Financial Stability Report of the Swiss National Bank

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Financial Stability Report

2009


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Swiss National BankFinancial Stability Report


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Published bySwiss National BankFinancial StabilityCH-8022 ZurichTelephone +41 44 631 31 11

Languages

The report is published in English, Frenchand German

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Publication dateJune 2009

ISSN 1661-7835 (printed version)ISSN 1661-7843 (online version)

Data and data sourcesThe banking statistics used in this reportare based on official data submitted and/oron data reported by the individual banks.As of 1995, the data on the big banks areanalysed on a consolidated basis. Before1995 and for the other banks, non-consoli-dated figures are used. This document isbased on data available as at 31 May 2009.

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extent they are of an individual character).

SNB publications containing a reference toa copyright (Swiss National Bank/SNB,Zurich/year, or similar) may only be used undercopyright law (reproduced, used via the inter-net, etc.) for non-commercial purposes and pro-vided that the source is mentioned. Their usefor commercial purposes is only permitted withthe prior express consent of the SNB.

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Swiss National Bank, Zurich 2009


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Contents

5 Overall assessment

Chapters11 1 General economic and financial conditions24 2 Profitability30 3 Risks36 4 Capital base39 5 Market assessment

Boxes9 1 Strengthening the regulatory framework

19 2 Chronology of the financial crisis28 3 Structure of the Swiss banking sector42 4 Stress index for the banking sector


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2009 Financial Stability Report

SNB 4 2009 Financial Stability Report


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ForewordThis report highlights the main trends in the

Swiss banking sector with respect to their impacton financial stability, to which the Swiss NationalBank (SNB) is required to contribute in accordancewith the National Bank Act (art. 5 para. 2 (e) NBA).A stable financial system can be defined as a sys-tem where the various components fulfil their func-tions and are able to withstand the shocks to whichthey are exposed.

Through this report, the SNB conveys its eval-uation of the stability of the banking sector andprovides the general public with relevant informa-tion and indicators. The report gives the SNB theopportunity to highlight tensions or imbalancesthat could jeopardise this stability. It is not thepurpose of this report to analyse the solvencyof individual financial institutions, and individualbanks are only considered if this is deemed relevantfor obtaining an overall picture.

Overall assessment

Severe deterioration in the economicand financial environmentThe turbulence in the money and credit mar-

kets that erupted in mid-2007 took a turn for theworse during 2008, resulting in a global financialand economic crisis. Whereas, at the onset of theturmoil, the focus was on the prices of US realestate and assets connected to that market, thecrisis has spilled over to numerous markets andcountries, depressing the value of many assets onbanks balance sheets.

The stress in financial markets escalated afterthe collapse of the US investment bank LehmanBrothers in September 2008. Premia on unsecuredmoney market transactions climbed drastically, riskpremia on large international banks debts reachedhistorical peaks, share prices plummeted anduncertainty grew sharply. Governments and centralbanks all over the world responded with broad sup-port measures aimed at preventing the financialsystem from collapsing (cf. box 2, p. 19).

The economic environment deteriorated morerapidly than most observers and market partici-pants had been expecting in mid-2008. All over theworld, the worsening of the crisis on the financialmarkets in autumn 2008 led to a major decline inGDP and a downward revision in economic fore-casts. Switzerland was also affected, entering into

recession in the second half of 2008. In response tothese developments, a number of fiscal and mon-etary policy measures have been enacted aroundthe world. In Switzerland, the Swiss National Bank(SNB) has substantially lowered the target range forthe three-month Libor and resorted to unconven-tional measures, buying Swiss franc bonds issuedby private sector borrowers, engaging in additionalrepo operations and purchasing foreign currencyon the foreign exchange markets (cf. box 2, p. 19).Acting as a mediator in a series of Swiss Pfand-brief (covered bond) transactions, the SNB hasalso helped reallocate funding between banks inSwitzerland. Furthermore, the Swiss parliament hasendorsed two economic stimulus packages.

