naked capitalism

Switzerland has taken the sensible move of recognizing that it cannot credibly backstop banks whose assets are more than eight times the country’s GDP. It is in the process of imposing much tougher capital requirements, expected to be nearly 20% of risk-weighted assets, well above the Basel III level of 7%.

UBS apparently plans to partition the bank in a Glass-Steagall lite split, leaving the traditional banking operations in Switzerland and putting the investment bank in a separate legal entity outside Switzerland. This resembles the approach advocated in the preliminary draft of the UK’s Independent Banking Commission report, of having retail banking and commercial banking separately capitalized.

The problem is that the devil lies in the details. Regulators need to be scrupulous that there is no lending or guarantees between the two units, or even cross promotion which may create liability. Recall that auction rate securities, a capital markets product, were sold as an alternative to money market funds. Regulators would need to bar this type of cross marketing if they were serious about separating the entities from a risk assumption standpoint. And if they really were THAT separate, why are they under the same roof? Managerially, it’s hard to manage such disparate businesses, particularly if you end the offsetting benefit of cheaper funding (well, there is one reason they will probably keep the companies combined: executive level pay in banking is very highly correlated with the size of the balance sheet).

The Wall Street Journal questions whether this finesse will work:

Under UBS’s planned overhaul, the investment bank would be transformed into its own legal entity, according to the people familiar with the matter. Swiss regulators hope that the change would mean that if the investment bank encountered problems, the parent company, which also includes a large wealth management arm, would no longer be liable for the losses. Right now, the bank’s units abroad have less capital than they otherwise would need because UBS has agreed to serve as a financial backstop, promising to bail them out if they ran into trouble, these people said.

However, it is unclear whether creating a legally and financially independent investment-banking vehicle will truly insulate the UBS parent company—or the Swiss government—in the event of another disastrous crisis. Local regulators could still demand that the Swiss government step in to cover any future losses at the investment bank….They haven’t decided where to locate the investment-banking entity or how to structure it.

Yves here. I recall well when Swiss Bank Corporation (the company that was dominant in the SBC-UBS merger despite the survival of the UBS name) decided to transform itself into a major capital markets player by investing in and later acquiring a client of mine, the cutting edge derivatives firm O’Connor & Associates. O’Connor had decided it needed access to a much bigger balance sheet in order to remain competitive. The European universal banks have tremendous funding cost advantages; US players in the 1990s would often contend that they needed to have a similar degree of integration to hold their ground. So query whether this arrangement will be economically viable continued cross subsidies between the two entities that vitiate the structural separation.

And of course, let us look at the intent. Whether or not the UBS scheme works, the objective is to move the risk of the investment banking operations to somewhere outside Switzerland. All the US investment banks needed to be rescued in the crisis (spare me the “Goldman was sound” palaver. And pretty much no one save a few loyal defenders of the Administration believes that the Dodd Frank Title II resolution authority will work for a meaningful capital markets firm. If you had told most financial professionals in 2006 that a crippled investment bank would be rescued by the government, they would have told you you were nuts. We now know better. So why should the US (or the UK) voluntarily take on risky operations that they may have to backstop? (One could cynically say this is a moot issue, given that the Fed lent money generously to foreign banks in the crisis).

The WSJ article voices some similar doubts:

Part of that calculus appears to hinge on where the investment bank would enjoy the greatest latitude to operate, although Swiss regulators want the unit headquartered in a country where the investment bank has major operations…

Under its current setup, the Swiss parent company has agreed to serve as a financial backstop for the world-wide operations of UBS’s investment bank if they encounter problems. As a result of those guarantees, local regulators in various countries permit the units to operate with thinner capital cushions than they would otherwise need to maintain.

Better insulating UBS’s investment bank from other operations could make it difficult, or at least costlier, for its bankers to use the company’s vast balance sheet to win deals, according to people familiar with the matter. Currently, the investment bank is able to use the heft of the balance sheet of the entire firm to borrow against to participate in deals. That financing capability would be reduced if the investment bank was isolated from the rest of the company and its balance sheet was smaller.

The UBS CEO complained that the Swiss rules will increase their cost of doing business. That is a feature, not a bug. Effective insurance is not free.