Perspective on Risk - Jan. 15, 2023 - Swiss Disagreements

Reuters May Be The Most Honest; FINMA Report; SNB Puts Out Their Own Report; Increased Swiss Supervision; More Aggressive FDIC Approach?

Recently, both FINMA and the Swiss National Bank released their respective reports on the failure and resolution of Credit Suisse. Both papers are written with a bias towards justifying their actions during the crisis, and IMO the FINMA report is a bit more candid.

• FINMA publishes report and lessons learned from the Credit Suisse crisis

• The role of the SNB as lender of last resort

In addition, Reuters published a fairly scathing take on the resolution.

• How Swiss authorities bungled Credit Suisse oversight

I’ve been thinking about this for a bit, prompted in large part by some of the comments on the CS resolution that was made at the Systemic Risk Advisory Committee (that I covered in Perspective on Risk - Dec. 19, 2023 (Systemic Risk)); it particular those of Dick Herring and Sheila Bair.

In that discussion, the consensus is that CS was essentially a failed business model.

Reuters May Be The Most Honest

Before I get to the FINMA and SNB reports, John O'Donnell, Stefania Spezzati and Elisa Martinuzzi of Reuters, who have covered the intervention quite well, published a summary argument How Swiss authorities bungled Credit Suisse oversight. It’s good to start with their take.

About six months before Credit Suisse was sold to rival UBS in a weekend rescue, the head of the Swiss central bank wanted to inject 50 billion Swiss francs ($57.6 billion) into the lender and nationalise it, according to three sources with direct knowledge of the matter. … Nationalising the bank would have allowed regulators to install new managers who could restore confidence, one person with knowledge of the matter said.

But Switzerland's financial regulator FINMA and the finance ministry opposed the idea, as did Credit Suisse's management, the sources said. Unable to agree, Swiss authorities decided the best solution was to let the company find its own way, the three sources added.

"Many people here feel that it would've been much better if policymakers had acted much earlier," said Stefan Gerlach, chief economist of Switzerland's EFG Bank and former deputy governor of Ireland's central bank. "One element common to many financial crashes is that politicians are often too quick to accept the views of the largest banks."

FINMA's powers as a financial regulator are among the weakest in the Western world, lacking some basic tools such as the ability to fine banks, something the agency unsuccessfully lobbied the government from 2021 to change.

That year FINMA went to the Swiss finance ministry, making the case for additional powers as well as the creation of a financial liquidity backstop like the United States and some other jurisdictions have, according to a former Swiss official. A liquidity backstop is a financing facility that banks can tap in an emergency, allowing the central bank to act as the lender of last resort.

Nationalization was not directly covered in either of the reports.

The FINMA Report

In reading the FINMA report, it is clear that too much supervisory forbearance was given to Credit Suisse. Credit Suisse should have been aggressively dismantled or resolved a decade ago. The evidence was there, but the supervisors did not seem to believe they could have taken more aggressive actions.

Credit Suisse’s US money-laundering issues (and similar issues in numerous other countries) could/should have resulted in a material change to the firm as early as 2012, and certainly by 2018 when the firm had similar issues associated with politically-exposed persons.

FINMA’s investigations and procedures in relation to cross-border transactions at various banks increased in the early 2010s. These also included investigations of CS’s transactions with clients in the USA, in Germany and Italy. FINMA concluded its enforcement proceedings against CS in connection with the cross-border US financial services business in 2012. CS was found to have seriously violated the requirements of its licence in terms of ensuring an adequate organisation and proper business conduct, following which the bank ended its relationship with certain US clients, and those responsible for the US country desk were discharged of their duties. CS was also required to implement an adequate compliance, risk management, and risk control system for its cross-border business.

In autumn 2018, FINMA concluded investigations in connection with the Petrobras, PDVSA and FIFA affairs as well as in respect of CS’s significant relationship to a politically exposed person. FINMA established that CS’s risk management and – in particular – its anti-money laundering processes were not suited to adequately identifying, limiting, and monitoring the inherent risks generated with such a high level of risk appetite.

Rather than breaking up the firm, or mandating more significant changes, the Swiss FINMA did what regulators due - they gave the firm and its Board a chance to remediate the problems while simultaneously stepping up its supervisory program.

FINMA warned CS of the risks in no uncertain terms and called for improvements and measures. Between 2018 and 2022, FINMA also conducted 108 on-site supervisory reviews at CS and recorded 382 items requiring action. Of these, 113 were classified as high-risk or critical.

And the firm’s strategy on its face seemed reasonable: shrink the investment bank, improve internal controls, and raise capital and liquidity levels. But this didn’t work.

The repeated attempts by CS over the years to reduce the size of the investment bank in order to generate more stable returns were incomplete, insufficiently effective, and ultimately unable to impress the markets and clients.

