Swiss banks UBS AG (UBSN) and Credit Suisse Group AG (CSGN) are among the safest in Europe, according to the measures regulators watch most closely. Therein lies a lesson in how easily we can be deluded into believing banks are secure. Switzerland has made laudable efforts to reduce the systemic threat that comes from having a tiny economy and being home to two of the world’s 30 largest banks, as Bloomberg Markets reports in its latest issue. The country has instituted limits on leverage, and pushed UBS and Credit Suisse to boost their Tier 1 capital — regulators’ preferred measure of financial soundness — to 20.2 percent and 18.5 percent of risk- weighted assets, respectively. That’s much higher than any of their European peers.A Tier 1 capital ratio, however, doesn’t provide a complete picture. Consider, for example, simple equity. Like the down payment a mortgage borrower makes on a house, it represents the money a bank’s shareholders put into the enterprise. The ratio of tangible equity to tangible assets at UBS stood at 3.4 percent as of Sept. 30, according to data compiled by Bloomberg. That’s up from 1.3 percent on Sept. 30, 2007, but still means that a 3.4 percent decline in the value of UBS’s tangible assets — similar to what occurred in the last crisis — could be enough to render the bank insolvent. The ratio at Credit Suisse (under U.S. accounting standards, not directly comparable to UBS) was 2.6 percent, up only slightly from 2.3 percent on Sept. 30, 2007.
Risk Weights: Why the difference? The Tier 1 measure allows banks to boost their capital ratios in two ways: by placing lower weights on assets they consider less risky and by counting as capital things other than shareholders’ equity. Credit Suisse has increased its Tier 1 capital by issuing so-called CoCo bonds, which can convert into equity in an emergency, a feature that some economists think might actually make the financial system more vulnerable to panic. UBS focused more on retaining earnings and cut deeper into risk-weighted assets. The banks’ moves demonstrate how regulations can create bad incentives. To the extent that the rules encourage banks to employ unnecessarily complicated capital instruments, or to avoid reasonable risks, they do a disservice to the economy. We want banks to take on risk, and we want their shareholders — rather than taxpayers — to be responsible for the outcome. The equity shareholders provide is not a rainy-day fund. It is the bedrock capital that gives banks the power to lend and the strength to survive their managers’ mistakes. As regulators struggle to put into place the latest iteration of global bank rules — known as Basel III — they should consider setting much higher requirements for equity. The banking system and the broader economy would be better off if they did.