Big banks hit hard by crisis banks with a domestic focus still stableThe international financial market crisis and

the deterioration in the economic environmenthave led to a rise in the overall level of stress in theSwiss banking sector (cf. chart 1, p. 6 and box 4,p. 42). Not all banks in Switzerland have beenaffected in the same way, however.

The two big banks and especially UBS havebeen hit hard by the crisis. They announced recordlosses running into billions of Swiss francs, largelyattributable to the poor performance of their trad-ing business. In addition, the markets confidencein the big banks has been seriously eroded. Afterthe collapse of Lehman Brothers, confidence weak-ened even further. As a result, prices for creditdefault swaps (CDS) increased sharply, share pricesplummeted, ratings were downgraded and the bigbanks liquidity situation deteriorated.

During 2008, both Credit Suisse and UBS tookmeasures to strengthen their resilience. In additionto reducing risky positions and the overall sizeof their trading portfolio and balance sheet, theyraised sizeable amounts of capital. Credit Suissemanaged to do so without financial support fromthe public sector. The resilience of UBS, on theother hand, was strengthened by both private cap-ital some of it already raised in the early stages ofthe crisis and a package of government measurestaken in October 2008. The main element of thispackage, put together by the Swiss government,the Swiss Federal Banking Commission (SFBC;now the Financial Market Supervisory Authority FINMA) and the SNB, was the possibility for UBSto transfer up to USD 60 billion1 of illiquid assetsto a special purpose vehicle (SPV) of the SNB (the

1 The amount for the maximum volume of assets to betransferred was subsequently reduced to USD 38.7 billion.Cf. www.snb.ch/en/mmr/reference/pre_20090403/source/pre_20090403.en.pdf.


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SNB StabFund) in order to facilitate their orderlyliquidation. The Swiss government, for its part,strengthened UBSs capital base by subscribing tomandatory convertible notes (MCN) in the amount ofCHF 6 billion (cf. box 2, p. 19). Owing to all of thesemeasures and mainly driven by developments at Cred-it Suisse, the big banks capital situation improvedslightly in 2008, despite the massive losses incurred.

However, even after the reduction of riskypositions and of the overall size of their tradingportfolios, the big banks overall risk exposure con-tinues to be material. In addition to the still size-able market risks, they face a marked increase incredit risks as a result of the economic downturn.Their overall risk exposure appears material not onlyin absolute terms, but also relative to their abilityto absorb future losses. First, while the big banksleverage has decreased, it nevertheless remains highby both historical and international standards.2

Losses in the order of roughly 2% of total assets atUBS and 3% at Credit Suisse would currently depletemost of these banks capital base unless simul-taneous corrective measures were taken.3 Second, asa result of the lower profit potential, the big banksability to absorb losses through current earningshas decreased.

Compared to the big banks, banks witha domestic business focus cantonal banks, regionalbanks and Raiffeisen banks present a morefavourable picture. While these bank categories sawtheir average profitability shrink moderately in2008, it still remains above the long-term average.In addition, their capital base remains high by his-

torical standards and they were able to build uptheir liquidity reserves last year, in particular asthey attracted a substantial share of the liquiditythat flowed out of the big banks during the crisis.However, the economic downturn will also pose anincreasing challenge for them.

OutlookThe outlook is for a strong and generalised

economic downturn. A sharp decline in real GDP isforecast for many countries, including Switzerland,in 2009. For instance, the SNB expects the Swisseconomy to contract by 2.5% to 3%. The uncer-tainty regarding the length and severity of thiseconomic downturn is large, however. Given thisuncertainty, the SNB uses two scenarios in itsassessment of the stability of the Swiss bankingsector. First, a baseline scenario that represents themost likely developments in economic conditionsbased on the most recent forecasts. Second, inorder to assess the impact of significantly worsedevelopments than currently expected, the SNBalso considers an adverse scenario.