Over the years, CS was unable to implement the measures requested by FINMA to reinforce the internal control system and risk management in a timely, effective, and sustainable manner. It took numerous measures to rectify the weaknesses, although these often did not go far enough.

FINMA exhausted the tools available to it to influence the bank (on-site supervisory reviews, assessment letters, investigations, ad hoc measures, enforcement proceedings, and restrictions on business activities)

FINMA recognizes that its efforts were insufficient:

FINMA repeatedly imposed measures on CS to reinforce its control environment and incentives system, and always responded immediately to serious shortcomings and incidents. It ordered further targeted measures that increased in severity over time, and exhausted the tools available to it to influence the bank (on-site supervisory reviews, assessment letters, investigations, ad hoc measures, enforcement proceedings, and restrictions on business activities). However, new shortcomings continually emerged in other areas involving various issues and occurring in different regions.

In retrospect, FINMA acknowledges that CS’s governance was inadequate, and that its ‘moral suasion’ ability didn’t work.¹

CS’s corporate governance was deficient in several respects: Responsibilities were not clearly defined and were often not enforced. The flawed management culture and the weak “tone from the top” over a longer period of time led to a poor risk culture. This was also characterised by deficiencies in the area of conflicts of interests and a lack of transparency towards FINMA. Over the years, the governing bodies of CS were unable to remedy the repeatedly identified shortcomings in the bank’s organisation in a sustainable way.

FINMA raised the absence of an adequate risk and corporate culture and the business divisions’ lack of responsibility for their actions with CS’s Board of Directors, and ordered measures to improve the situation.

Despite these interventions, it was not possible to make a sufficient impact. A Senior Managers Regime or statement of responsibilities, powers to impose fines, and the ability to regularly publish enforcement proceedings would all be ways of increasing the impact of supervision in the area of corporate governance in the future

So, much of this is easy to see with hindsight, but think through how it appeared in real-time to the supervisors. Yes there were problems, but the bank has shown you a plan to fix the situation. Tidjane Thiam had only been appointed CEO a year or two before, replacing Brady Dugan under whose watch the initial problems had occurred. He was pledging to do what the supervisors wanted, downsize the investment bank and clean up asset management. Euromoney recognized Thiam as the Banker of the Year in 2018. He had yet to be caught spying on subordinates.

Clearly, replacing Dugan with Thiam did not improve the culture or the “tone from the top,” but in 2018, you did not know this, and perhaps had hope he would turn it around. Besides, this was one of your countries flagship firms.

CS was always known for an aggressive culture. The Flaming Ferraris, money laundering and client tax evasion conspiracies in the US, Italy, Singapore’s 1MDB scandal, Germany, Brazil, Venezuela, and other countries (including Bulgarian drug running), Archegos, Greensill. The FINMA report comments on culture:

Although the CS remuneration scheme included the consideration of risk behaviour on paper, in practice the assumption of high risks and/or misconduct (risk-adjusted performance) had very little effect on remuneration.

The high variable remuneration in loss-making years, the sometimes inadequate influence of misconduct and risk behaviour on individual remuneration, and the exclusion of what the bank deemed to be extraordinary events when setting the variable remuneration encouraged an inappropriate risk culture over the past decade.

As an aside, its interesting to me to see when a rotten culture has spread. Usually the firm, its management and the regulators figure that there are one or two bad apples. But sometimes it is much broader. I saw this at Bankers Trust. BT was highly aggressive, in some ways dismissive of examiners, and certainly full of hubris. The initial problems were identified in the investment bank; the marketers were ripping off their customers by creating highly complex derivatives, “hiding the leverage” and providing misleading disclosures. The traders were similarly ripping off the marketers by quoting off-market rates. After these problems, other problems were subsequently discovered in other areas; they were allocating trades inappropriately in their asset management business. Businesses were maintaining “slush funds” hidden from finance. Credit Suisse has distinct echoes of what I saw at BT.

Back to CS. FINMA used its tools, and these seem to have limited the risk to the Swiss sovereign from a Credit Suisse failure.

Based on its loss potential analysis (LPA), FINMA identified increased risks from the business model at CS and imposed additional capital charges on the bank.

As a result of the market upheavals during the Covid-19 pandemic, FINMA imposed higher supervisory requirements on CS in terms of its liquidity holdings. Thanks to the corresponding liquidity risk management measures, CS had built up a comfortable liquidity buffer by summer 2022 that was able to cushion the first major wave of client deposit outflows in October 2022.

Legislation partially tied FINMA’s hands.

Upon the entry into force of the “too big to fail” (TBTF) regime, the legislation provided for lower requirements applying for the parent bank under certain circumstances than for the Group as a whole. FINMA was obliged to grant relaxations to this legal entity. FINMA advocated the abolition of these provisions.

