What could be safer than a Swiss bank? This article takes a deep dive into what Swiss authorities are doing to restore confidence in the country’s banking system. As discussed in a previous article, the Public Liquidity Backstop (PLB) is a measure implemented by the Swiss government to insulate the country’s banking system from a run on its systemically-important banks. Designed prior to the involuntary merger between Credit Suisse and UBS, the PLB will, at long last, go into effect in 2025. Yet, the measure could have unintended consequences that need to be fully considered. So how did Credit Suisse (CS) collapse in the first place?
A Look in the Rearview Mirror
In March 2023, a little-known California bank was in distress; it didn’t receive a bailout and quickly folded. Investors were spooked and began searching for the next weak link in the banking industry [1] .They trained their sights on CS, which had been plagued for years by scandals and poor results. Investors expected a drop in the share price; they voted with their feet and shares plummeted. With its stock plummeting, CS entered a vicious circle.
The forced tie-up between UBS and CS has been well publicized and its outcome mostly positive. That being said, the PLB contains three fatal flaws. First, if the PLB is implemented in its current form, systemically-important banks encountering substantial difficulties would not be able to distribute dividends, which would send markets a clear signal that something is wrong. This will drive the share price lower and strengthen the vicious and dangerous circle. Moreover, as dividends are part of the value of a share, not being able (by law) to pay dividends might decrease the market capitalization of the company and, therefore, accelerate the snowball effect.
When Regulators Force a Bank To Halt Dividend Payments
When markets are perfectly efficient, investors “price in” all information available to them; otherwise there is “information asymmetry”. Investors will therefore expect a struggling bank to forego dividend payments. At best, having a law on the books that forces banks to stop paying dividends would be redundant; at worst, it would even be harmful if, for instance, the bank has enough reserves to keep the dividend payments flowing. In this case, a bank that 1) is struggling but 2) has enough reserves to keep paying dividends but can’t because the PLB forces them to halt payments will 3) see its share price plummet as investors walk away.
This is called a “pro-cyclical measure”, i.e. one that reinforces a trend that is already underfoot. What’s more is, Swiss law already stipulates the conditions under which dividends should – and should not – be paid out. Having a lex specialis that overlaps current law could create confusion and excessively limit Swiss banks’ room for maneuver.
Finally, it appears the PLB could unfairly punish shareholders. (Systemically important banks have a huge number of small shareholders, spread over a large geographic area, with little say in management decisions.) And yet, shareholder support is crucial when things go south.
On paper, it sounds fair to prevent these banks from paying dividends to shareholders while they are being propped up by the taxpayer; yet, doing so could have the unintended effect of actually speeding up a bankruptcy.
Sharing the Risk, Spreading the Danger
The PLB’s second weakness is the inherent danger in asking a systematically-important bank to pay a fee based on the risk of failure (see art. 32c of the proposed PLB). According to art. 32c par. 3, the flat, annual fee is based on the potential average long-term loss of the Swiss Confederation (lit. a) and the financial results of each bank (lit. b). Par. 4 lit a, in particular, links the size of the fee to the risk (as per the Basel standards) carried by the bank. The banks are interconnected, which creates a strong incentive for them to collude.
Let’s consider the scenario in which either UBS, the Raiffeisen Group, Zürcher Kantonalbank, or PostFinance (the four systemically-important banks in Switzerland) encounters turbulence. This will also expose the others to higher risk. By definition, a systematic bank is part of a ‘system’. Thus, if one bank’s assets drop in value, then the value of the other banks’ assets will rise. This would automatically increase the size of the fee that the other banks would have to pay.
Instead, they could cooperate privately and bypass the PLB system by snatching up the shares of a peer bank in distress. Note that the shares of other systematic banks are liquid assets that count towards the Liquidity Coverage Ratio (LCR) under the Basel framework. This would be a win-win situation for both the struggling bank in and the supporting peer.
This type of collusion might, however, break antitrust law and exacerbate the keiretsu effect. In other words, the system's interconnectivity and alliances will be reinforced, and so will market concentration. More worrisome, it might result in a domino effect. If one goes down, all try to help, and they all end up drowning. Again, what looks like a common sense solution hides a lupus in fabula (a wolf in sheep’s clothing).
A Tale of Two Compensation Schemes
Thirdly, according to Article 10a of the Banking Act, credit establishments in distress cede control over their remuneration policy to the Swiss Federal Council. But this could make matters worse. Let’s imagine a bank that suddenly finds itself in choppy waters. Who do they want at the helm? The best managers. Would they have accepted to come on board if they knew that, retroactively, they may have to return part of their compensation? Wouldn’t they be tempted to jump ship? Who then would be willing to go work for one of these banks to start with? Probably the most risk-loving managers.
Executives not only invest their money in the company (restricted shares, options, etc.) but also their physical labor; and thus, they are tied to the fate of the company because they can’t diversify this risk (i.e., they can’t work for two banks at the same time) [2].
Top managers receive a salary and, very often, a bonus that is based on performance. The former is how much they are guaranteed to earn on an annual basis; the latter heavily influences the level of risk they are willing to take on (regardless of their level of compensation). Imagine that managers are only paid in stock options. They might end up with a pay of $0 if the stock price doesn’t increase. To drive up the company’s shares, managers are therefore incentivized to take big risks.
Now, imagine the same managers, but the bank gives them a huge salary. With their pockets already well lined, they have no incentive to gamble. On the contrary, the company’s survival and well-being is their number one goal. All else being equal, it is not the size of compensation, but rather the type of compensation that drives the risk cursor of a given company.
A Word of Caution for the PLB
From the three points I’ve made above, I would indeed raise a red flag. Given the financial turmoil seen in the last two decades in Switzerland, it is, indeed, high time for reform. However, the change in legislation is an attempt to make common sense adjustments and provide political answers to financial questions. It does not include an economic analysis of the law à la Posner, which would show that seemingly reasonable measures can actually be counterproductive; what seems fair can be detrimental; what aims to help actually hinders; and what seems to be the right punishment for certain people actually punishes others. The PLB runs the risk of missing the mark and should be adjusted to reflect a more economics-oriented point of view.
References
[1] Bianchi, par. All eyes now on Credit Suisse collapse.
[2] Hall/Murphy,p. 8.