The baseline scenario assumes that the manymeasures already taken by governments and centralbanks will lead to a gradual recovery in the globaleconomy as of 2010, and to a stabilisation of finan-cial markets. Even in that case, however, one mustexpect further real estate price corrections inparticular in some European countries and a sharpdeterioration in credit quality in the short andmedium term.

2 The leverage of a bank is defined as the ratio between its debtand its capital.3 At the end of Q1 2009, the ratio of Tier 1 capital to balance sheettotal was 1.6% for UBS and 3.2% for Credit Suisse. Source: quarterlyreports.

Sources: Swiss Financial Market Supervisory Authority (FINMA),Swiss National Bank (SNB), Thomson Datastream. SNB calculations

*The higher the level of the index, the higher the level of stress in theSwiss banking sector. The index is expressed in terms of standard devia-tions from its 19872008 average. A value above (below) zero indicatesthat the stress is above (below) its historical average. The stress indexfor the first quarter of 2009 has been computed with provisional data.For a description of the underlying variables and the methodology,cf. box 4, p. 42.

Stress index* Chart 1

In standard deviations

3

2

1

0

1

2

3

2004 2005 2006 2007 2008 2009


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Under this scenario, substantial loan losses,lower earnings and a negative impact on capital arelikely. Overall, however, the banks with a domesticfocus appear in relatively good shape to withstandsuch a scenario. First, there are currently no signsof a real estate or credit bubble in Switzerland. Thebanks losses resulting from Swiss lending businessare therefore likely to be smaller than in countriessuch as the US or the UK. Second, owing to theirhigh levels of capital and liquidity, the resilience ofthese banks to an economic downturn should berelatively high overall. The situation for the bigbanks appears more difficult. In addition to theirexposure to deteriorating conditions on the domes-tic market, they are also exposed to decreasingcredit quality abroad, notably in the US. Moreover,their capital situation and their leverage point toa lower resilience.

The adverse scenario considers a situationin which economic developments are significantlyworse than anticipated at present: a deeper andmuch longer-lasting recession than currently fore-cast on the one hand, substantial price correctionson the financial markets on the other. Since theinternational banking system is already in a weak-ened state, the materialisation of such an adversescenario would constitute a considerable threat tothe stability of the Swiss banking sector.

It is therefore essential that the big bankstake all the necessary measures to ensure theirresilience to the eventuality of a further significantdeterioration in economic and financial conditions.These measures include another reduction in theirrisk positions, a further strengthening of their cap-ital base, the preservation of an adequate liquiditycushion and the alignment of their cost structurewith the changed market environment.

Lessons learned and measures(to be) takenThe financial market crisis has exposed many

weaknesses of both the banking sector and the reg-ulatory framework. Some of these weaknesses wereaddressed last year. The big banks, for instance,have taken steps aimed at reducing their riskexposure and leverage, thereby increasing theirresilience to shocks. Moreover, intensive efforts areunder way to improve the regulatory framework ofthe financial system. At the international level,the Financial Stability Board (FSB) and the BaselCommittee on Banking Supervision are carrying outwork on these issues. Switzerland is represented by

the Federal Department of Finance (FSB), theFINMA (Basel Committee) and the SNB (Basel Com-mittee, FSB) (cf. box 1, p. 9).

In line with the efforts made at the interna-tional level, an initial set of measures has beendrawn up in Switzerland. For instance, FINMA hastaken important steps aimed at strengthening cap-ital regulation for the two big banks. According todecrees issued by FINMA in 2008, the big banks willhave to meet risk-weighted capital requirements ingood times that are double what they are now. As acomplement to the tighter risk-weighted capitalrequirements, FINMA has also introduced a lever-age ratio, i. e. a limit to the banks leverage. TheSNB considers that leverage of over 20 in the bank-ing sector is not prudent and is thus undesirable ingood times. In other words, in good times, the cap-ital base should account for at least 5% of the bal-ance sheet total. This is in line with FINMAsrequirements. FINMA expects the big banks lever-age ratio to be well over 3% at group level and wellover 4% for individual institutions in good times(cf. box 1, p. 9). To prevent a procyclical impact,these targets will apply as of 2013 at the earliest,leaving banks with enough time to recover from thecurrent crisis. Moreover, in bad times, banks will beallowed to temporarily fall short of these targets.In addition to these measures targeting capital,extensive work is currently being carried out todraw up a more robust liquidity regulation for thebig banks. FINMA and the SNB have been workingtogether closely on all of these projects.

