How does a bank work? A bank accepts deposits and lends the funds to others. Shareholders put up equity capital in the expectation of a good return. Savers deposit their money in savings accounts, insurance companies, and pension funds buy bonds issued by the bank. Now the bank can grant mortgages and corporate loans. Investments like these, plus equity holdings and cash reserves, constitute the asset side.
Losses, Crash and Insolvency
Normally the bank earns money and the asset side grows, and so does shareholders' equity. But if the bank incurs losses, shareholders' equity falls. It doesn't come to a crash until the losses incurred are so great that the shareholders' equity is all used up. Now the money owed to customers is no longer covered, the bank's liabilities exceed its assets, and the outcome is insolvency.
Run on The Bank
Insolvency proceedings can take years, and they often have dramatic consequences. In many cases the bank must go out of business. And the value of its assets can suffer further catastrophic losses because customers have lost all confidence. In a situation like that, depositors may even panic and make a run on the bank. That's what happened to Thun Savings and Loan when it went under in 1991.
A Gigantic Real Estate Bubble
In the years leading up to 2007 a gigantic real estate bubble formed in the US. Many major banks, UBS among them, invested in it. In 2008, the bubble burst, and the banks were in trouble. Because there were fears for the entire financial system, the most important banks - UBS among them - were rescued. It was ?too big to fail.? While Switzerland didn't actually lose any money, the Swiss people never want to feel they are being forced into such a rescue operation again.
A Four-Phase Concept
How can something like this be prevented from happening again? This was the idea behind the development of the four-phase concept. It specifies measures at every stage of the escalation to handle current operations, crisis management, reconstruction, and in the worst case liquidation.On the one hand, the balance sheet is repeatedly strengthened, while on the other special action is taken to protect systemically important functions such as payment transactions.
First Phase: Current Operations
In the first phase business functions normally, but even at this stage preparations for a crisis are underway. First, the share capital is increased significantly to a level that exceeds the international standard - referred to as a 'Swiss finish.' This is a way of heading off major losses. A second measure is the issue of what are called CoCos. These are bonds that under certain conditions are converted into shares. They function like a reserve tank. The big banks are required to hold two such reserve tanks.
Second Phase: Crisis Management
In the event of a major loss that - as in the last crisis - threatens the bank, we enter the crisis management phase. Now the first tranche of CoCos is converted into shares, creating new equity capital. The bank and its systemically important functions remain protected. Instead of taxpayer money, the capital in the CoCos is used for this purpose. When the bank recovers, this benefits the former CoCo holders - who are now shareholders. If losses continue to mount, however, they are borne by the shareholders ? who now include the former CoCo holders.
Third Phase: Reconstruction
Theoretically, losses can be so great that even the capital from the first tranche of CoCos is insufficient. This has never happened yet. We now enter the restructuring phase, when the second and last tranche of CoCos is converted into shares. The regulatory authority intervenes, replaces the bank's management, and restructures it without recourse to taxpayers' money.The conversion of the two CoCos deprives the original shareholders of the bulk of their claims. This measure creates yet more equity capital, and the bank is restored to health. Savings deposits are protected throughout, and systemically important functions are safeguarded ? all without the use of taxpayer money.
But let's go back to the stage before major losses are incurred. The big banks conduct transactions that are crucially important to the national economy, such as operating loans and payment transactions. If they were suddenly to close their doors, the Swiss economy would be in deep trouble.
Subsidiary Bank as a Life Boat
Accordingly, the concept protects these systemically important functions with a lifeboat in the form of a subsidiary bank. In normal circumstances the lifeboat, though fully equipped, is not used. In order to be able to react to crises as flexibly as possible, the systemically important functions are not placed in the lifeboat in advance.The lifeboat is activated only when losses threaten to assume menacing proportions ? in the third phase, when the last CoCos are converted into shares. The lifeboat is then lowered into the water, and the relevant business areas are transferred to it. It remains in the ownership of the bank, but as an independent organization it can continue to conduct systemically important functions without restriction.
If the crisis continues and the parent bank is still under threat, that's phase three - when the authorities intervene. They have a number of options available to them. They can rescue the whole bank, or they can either rescue the lifeboat or sell it to another 'sound' and reliable bank. Since the lifeboat is a normally functioning bank, it commands a normal market price.
Phase 4: Liquidation
By this time, the lifeboat no longer belongs to the bank that's under threat, and the proceeds of the sale can go to its creditors. Now comes the final phase. In the best-case scenario, the bank under threat survives. If it is no longer able to do so on its own, it is taken over by another bank or liquidated.
Banks Must Be Able to Fail
In a market economy, banks must be able to fail without endangering the Swiss financial system. The lifeboat mechanism enables any bank to be allowed to go under safely.The four-phase concept would not only have prevented the UBS case from arising, it would enable banks to be wound up even in crises of far greater severity. It ensures that Switzerland as a financial center will remain both secure and attractive in the future.
The combination of high equity capital, CoCo bonds, and the lifeboat mechanism is thus the most promising way of protecting taxpayers from future financial crises.
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