should no longer be any subsidised liquidity protection. This means that banks should be able to cover all their deposits with valuable collateral as far as possible, so that the SNB would not have to take any risks when providing liquidity in the event of a bank run.

As a minimum, however, Swiss banks should assume this responsibility for their foreign transactions. Such transactions can reach a size that could jeopardise the stability and independence of Switzerland, and the Swiss franc, if a bank is rescued or wound up.

The views expressed in this article are solely those of the author and do not necessarily reflect the views of SWI swissinfo.ch.