In addition to the major gaps in the regula-tory framework, the crisis has also highlighted thescale and importance of the too big to fail prob-lem. The authorities, in Switzerland as elsewhere,have clearly indicated that they see the cost ofa potential failure of a large banking institution asprohibitive, and that they are willing to take thenecessary measures to avoid it. This willingness is

justified from a crisis management perspective.From a longer-term perspective, however, it is prob-lematic as it encourages greater risk-taking, thusmaking another major crisis more likely. The toobig to fail problems arising from bank support mea-sures such as those taken during the crisis will haveto be addressed decisively once the crisis itself hasbeen dealt with. There are three potentially com-plementary approaches to doing this.

A first approach is to design a regulatoryframework which ensures that systemically import-ant financial institutions hold especially large cap-


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ital and liquidity buffers. This lessens the likeli-hood of government assistance being required, cutsthe cost of such an intervention and reduces theincentive for banks to take excessive risk (moralhazard) and inflate their balance sheets. The SNBwill continue to support efforts in that direction, atboth national and international level.

Second, the too big to fail problem could alsobe mitigated by adapting the regulatory frameworkand the financial market infrastructure to enablean orderly wind-down of systemically importantfinancial institutions in a crisis. As the conse-quences of the collapse of Lehman Brothers haveshown, this is almost impossible today. Clearlydefined and internationally coordinated wind-downprocedures would help cut the costs of a bank fail-ure. Hence, the SNB supports the ongoing interna-tional efforts in this regard. However, in spite ofthe efforts made, progress in this area might be slowdue to the complexity of the interplay betweeninternational jurisdictions. Alternative approachesmust therefore be given careful consideration aswell. These include rules governing the organisa-tional structure of large financial institutions. Theaim of such rules would be to enable those units ofa bank that are important for the functioning of the

economy to be split off, and the rest wound down. Inorder to be effective, as well as compatible with theuniversal bank model, such rules would have to bedesigned in close collaboration with the banks.

Third, should efforts to facilitate the wind-down of large financial institutions not resultin significant progress within a reasonable timeframe, further measures that tackle the root causeof the too big to fail problem, i. e. the size of theinstitution, should be carefully examined. This canbe done indirectly as mentioned above by cre-ating incentives to reduce the size of banks by, forexample, imposing more stringent capital and liq-uidity requirements on larger financial institutions.Measures that put a direct cap on the size of banks,by setting a limit on their market share or on theirbalance-sheet-to-GDP ratio, are also conceivable,however. While such measures would be far-reach-ing, they are by no means new. In the area of compe-tition policy they are one of the tools commonly usedfor preventing market dominance. Nevertheless, inthe area of financial stability, as in the area of com-petition, size-related benefits, such as economies ofscale and risk diversification, would have to be care-fully weighed against size-related costs.


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International effortsAt the international level, various groups are working

intensively on improvements to the financial regulatoryframework. The improvements are aimed at making thefinancial system more robust. Of particular note in thisregard are the efforts of the Financial Stability Board (FSB;formerly the Financial Stability Forum) and the Basel Com-mittee on Banking Supervision. Switzerland is a member ofboth bodies, and is represented by the Federal Departmentof Finance (FSB), FINMA (Basel Committee) and the SNB

(Basel Committee, FSB).Based on its analyses and recommendations of

spring 2008,4 the FSB drew up policy recommendations5

with a focus on the following areas: Procyclicality. The Board identified mechanisms in the

existing regulatory framework and in market participantsbehaviour which act to further reinforce negative shocksto the financial system. Proposals were drawn up onchanges to regulation and accounting rules aimed atreducing this procyclicality. The proposals include in-creasing the capitalisation of the banking system andcontaining banks leverage.

