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Philipp Hildebrand, SNB

Geneva, Switzerland (GenevaLunch) – The incoming head of the Swiss National Bank, Philipp Hildebrand, says Switzerland needs tighter banking regulations than most countries, due to its size relative to the country’s economy. Total banking assets exceed seven times Switzerland’s GDP, he notes, and they are very concentrated, with the two big banks, Credit Suisse and UBS, having two-thirds of the total.

Recovery may be underway but the costs to the global economy, longer term, loom large. “The potential costs of the support measures taken – capital injection, asset purchases, and guarantees of bank debt – in the G7 countries together with Australia, the Netherlands, Spain and Switzerland amount to about 20 percent of GDP in these economies,” he says, although actual outlays have been about 8 percent.

Hildebrand, who takes over as SNB chairman in January 2010 when Jean-Pierre Roth retires, made his remarks in a speech Wednesday evening 18 November at the University of Geneva.

The SNB is focusing on two areas of bank regulation changes, in line with recommendations drawn up by the Financial Stability Board (FSB) The FSB was created in April 2009 and is housed at the Bank for International Settlements in Basel, Switzerland.

The first is preventive measures, mainly in three areas: capital requirements, liquidity and compensation. The second covers the response when a bank runs into trouble.

Bank capital requirements already tougher, will become more so

Hildebrand says the SNB is looking for banks to strengthen their capital bases substantially. Switzerland’s two big banks have argued this will make them less competitive. He believes that in the medium term this will not pose a problem for the banks. “The key to this will be a sufficiently long time horizon and, crucially, more discipline in retaining earnings. The outlook for future earnings is by definition uncertain. Nonetheless, if we review the banks that have received public support, it is striking that many of them paid out more in dividends and share buybacks during the years preceding the crisis than they subsequently faced in losses.”

In addition to increasing capital the system needs to have a leverage ratio restriction to avoid massive leverage buildup: “Fundamentally, anybody who claims that the leverage ratio is a useless or even a counter-productive complementary regulatory instrument is arguing that gross exposure doesn’t matter. If there is one lesson we should learn from the crisis, it surely is that gross exposure manifestly matters a great deal.”

The system will need flexibility, however, in order not to penalize banks in the marketplace: encouraging capital buildup in good times and allowing the banks to slip below capital requirements when necessary. New requirements passed at the end of 2008 mean Swiss big banks will have to meet risk-weighted capital requirements that are double what they were before the crisis, he notes.

“Banks’ liquidity holdings were clearly insufficient”

Hildebrand says one reason for the insufficient liquidity of banks was that banks were far too optimistic about possible stress scenarios. Swiss banks will have new and much higher liquidity requirements, which go into effect in Spring 2010, but he did not provide details of the change, which is still being worked out.

Compensation needs an international system to be workable

“Compensation systems must not remain the one-way street they were for many individuals and firms in the run up to the crisis,” Hildebrand argues. “They must become risk aligned and long-term oriented.” The SNB wants Switzerland to develop a national compensation policy but for it to be effective it must be in line with an international system, the FSB’s September 2009 Principles for Sound Compensation, and he called for a strong commitment to this, worldwide.

Banks must be allowed to fail, destabilizing effect must be minimized

Hildebrand addressed the moral muddle created by market-oriented banks bailed out by governments and told his audience that “If we are committed to a market-based system, the financial system of the future must expose financial
institutions of all sizes and structures to the ultimate test of the market place. The very definition of a market economy is that it must allow for failure as a sanction of excessive risk taking or managerial incompetence. In the event that
large, systemically relevant financial firms face the threat of failure in a next crisis, the financial system of the future must allow for their orderly resolution.”

The challenge for central banks and regulatory bodies is to design solutions now that will minimize the impact on national economies of such potential failures.

Link to Hildebrand’s speech