The Swiss government on Friday will lay out its long-awaited reforms to the country’s bank capital rules, and the centrepiece proposal will affect just one company: UBS.
Switzerland’s Federal Council and financial regulators have been at loggerheads with the country’s largest lender — and most systemically important company — since last year when they proposed strengthening the country’s banking system in the wake of Credit Suisse’s demise.
The uncertainty has weighed on UBS’s share price, with the stock falling 3 per cent over the past year, while the Euro Stoxx Banks index, which tracks the biggest lenders in the Eurozone, has climbed about 40 per cent.
The draft legislation on Friday will set out a series of measures as part of a “too-big-to-fail” package. By far the most important will be the proposals for how much loss-absorbing capital UBS will be forced to have.
The bank’s executives believe they are being punished for the mismanagement of Credit Suisse — including by regulators — in the years before its collapse and subsequent rescue by UBS.
In 2017, Finma granted Credit Suisse capital relief which in effect allowed the bank to inflate the value of its foreign subsidiaries. Last year, Swiss lawmakers criticised Finma for the move, calling it “incomprehensible”.
Despite an extensive public and private lobbying campaign by UBS’s leadership, senior figures at the bank are resigned to the government proposing what they see as the most “extreme” option: forcing it to fully capitalise its foreign subsidiaries, a move it says would increase its total capital requirements by 50 per cent from current levels.
But the way in which the government imposes the additional capital requirements on UBS — as well as details surrounding the implementation timeline — will be crucial to the severity of their impact on the bank.
What are the potential rule changes?
At the centre of the stand-off between UBS and Switzerland’s political and regulatory establishment is a proposal that banks with foreign subsidiaries be subject to additional capital demands to deal with future crises.
Officials have argued that, given the size of the combined bank since the Credit Suisse acquisition — it now has a balance sheet larger than Switzerland’s economy — UBS needs more capital as a buffer against potential losses at its international units.
At present, UBS is required to match 60 per cent of the capital at its international subsidiaries — such as the US and UK — with capital at the parent bank. Forcing the lender to match the entire capital at these units would increase its requirements by about $25bn, according to the company and analysts.
“The Federal Council views a less than 100 per cent backing as problematic during a crisis when the value of foreign subsidiaries deteriorates fast, as a hypothetical fire sale of a foreign subsidiary could materially dent the capitalisation of the parent company,” said Giulia Aurora Miotto, an analyst at Morgan Stanley.
The Federal Council could require UBS to boost capital either by requiring it to fully deduct its foreign subsidiaries from equity, or by increasing their risk-weighting.
Regulators determine how much capital is required to support risk-weighted assets, or RWAs.
Under the current regime, UBS’s foreign subsidiaries will by 2028 have their capital risk-weighted at 400 per cent. The Federal Council could increase that to about 600 per cent if it wanted UBS’s parent company to fully match the foreign subsidiaries’ capital.
How the risk-weighting approach would work
Assume UBS has a 16.7 per cent ratio requirement of “going concern” capital to risk-weighted assets, as Morgan Stanley analysts laid out last year.
If foreign subsidiaries are risk-weighted at 400%, that implies a 67% capital participation by the UBS parent (since 400% x 16.7% = 67%).
If foreign subsidiaries are risk-weighted at 600%, the parent would fully match the capital in its foreign subsidiaries (since 600% x 16.7% = 100%).
Aurora Miotto said the risk-weighted approach “would lead to a lower impact” for UBS, while the capital deduction approach — regarded as the more likely outcome — would be “more penalising”.
Analysts at RBC, including Anke Reingen, co-head of global financials research, said their “base case” was that UBS would be required to make a “full [capital] deduction”, adding: “Every $1bn in additional capital needed is a 1 per cent hit to the market cap [of UBS].”
Will they affect UBS’s competitiveness?
If UBS were forced to fully capitalise its foreign subsidiaries, it would push the bank’s core equity tier 1 ratio — a key measure of capital strength — to between 17 per cent and 19 per cent, according to the bank’s calculations, significantly above the level required of its international peers.
Other global systemically important banks such as HSBC, Deutsche Bank and Morgan Stanley have minimum CET1 requirements of 11.1 per cent, 11.3 per cent and 13.5 per cent respectively.
Analysts at Goldman Sachs said the proposed increase to UBS’s CET1 ratio would “significantly impair [its] competitiveness versus large international peers”.
This is a point that UBS’s senior management, including chief executive Sergio Ermotti and chair Colm Kelleher, have been at pains to stress in recent months.
“We are not magicians,” Ermotti said in April. “We are not going to be able to be competitive and provide and be an engine of growth for the financial centre, but also for the economy, if the regulatory framework is not competitive.”
Separate to the anticipated reforms, UBS is already adding about $20bn to its capital because of Switzerland’s early implementation of global rules, and its increased size following the Credit Suisse takeover.
As a result, there has been speculation UBS may need to offload some of its international businesses.
“Depending on the amount of additional capital required, some businesses may become uneconomical for UBS, and this could lead to strategic decisions for the bank, like the potential to sell the US business,” said Morgan Stanley’s Aurora Miotto.
Such a move would be a blow to Ermotti and Kelleher’s ambition of turning UBS into a European version of Morgan Stanley, which also has a large wealth management operation but trades at a much higher multiple than its Swiss peer. UBS has identified US growth, especially in wealth management, as a key strategic priority.
How could UBS mitigate higher capital requirements?
The Federal Council will announce on Friday whether the capital reforms will be implemented via government ordinance — in effect an executive order — or if the legislation will be put to parliament for consultation.
While the latter option would give UBS the ability to lobby politicians to water down the new regime as the bill is amended, it would also prolong the uncertainty facing the bank. Industry observers have estimated that the proposed law might not come into force until 2028 or even 2029.
There is also the question of how long UBS will be given to implement the new capital regime once it is finalised. Morgan Stanley analysts said: “Anything below 10 years would be a negative, while a longer timeline would be taken positively by the market.”
RBC estimated that, based on its analysts’ forecasts for the bank’s free cash flow from 2030, every additional phase-in year would provide UBS with $4bn of capital.
Jérôme Legras, a managing partner at Axiom Alternative Investments said one way UBS could mitigate the impact of higher capital requirements would be to bring excess capital back from its subsidiaries to the parent bank.
For example, he said, if one international subsidiary had $13bn of capital, but the local supervisor only required $10bn, UBS could repatriate $3bn. Such a move would require approval from the local supervisor, but Legras said that UBS was likely to ask for the minimum amount needed in each subsidiary.
The government is also expected to publish on Friday proposals to boost capital quality, changing the treatment of assets that are not sufficiently recoverable in a crisis, such as in-house software costs and deferred tax assets (DTAs). RBC estimates that these adjustments could take up to 2 percentage points off UBS’s CET1 ratio.
How might the bank’s shares react?
Friday’s announcement is a “significant risk event” for UBS’s share price, according to analysts at Morgan Stanley. They put the potential size of the stock move on the day at 5 per cent — up or down.
After more than a year of uncertainty, UBS will get some clarity on the scale of the regulatory challenge it faces — even if the centrepiece proposal is likely to be an unwelcome one for the bank.