Compensation schemes. To avoid excessive risk incentivesfor financial institution staff, principles for sound com-pensation practices were drafted. These principles are

designed to ensure that the relevant decision-makers infinancial institutions take appropriate account of the risksunderlying their decisions, which in turn should limitexcessive risk-taking. In particular, the principles addressthe governance of compensation, the alignment of com-pensation with prudent risk-taking, and supervisory over-sight and engagement by stakeholders.

International cooperation and coordination. Supervisoryauthorities need to cooperate more closely in normaltimes, to enable them to better identify risks at interna-tional financial institutions, as well as weak points in thefinancial system. Furthermore, there needs to be strongercoordination of cross-border crisis management, includ-ing how information is exchanged in crisis situations orto what extent joint crisis preparations should be made.

The Basel Committee is centring its efforts aroundstrengthening its internationally used Basel II capital stan-dards. In the medium term, the Basel Committee aims toarrive at a total level of capital that is higher than that de-fined in the current Basel II framework. At the moment,apart from the issue of procyclicality which the FSB andothers6 are also addressing the Basel Committee is focus-ing on the following improvements: Risk coverage. The current crisis has shown that, under

existing capital regulations, not all relevant risks are ad-equately covered. There is thus a need to better capturerisks, especially in off-balance sheet items and the trad-ing book.

Quality of capital. The regulatory definition of capitalalso includes debt-like instruments. Since these instru-ments do not protect a bank from default, the extent towhich they can be counted towards eligible capitalshould be reduced in future.

Box 1. Strengthening the regulatory framework Supplementary measures of capital. Since there is a dan-

ger that, even with the enhanced risk-weighted capitalrequirements, not all risks will be adequately taken intoaccount, they should be supplemented with risk-indepen-dent measures of capital adequacy, such as a leverage ratiolimit.

Measures in SwitzerlandAgainst this background and in line with these inter-

national efforts, Switzerland has already implemented or

set in train a first set of concrete measures, which consti-tute a significant contribution to financial stability:7

Higher capital requirements for the big banks. In Decem-ber 2008, FINMA issued decrees imposing higher capitalrequirements on the two big banks. According to thesedecrees, the big banks will have to meet risk-weightedcapital requirements that are double what they are now.As a complement to the tighter risk-weighted capital re-quirements, FINMA has also introduced a leverage ratio,i.e. a limit to the banks leverage. The SNB considers thatleverage of over 20 in the banking sector is not prudentand is thus undesirable in good times. In other words, ingood times, the capital base should account for at least5% of the balance sheet total. This is in line with FIN-MAs requirements. FINMA expects the big banks lever-age ratio to be well over 3% at group level and well over4% for individual institutions in good times.8 To preventa procyclical impact, these targets will apply in goodtimes as of 2013 at the earliest, leaving banks withenough time to recover from the crisis. Furthermore, thebig banks will be allowed to temporarily fall short ofthese targets in bad times. The definition of good andbad times is still an open issue. One suggested pragmaticand transparent definition, supported by the SNB, is thattimes are bad when a bank suffers losses, and good whenit makes a profit. This solution has the advantage of al-lowing capital to develop its full potential as a buffer.Losses can be absorbed by the capital cushion withoutautomatically triggering a damaging adjustment process.If a bank falls short of the prescribed targets, however,steps must be taken to ensure that it is able to meetthese targets again within an appropriate time frame. Atthe very least, restrictions should be imposed on divi-dend payments and on asset growth as long as banks donot meet the capital targets. As regards defining thespeed of adjustment, the SNB can make a valuable contri-bution by providing its macroprudential viewpoint.

