Too big for Switzerland?: Nobel laureate megabank raises alarm about UBS

This insight is not new, but now comes the warning from someone who knows banking uniquely: US economist Douglas Diamond, who received the Nobel Prize in Economics last fall alongside Philip Dybvig and former Fed chairman Ben Bernanke. Research focus: banks and financial crises. A model was even named after him – the Douglas-Dybvig model that explains the causes of bank runs.

Nobel Prize winner calls for tighter control

“You shouldn’t have a global bank if you can’t save it,” Diamond said at an investor conference in Paris recently. He praised UBS for its “great risk reduction culture”. However, you need to think carefully about how to deal with such a huge bank. “I think control needs to be tightened.”

That should give Finma, the Swiss financial market authority, something to think about and piss off UBS boss Sergio Ermotti. Better to be too big to fail than too small to survive, it’s his usual reaction to the criticism of greatness.

When asked about Credit Suisse’s collapse, Professor Diamond said he was “disappointed”. After all, after the 2008/2009 financial crisis, Switzerland went further than any other country in terms of big bank regulations.

But a lot of things went wrong at Credit Suisse. The undesirable developments would have started years ago. While its rival, UBS, had to be bailed out by the state in 2008 and was forced to adopt a less risky strategy, “CS was starting to take more risks”.

Trigger AT1 convertibles sooner

A lesson learned from the CS crash is that contingent convertible AT1 bonds introduced specifically for such situations must be converted to equity much earlier. At Credit Suisse, these instruments were only triggered when UBS was forced to take over them and were completely wiped out instead of converted. Because up until this point, the bank was still seen as a solvent, at least on paper.

“Rules will need to be adjusted so that capitalization tools can be triggered faster,” Diamond says. Since a bond-to-equity transition dilutes shareholders, shareholders will have an incentive to ensure that the bank has sufficient capital upfront.

Even if Credit Suisse did not go bankrupt due to insufficient equity, Diamond is clear: “With a well-capitalized bank, customers are not afraid of losing their money.”

Bonuses in the form of dividend freezes and bonds

The biggest challenge for regulators is to recapitalize banks without causing panic. To that end, Diamond recommends stress testing where long-term assets are valued at market prices, and dividend freezes to raise capital.

According to Diamond, so-called bonus bonds can help against management misconduct, as in the case of CS. Part of the bonus is paid out in the form of conditionally convertible bonds. This should allow managers to think more like bondholders and reduce risk.