It Is Time to Admit It: Bank Regulation Doesn’t Quite Work

The Swiss government this month backed a parliamentary inquiry—the fifth in the country’s history—to examine the bank’s sale to its main rival UBS, scheduled to close as soon as next Monday. The merger was hurriedly brokered by officials during the third weekend of March, on the premise that a massive deposit flight could otherwise have toppled Credit Suisse the following week.

The inquiry may have far-reaching consequences. After the 2008 crash, global regulators embraced the so-called Basel III framework to curb lenders’ risk. In the U.S., rules were softened for regional banks under the Trump administration, but loopholes are now set to be closed. Also, regulators could raise capital requirements on big U.S. banks by about 20%.

But if Credit Suisse was on the brink of collapse despite exceeding all regulatory targets, what is the point of them?

Basel III was supposed to turn highflying banks into “boring" investments. A higher cost of capital meant lower profitability, but a negligible risk of failure also meant lower risk. The idea was for bank shares to become steady income payers, almost like those of public utilities.

Yet, though the return on equity of developed-world banks has fallen to a utility-like 10%, from around 15% in the mid-2000s, the bank sector almost matches technology for volatility. That suggests investors are taking on quite a lot of risk.

Credit Suisse makes the point. A few days before officials intervened, executives claimed it had a liquidity coverage ratio—high-quality assets that can be sold to cover 30 days of outflows—of 150%, far above the regulatory minimum of 100%. Documents disclosed to investors have shown that the Swiss National Bank provided it with two rounds of emergency liquidity totaling 70 billion Swiss francs, or about $77 billion.

Even if fleeing depositors had eaten up this entire buffer in less than a week, Credit Suisse could theoretically have sold assets and absorbed losses. Its key capital ratio was 14.1% at the end of last year, one of the highest among top banks, after it sold about $4.3 billion of stock in November.

Spain’s Banco Popular also complied with liquidity and capital ratios right before officials invoked resolution powers and sold it to Banco Santander for 1 euro in 2017.

In both cases, Additional Tier 1 or AT1 bonds were wiped out, though Credit Suisse stands out because equity holders didn’t also lose everything. AT1s were set up by European authorities after 2008 to automatically “bail in" lenders whenever capital fell below regulatory levels, allowing them to carry on. Instead, they have become a way to clean up the books of compliant banks after officials have already decided to pawn them off, even if their problems had to do with liquidity and not capital. This is now the central argument of a big lawsuit, coordinated by law firm Quinn Emanuel Urquhart & Sullivan, that bondholders are launching against Swiss regulators.

It is time to say that Basel III just doesn’t work as intended.

Perhaps even big financial cushions can’t stop a destructive panic once a bank has tarnished its own reputation beyond repair. Worse, every time regulatory ratios are raised, they become the new threshold under which fear is warranted. Banks have voluntarily stayed far above their required individual targets, in turn set higher than the Basel III ratios.

The other possibility is that Credit Suisse and Banco Popular could have kept limping along, but officials considered that option too great a threat to financial stability. If so, they may never allow Basel III safeguards to fully play out. While the banks were unprofitable after years of bad decisions, they weren’t yet insolvent.

The global banking system is much safer than it was a decade and a half ago, but the arbitrariness of regulatory interventions gives investors another reason to stay away, despite low valuations. European bank stocks are still trading below book value, but the problem is clearest in the $250 billion AT1 market. The net value of the assets in the Invesco AT1 Capital Bond ETF is down 10% versus three months ago.

Experts in Switzerland and abroad are now studying whether Basel III needs amending. It could be argued that regulatory ratios should be increased, or conversely that they should be lowered and governments given even wider legal discretion to act. Liquidity coverage ratios need fine-tuning to better reflect the dangers of a flighty deposit base. Maybe all deposits should be insured.

What is clear is that, as things stand now, investors can’t trust the metrics designed to show banks’ financial health. And that is a systemic problem.