More robust liquidity regulation for the big banks. Liquidityrequirements for the big banks are in the process of beingcomprehensively revised. The new regime will ensure thatthe big banks are able to cover their potential liquidityneeds in the event of a widespread loss of market confi-dence. In contrast to the existing regime, liquidity flowsfrom both balance sheet and off-balance-sheet operations

will be taken into account in the new regime. Furthermore,the focus of the new regime will be on severe rather thanmoderate stress situations. The new regulation is likely tobe finalised before the end of 2009 and enter into forcesoon afterwards.

4 Report of the Financial Stability Forum on enhancing marketand institutional resilience, April 2008; available atwww.financialstabilityboard.org/publications/r_0804.pdf.5 The policy recommendations and associated background analysesare available at the FSB website: www.financialstabilityboard.org.6 Notable contributions include: the proposals in the report

The fundamental principles of financial regulation by M. Brunner-meier, A. Crockett, Ch. Goodhart, A. Persaud, and H. Shin (forth-coming); the ideas formulated by the governor of the Peoples Bankof China in his speech on 26 March 2009 (available atwww.pbc.gov.cn/english/detail.asp?col=6500&id=182); or thesystem of dynamic provisioning already in effect in Spain.

7 Cf. box 1, Lessons learned, on p. 8 of the SNBs Financial StabilityReport2008.8 This is a capital-to-assets ratio limit which excludes Swiss lendingbusiness from the balance sheet total. For details, cf. the FederalGovernment Message of October 2008 regarding the package ofmeasures.


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Strengthening of depositor protection. As part of its pack-age of measures announced in October 2008, the Swissgovernment decided on a comprehensive revision of thedepositor protection scheme. The government plans topresent concrete proposals in summer 2009. As an imme-diate expedient, the law was amended to enhance the ex-isting depositor protection scheme.9 In particular, theceiling for insured deposits was raised from CHF 30,000to CHF 100,000.

The too big to fail issue potential solutionsThe current crisis has shown that the too big to fail

problem is much larger than previously assumed. Fearingthe economic consequences of the failure of systemicallyimportant financial institutions, governments throughoutthe world were forced to come to the aid of large and ailinginstitutions. This too big to fail policy does not just bringhigh bailout costs for the public sector; it also involvesmoral hazard. Large financial institutions are faced withstrong incentives to take on excessive risk: so long aseverything runs smoothly, they reap the benefits. Whenthings go wrong, the taxpayer bears a substantial share ofthe losses. Although a number of countries have been con-fronted with this issue, it has particular relevance forSwitzerland. The countrys two big banks are regarded astoo big to fail by market participants and rating agenciesalike, owing to their importance in terms of both theirmarket share and their balance sheet size, which representsa multiple of Swiss GDP (cf. box 3, p. 28). In view ofthe severity of the problem, a number of requests havebeen submitted to parliament, calling for a solution to befound.10

There are three basic strategies for resolving, or atleast alleviating, the too big to fail problem. First, one canimpose very strict capital and liquidity regulations on sys-temically important financial institutions. This can reduceboth the likelihood of government assistance being re-quired and the cost of such an intervention. Moreover,strict capital requirements reduce moral hazard, by forcingbanks to themselves bear more of the risk of losses, andalso reduce the banks incentive to inflate their balancesheets. At both the international level and within Switzer-land, the SNB is working for a sounder regulation of sys-temically important banks.