In some ways, the extended resolution of CS may be beneficial. There were “lessons learned” by the supervisors with regard to recovery and resolution planning.

It became apparent in the specific course of the crisis at CS that not all stabilisation measures could be implemented promptly as envisaged by the recovery plan.

FINMA has discretionary powers when assessing the recovery plans of systemically important banks. In future, the focus will be increasingly on the feasibility of the planned measures.

The resolution plan pursuant to the TBTF rules played a decisive role in finding a solution. On the one hand, it provided the responsible authorities with a choice when the situation of CS deteriorated massively within an extremely short time. On the other hand, it can be assumed that the prepared restructuring ruling and the measures provided for therein (the integral write-off of the share capital of all shareholders and the claims of all AT1 bond holders, the conversion of bail-in bonds into shares, the replacement of the Chair of the Board of Directors, the engagement of a restructuring agent, and the liquidity support from the SNB and the federal government) were a strong incentive for the bank.

The resolution planning of systemically important banks focuses strongly on scenarios in which a crisis impacts primarily on the bank’s capital (loss absorption). The massive liquidity outflows in autumn 2022 called on FINMA to develop the available options further.

FINMA started preparing for a specific restructuring in good time and closely involved the national and international authorities.

The close collaboration with the partner authorities within the CS Crisis Management Group (CMG) before and during the crisis strengthened confidence in the operational feasibility of the restructuring on and as of 19 March 2023 if this were to be implemented.

Again, though, there is a “tell” here - resolution activity is not taken until the crisis begins. If the market doesn’t object, the supervisors will allow a damaged firm to drag along for a long time.

The Swiss National Bank Puts Out Their Own Report

In The role of the SNB as lender of last resort, the SNB seeks to make three points to absolve themselves:

1. The National Bank may only provide liquidity against collateral

2. The National Bank is not overly conservative when it comes to accepting collateral

3. The National Bank has shown no restraint in providing liquidity to Credit Suisse

So as stated in the Reuter’s article, a formal liquidity backstop did not exist. This is part of the reason that I think Bagehot needs rethinking (see Perspective on Risk - May 19, 2023 - Bagehot Is Out Of Date)

The first point is the SNB saying they are constrained by the law. But they did manage to pass an emergency law that allowed them to fund CS!

On point #2, as in the US, they blame the lack of preparation by CS in positioning collateral. If true, this is a huge failure in preparation by the supervisors and indicates inadequate coordination within Switzerland.

Point #3 is clearly just “don’t blame us - we didn’t cause the problems.”

Increased Swiss Supervision

As is typical, supervisors react strongly to past lapses. Julius Baer Probed by Regulator Finma Over Signa Risk Lapses (Bloomberg)

Switzerland’s financial regulator is investigating Julius Baer Group Ltd over inadequate risk-control structures that contributed to the bank’s exposure to bankrupt property mogul Rene Benko.

Finma is looking into the reporting lines of the bankers responsible for structuring loans for private clients such as Benko, which lead to the same person as the teams managing credit risk, the people said. Both units are ultimately overseen by Chief Financial Officer Evie Kostakis, while a typical setup would see the risk team report into the chief risk officer, they said.

This next line is a classic:

Within the bank there’s recognition that no individuals will shoulder the blame for the situation given the loans to Benko passed through three separate risk committees, a person familiar with the matter said.

More Aggressive FDIC Approach

Not a systemically important bank, but perhaps the US is starting to be more aggressive in resolving problems earlier: FDIC's unusual order against tiny Utah bank: Sell yourself or liquidate (American Banker). Kudos to the FDIC.

Federal regulators are forcing a tiny bank in Utah to either sell itself or liquidate, an unusual step that appears to be a last-ditch effort to avoid placing it into receivership.

The order from the Federal Deposit Insurance Corp., which the agency made public last week, is similar to the sell-or-merge directives that regulators used after the 2008 financial crash to force troubled banks to take action, industry lawyers say.

Most surprising was the public nature of the FDIC's repudiation, an escalation from what likely was behind-the-scenes pressure from agency officials, the experts said.

1. In some ways, the Swiss regime is much tougher that that seen in the US.

FINMA is responsible for verifying that the requirements for irreproachable business conduct are met. The banking licence and the associated fitness and propriety assessment constitute a “police authorisation”, i.e. if the licensing requirements are met and there are no indications to the contrary, the bank is entitled to be granted a licence by FINMA. Any shortcomings in the exercise of their functions by the members of the Board of Directors and Executive Board, particularly with regard to an appropriate risk and corporate culture, can only be identified after taking office. Despite the major hurdles to later interventions, FINMA raised these shortcomings with CS’s Board of Directors, ordered measures, and started enforcement proceedings against the bank’s top managers.