On Friday, the Swiss government led the much-anticipated reforms into the country’s bank capital rules, with the Centerpiece proposal affecting only one company, UBS.
Swiss Federal Council and financial regulators have been at Loggerheads alongside the country’s biggest lender and most systematically important companies since proposing to strengthen the country’s banking system in the wake of the end of Credit Switzerland.
Uncertainty has put a strain on UBS stock prices, with stock prices falling by 3% over the past year, but the Euro Stoxx Banks index, which tracks the biggest lender in the eurozone, has risen by around 40%.
Friday’s bill sets a series of measures as part of “too many” packages. Most importantly, their suggestions on how much losses UBS will absorb.
The establishment of Swiss political and regulatory authorities proposes that banks with foreign subsidiaries will be subject to additional capital demands ©Fabrice Coffrini/AFP/Getty Images
Bank executives believe they have been punished for mismanagement of Credit Switzerland, including regulators, and rescue by UBS in the years before the collapse.
In 2017, FINMA recognized the Credit Suisse Capital Relief. This allowed banks to inflate the value of their foreign subsidiary. Last year, Swiss lawmakers criticized Finma for the move, calling it “unable.”
Despite extensive public and private lobbying campaigns by UBS leadership, senior bankers will step down from proposing what is considered to be the most “extreme” option to the government. It forces foreign subsidiaries to be fully capitalized.
However, the way governments impose additional capital requirements on UBS, as well as the details surrounding the implementation timeline, are important for the severity of impact on banks.
What are the potential rules changes?
At the heart of the standoff between UBS and Swiss political and regulatory facilities is the proposal that banks with foreign subsidiaries will be subject to additional capital demands to deal with future crises.
Authorities have argued that the balance sheet is now larger than the Swiss economy, given the size of the total bank since the acquisition of Credit Switzerland.
Currently, UBS needs to match 60% of its capital with the capital of its international subsidiary, such as the US and the UK, with Parent Bank’s capital. According to the company and analysts, lenders matching their overall capital in these units would increase that requirement by about $25 billion.
“The Federal Council sees a rapid decline in value of foreign subsidiaries as problems during the crisis.
In 2017, FINMA granted the Credit Suisse Capital Relief.
The Federal Council can request that foreign subsidiaries be deducted entirely from equity or to request UBS to boost capital by increasing risk-weighting.
Regulators determine how much risk-weighted assets are needed, or how much capital is needed to support RWA.
Under the current regime, UBS’s foreign subsidiaries are risk-weighted by 2028 at 400%. The Federal Council could increase it to about 600% if the UBS parent company wanted to perfectly match the capital of its foreign subsidiary.
How a risk-emphasis approach works
Assuming UBS has a ratio requirement of 16.7% of “concern” capital for risk-weighted assets, as laid out by Morgan Stanley analysts last year.
If a foreign subsidiary is risk-weighted at 400%, it means 67% capital participation by UBS parents (400% x 16.7% = 67%).
If a foreign subsidiary is risk-weighted at 600%, the parent will perfectly match the capital of the foreign subsidiary (600% x 16.7% = 100%).
Aurora Miott said the risk-weighted approach “reduces a lower impact” for UBS, while the capital deduction approach (which is considered a more likely outcome) is “more punishable.”
RBC analysts, including Anke Reingen, co-head of Global Financials Research, said their “basic incident” would require UBS to make a “full (capital) deduction,” adding “every billion dollars of additional capital will have a 1% hit on (UBS) (UBS).”.
Do they affect UBS’s competitiveness?
If UBS is forced to fully capitalize a foreign subsidiary, the bank’s calculations will increase the bank’s core equity 1 ratio (an important measure of capital strength) from 17% to 19%.
Other globally important banks such as HSBC, Deutsche Bank and Morgan Stanley have CET1 requirements of 11.1%, 11.3% and 13.5% respectively.
Analysts at Goldman Sachs said the proposed increase in UBS’s CET1 ratio “significantly undermines its competitiveness against its large international peers.”
This is the point that senior UBS executives, including CEO Sergio Hermotti and Chairman Colm Kelleher, have been struggling with stress over the past few months.
“We are not magicians,” Elmotti said in April. “We cannot be competitive if our regulatory framework is not competitive, we can’t be competitive, provide an engine of growth and become an engine of growth.”
Apart from the expected reforms, UBS has already added around $200 billion to its capital due to the early implementation of Swiss global rules and the increase in size after credit swiss takeover.
As a result, it is speculated that UBS may need to offload some of its international business.
“Depending on the amount of additional capital required, some companies could become uneconomical for UBS, which could lead to strategic decisions for the bank, such as the possibility of selling US operations,” said Auroramiot of Morgan Stanley.
Such a move would hit Ermotti and Kelleher’s ambitions to turn UBS into a European version of Morgan Stanley. UBS identifies US growth, particularly in wealth management, as a key strategic prioritization.
How can UBS reduce higher capital requirements?
The Federal Council will announce on Friday whether capital reform will be implemented through government ordinances (effectively via executive orders).
The latter option gives UBS the ability to lobby politicians to remove water from the new administration as the bill is amended, but also extends the uncertainty facing banks. Industry observers estimate that the proposed law may not be in effect until 2028 or 2029.
There is also the question of how long UB will be given once the new capital regime is complete. Analysts at Morgan Stanley said, “All things under ten years will be negative, while longer timelines are taken actively by the market.”
UBS has a larger balance sheet than the Swiss economy since its acquisition of Credit Switzerland ©Fabrice Coffrini/AFP/Getty Images
The RBC estimated that it would provide $4 billion in capital for each additional stage, based on analysts’ forecasts for banks’ free cash flows from 2030.
Jérôme Legras, managing partner at Axiom Alternative Investments, said that the way UBS can mitigate the impact of higher capital requirements is to bring excess capital back from its subsidiary to its parent bank.
For example, if one international subsidiary had $13 billion in capital, but a local supervisor only needed $1 billion, UBS said it could repatriate $3 billion. Such a move will require approval from local supervisors, but Legras said it is likely that UBS will request the minimum amount required for each subsidiary.
The government is also expected to release proposals to improve the quality of capital on Friday, changing the treatment of assets that are not fully recovered in the crisis, such as internal software costs and deferred tax assets (DTAs). RBC estimates that these adjustments could take up to 2% points from UBS’s CET1 ratio.
How do bank stocks respond?
According to analysts at Morgan Stanley, the announcement on Friday is a “significant risk event” for UBS stock prices. They placed the potential size of the day’s stock movement at 5% (up and down).
After more than a year of uncertainty, UBS is somewhat clear about the size of the regulatory challenges it faces, even if the centrepiece proposal is likely to be unwelcome to banks.
Additional Reports by Mercedes Ruell of Zurich