Second, one can adapt the legal framework and thefinancial market infrastructure to simplify, or make possi-ble, an orderly wind-down of large financial institutionsduring periods of severe crisis. Today, as a result of theircross-border activities and close linkages with major coun-terparties and markets, the orderly wind-down of a systemi-cally important institution would be almost impossible(too interconnected to fail). Clearly defined and interna-tionally coordinated wind-down procedures can help to cutthe costs of a bank failure. The SNB supports the ongoinginternational efforts in this area. Yet it is also aware thatthe interplay between international jurisdictions is ex-tremely complex and that a solution is correspondinglychallenging and time-consuming. If no progress is achievedat the international level, Switzerland should, once the cur-rent crisis has been overcome, consider solutions that canbe implemented in a purely domestic context. In such a

case, an orderly wind-down of entire banking groups orholding companies will not be possible. However, oneshould examine the extent to which, in a crisis, those bigbank units that are economically important for the Swisseconomy can be split off and possibly transferred to otherbanks within the country and the rest wound down. This re-quires close cooperation with the banks, in order to definean appropriate organisational structure which would simpli-fy such a wind-down, while remaining compatible with theuniversal bank model.

Third, one can directly tackle the cause of the toobig to fail problem by limiting the size of financial institu-tions. One could consider direct size restrictions, forinstance by imposing a maximum market share or balance-sheet-to-GDP ratio, or indirect incentives as mentionedabove such as increasingly strict capital requirements forbig banks. Yet it should be borne in mind that size can alsohave its advantages. True, economies of scale largeramounts can be produced at lower average cost can al-ready be achieved with relatively small banks.11 But ifa bank is active in different regions or business areas, thiscontributes to better diversification and thus to lowerrisks. For instance, the strength of the big banks foreignbusiness was a major factor in stabilising the Swiss bankingsector in the first half of the 1990s. Therefore, it would not

seem advisable to prohibit certain activities. Moreover, oneshould not forget that a banking system made up of onlysmall banks is not an automatic guarantee of stability. 12

Although size restrictions are a radical measure, the SNBtakes the view that this instrument should be seriouslyexamined if efforts to facilitate the wind-down of large fi-nancial institutions do not result in significant progresswithin a reasonable time frame.

9 Federal Act on Banks and Savings Banks (strengthening ofdepositor protection), amended 19 December 2008.10 For example, the motion on Prevention of unacceptable risks forthe Swiss economy (National Council motion 08.3649) requeststhe Swiss government to set up a committee of experts, with the taskof proposing measures to limit risks in the event of failure ofa large Swiss company. The motion Fewer risks for the financial market(National Council motion 09.3019) explicitly calls for domestic andforeign banking activities to be separated.

11 Cf. for example, Y. Altunbas et al., Efficiency in European banking,European Economic Review45, 2001, pp. 19311955.12 One can take as an illustration the savings & loan crisis in the USat the end of the 1980s, or the regional banking crisis in Switzerlandin the early 1990s. In both cases, a large number of small bankswere simultaneously confronted with the same problem, resultingin the destabilisation of the banking system as a whole.


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1 General economicand financial conditions

The general economic and financial conditionsfor the Swiss banking sector deteriorated further in2008. The financial turmoil, which started in 2007,intensified and extended to a global financial crisisand economic downturn. The onset of the crisissaw decreasing house prices in the US and fallingprices of real estate-related securities. Since then,a broad range of assets has been affected, andeconomic output has contracted sharply. As a resultof these developments, many financial institu-tions were faced with increasing refinancing diffi-culties and reported record losses in 2008. Someinstitutions failed or had to be supported by theauthorities.

The major economies are expected to suffer fur-ther deterioration in 2009, before recovering gradu-ally as of 2010. As a consequence, credit risk islikely to increase significantly both in Switzerlandand abroad. The US and some European countriesare likely to be hit harder than Switzerland due toadverse developments on their housing markets.

The materialisation of this baseline scenario,however, depends to a large extent on the successof the efforts made to revive economic activity andto restore and maintain confidence in the financialsector. Should such efforts fail, there is a risk ofa substantially more adverse scenario, where globalrecession could be deep and long lasting. In sucha scenario, conditions for the stability of the Swissfinancial system would deteriorate even further.

