Business

Swiss medicine could be painful for UK banks

BBC business editor Robert Peston on higher capital requirements for banks

There are weighty and potentially painful implications for British banks from a report of a commission of experts set up by the Swiss Federal Council on how to limit the risks to the Swiss economy of banks that are so big that they can't be allowed to fail.

In the case of Switzerland, the relevant mega banks - or too-big-to-fail banks - are UBS and Credit Suisse.

The report matters to the UK for a number of reasons.

First, George Osborne's banking commission is looking at the same issue.

Second, the UK's Financial Services Authority and Bank of England have been on the same side as the Swiss Authorities in battling for the imposition of higher capital ratios for banks - as a protection against losses - in negotiations on the Basel Committee. There is considerable mutual respect and empathy between UK and Swiss regulators.

Or to put it in more concrete terms, like the Swiss, the FSA is determined to impose significantly higher capital requirements than the new Basel minimum on the UK's biggest banks.

What would be the implications of the adoption of the Swiss approach in the UK?

Well the likes of Barclays, Royal Bank of Scotland, HSBC and Lloyds might think that would be good news, in that the Swiss have opted against breaking up their two giant banks.

But I am not sure that's quite right, because what the Swiss authorities are implementing may massively increase the costs of doing business for their banks - and presumably the banks themselves will have to swallow some of that cost increase, rather than passing it on to customers in the form of higher fees and interest rates.

What is most striking is the calibration of the capital that UBS and Credit Suisse would have to hold.

There would be the absolute minimum of equity equivalent to 4.5% of risk-weighted assets, as per the new so-called Basel III minimum.

Then there would be a buffer of a further 8.5%, much bigger than the Basel III 2.5% buffer.

That 8.5% would consist of 5.5% common equity and up to 3% in so-called contingent convertible bonds, or CoCos. The investors in these bonds would see the bonds automatically converted into equity at the moment that the ratio of the banks' equity to risk-weighted assets were to drop below 7%.

And here's what may particularly alarm the UK's big banks: the Swiss banks are being obliged to hold CoCos equivalent to a further 6% of assets simply because they are big, in what the commission calls a "progressive component" in the capital requirement.

The relevant statistics of their bigness is that both UBS and Credit Suisse have total assets of around CHF1.5 trillion (£977bn) and a share of the relevant Swiss markets of around 20%.

The commission says that UBS and Credit Suisse would have to hold even more capital if their balance sheets and respective market shares were to increase further - and they would be rewarded with a decline in the progressive component of the capital requirement if they were to shrink.

So what are the potential implications for Britain's big banks?

Well none of them hold equity and CoCos even close to 19% of assets - and only Lloyds has any CoCos at all.

So if the FSA were to adopt more-or-less the same capital approach as the Swiss, British banks would have to raise something of the order £200bn of new capital in the form of equity and CoCos. Which is a colossal sum.

Here's the thing. It's not clear that insurers, pension funds, hedge funds and the like have £200bn going spare that they would want to provide as risk capital to banks.

What's more, if the FSA were adopting the most prudent approach, it would discourage UK insurers and pension funds from buying this stuff and hope it was sold overseas, so as to insulate the UK financial system and economy from a UK banking implosion. But it would not be at all easy to persuade overseas investors to put £200bn into British banks.

As for the biggest investor in RBS and Lloyds, which is the British government on behalf of British taxpayers, I'm not sure the chancellor would want to inject a further £70bn odd into RBS and Lloyds at a time when money is tight.

Here's where the Swiss remedy could be particularly painful for British banks: there's an argument that the UK's too-big-to-fail institutions should hold even more capital than Swiss ones.

First, the gross assets of RBS, Barclays and HSBC are each between 50% and 60% greater in absolute terms than their Swiss rivals: their respective gross assets are all between £1.5tn and £1.6tn. Or to put it another way, they all have balance sheets significantly greater than the value of UK GDP.

As it happens, Credit Suisse and UBS are bigger relative to Swiss GDP than individual British banks. But that relative size disparity does not mean that rescuing an RBS or a Barclays would be significantly simpler and less dangerous for the British economy than rescuing a UBS is for Switzerland.

Second, Lloyds' market share in the UK - 30% of current accounts, 24% of mortgages, 23% of services to small businesses - would imply on the Swiss model that it should hold quite a lot of additional CoCos.

Nor is that the only pain being inflicted on Swiss banks. The commission say it is imperative that they put in place arrangements to ensure that in a crisis they can be "resolved" or broken up in a way that minimises the likelihood than any taxpayer funds will have to be injected into them - which, as I've pointed out before, will probably mean that it becomes more expensive for the banks to borrow (another increase in their cost of doing business).

What I'm driving at, in a meandering way, is that the management of Barclays, RBS, Lloyds and HSBC may be deluding themselves that a forcible break-up of their banks is the worst that could possibly happen to them - and that they've got to prevent such a dismantling at all costs.

The Swiss model of sanitizing mega banks, making them safe, would - for a transition period that could last many years - massively reduce the returns for shareholders and the remuneration of bankers.

In those circumstances, it might be rational for mega banks to voluntary break themselves up and shrink, to ward off the burden of additional capital requirements.

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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