The demise of Credit Suisse in March 2023 has called into question banking regulations and supervision. But it also highlights how their mere existence, implying that they are fit for purpose, is not enough to prevent a crisis.
On March 15, before the UBS takeover, Credit Suisse’s regulatory capital ratios were above prudential requirements. Its Common Equity Tier 1 capital (CET1) was stable at almost 15%, and its leverage ratio for total loss-absorbing capacity was 15%, both about one-third higher than called for.
However, just four days later, the bank was on the brink of collapse on liquidity grounds.
Are current requirements fit for purpose?
“This shows that actually the regulatory metrics on capital and liquidity like Common Equity Tier 1 capital and liquidity coverage ratio [LCR] cannot really provide a good view of the bank’s viability,” said Eva Hüpkes, secretary general at the International Association of Deposit Insurers, during a webinar organised by the Peterson Institute for International Economics.
“Important amounts of capital and liquidity were actually trapped in entities in other jurisdictions and were actually not freely usable. We need to consider forward-looking information,” she added.
Indeed, legal, regulatory or operational obstacles to mobilising collateral or liquidity across borders could impede an effective resolution, admits the Financial Stability Board (FSB).
“We need to look at liquidity in light of accelerated bank runs, and the runoff rates assumed in the liquidity coverage ratio appear low. This discussion is happening at the international level,” explained Ms Hüpkes.
According to a report published by the Expert Group on Banking Stability, ‘The need for reform after the demise of Credit Suisse’, the quality of capital can be enhanced: “FINMA [the Swiss Financial Market Supervisory Authority] should publicly disclose any relief granted and transitional agreements for capital adequacy demands, as well as the level of ‘double leverage’ employed by banks.”
Indeed, the Expert Group found that FINMA had granted Credit Suisse relief on capital requirements, transition periods, and adjustment paths with regard to new regulations.
While Credit Suisse had a recovery plan, “the question is, was there a mechanism to ensure that the bank implements radical recovery action before entering non-viability?” asked Ms Hüpkes, who is also a member of the Expert Group on Banking Stability.
“Maybe having very clear qualitative/quantitative triggers, that in a way obligate the authority to intervene and take action, and in a sort of structured way [are needed],” Ms Hüpkes added.
The relevance of preserving liquidity when a bank fails
The Credit Suisse case highlighted how relevant it is for a bank to maintain access to liquidity during a crisis. A public liquidity backstop had been under discussion for years in Switzerland and was to be enacted as emergency legislation during the crisis.
“[The public liquidity backstop] must be introduced expeditiously. Its adoption is critical to guarantee access to funding in the resolution for a systemically significant bank,” reads the Expert Group’s report.
Public sector backstop funding should remain subject to strict conditions to avoid moral hazard risks. The report also suggests systemically significant banks should deposit sufficient collateral with the central bank to ensure adequate access to liquidity.
Political biases vs resolution
The Credit Suisse case raises the question of why resolution was not the chosen path. Resolution frameworks, established in many jurisdictions since the global financial crisis, envisage shareholders losing their investments and debtholders being bailed in where there is a systemic bank failure. They seek to achieve such outcomes while avoiding exposing taxpayers to losses.
In the Credit Suisse case, the guarantee provided by the Swiss government “remained a potential cost to taxpayers until the termination of the guarantee in early August”. Moreover, the absorption of losses by shareholders and bondholders did not follow the established hierarchy of claims.
Several factors have been suggested to explain why resolution was not chosen. These include possible knock-on effects from imposing losses on shareholders and bailing in bondholders, uncertainty about the market, and customer acceptance of a stand-alone recapitalised entity, summarises the FSB.
There are also political reasons as to why there is strong reluctance to impose resolution, as in the Credit Suisse and other cases in Europe, which is why the EU presented a legislative proposal to update the 2014 bank crisis-management framework.
“Often, politicians have problems with some specific items of resolution and therefore tend to find loopholes or use different legal routes to achieve some of the objectives of resolutions, but not the ones that they don't like,” said Jérôme Legras, managing partner at Axiom Alternative Investments, during the webinar.
Mr Legras explained: “They were a bit annoyed by the fact that the largest shareholders of Credit Suisse were also the largest clients of its wealth management business. It was complicated for them to have straight losses for those shareholders, especially as many of them had invested very late in the process when they, after the first crisis, materialised in 2022.”
In the Credit Suisse case, as well as in others, the institution was merged with a national peer. Domestic solutions seem easier to implement as authorities have better knowledge of, and control over, the management teams.
But there are risks to this. The preference for national solutions “cannot go on forever, because at some point someone is going to hit a roadblock”, admonished Mr Legras. Indeed, in the event of a UBS crisis, the option of a Swiss takeover is no longer available.