Economic environmentThe financial crisis, which has developed into

the most severe crisis of the post-World War II era,has severely hit the real economy. With output con-tracting sharply in a large number of countries in thefinal quarter of 2008 and the first quarter of 2009,the downturn has deepened and become global.Emerging economies have also been affected by thecrisis: their export demand has plunged and many ofthem have seen a sharp drop in capital inflows.

The impact of the financial crisis and theglobal recession on the Swiss economy was rela-tively mild in 2008. At 1.6%, Swiss GDP grew morestrongly than GDP in the US and the euro area (cf.chart 2). However, economic activity also declinedsharply in Switzerland in the fourth quarter of 2008and the first quarter of 2009.

Prospects for the global economy remain bleak,although various indicators suggest that the pace ofcontraction has slowed. Credit constraints, hugewealth losses and a rapidly deteriorating labour mar-ket are weighing heavily on global economic activi-ty. Against this background, GDP is expected to con-tract substantially in the US, the EU and Switzerlandin 2009. Supported by fiscal and monetary measures,a gradual recovery in these economies is expectedas of 2010. In emerging markets, the IMF forecastsweak economic growth in 2009 and a gradualstrengthening in the following year.13

Furthermore, uncertainty as to the length anddepth of the recession is high and risks remain tiltedto the downside. Real estate crises in combinationwith banking crises tend to have a long-term

GDP growth Chart 2

Annual growth rates of real GDP

Switzerland EMU US Japan

%

1

0

1

2

3

4

5

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: SNB 13 Cf. IMF, World Economic Outlook, April 2009.


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Short-term interest rates Chart 3

Three-month Libor

CHF EUR USD JPY GBP

%

0

1

2

3

4

5

6

7

8

9

10

11

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Chart 3: Source: Reuters

Chart 4: Sources: Bloomberg, SNB* The overnight rates are: TOIS for CHF, EONIA for EUR, OIS for USD,

TONAR for JPY, SONIA for GBP.

14 Cf. C. M. Reinhart and K. S. Rogoff, The aftermath of financialcrises, NBER Working Paper 14656, 2009.15 Cf. IMF, Global Financial Stability Report, April 2009.16 Cf. Bank of England, Financial Stability Report, October 2008.

Money market spreads Chart 4

Spreads between three-month Libor and three-month overnight indexed swap rates*

CHF EUR USD JPY GBP

%

0.5

1

1.5

2

2.5

3

3.5

4

A M J J A S O N D J 08 F M A M J J A S O N D J 09 F M A M

depressing effect on the economy. During the GreatDepression in the US and following the financialcrises in Finland (1991) and Argentina (2001),for instance, per capita GDP in these countriesdeclined for four consecutive years. This is abouttwice as long as the average duration of a negativegrowth period following a financial crisis.14

Funding conditionsIn reaction to falling inflation rates, the weak-

ening economic outlook and tight funding condi-tions for financial institutions, all major centralbanks significantly relaxed monetary conditions in2008 and early 2009. This led to a sharp fall inshort-term interest rates, especially in the US,the UK, the euro area and Switzerland (cf. chart 3).

Further measures were taken to alleviate the grow-ing refinancing difficulties in the banking sector.In various countries, banks were given the possibil-ity to issue state-guaranteed debt on the money orcapital markets. In Switzerland, the SNB acted asa mediator in private sector transactions involvingSwiss Pfandbrief bonds that helped reallocate fund-ing within the banking sector, thereby contributingto reduce refinancing difficulties experienced bythe big banks.

In spite of these measures, overall liquidityand funding conditions remained unusually tightthroughout 2008, especially for large internationalbanks. This is reflected in the record values reachedby the IMF Funding and Market Liquidity Index15

and the Bank of England Liquidity Index.16 These


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17 For example, the Nikkei after its peak in 1989 or the Dow Jonesfollowing its peak in 1973, 1987 or 2000.

indices combine different measures of liquidity onequity, foreign exchange and money markets.Developments on the money market are representa-tive of these abnormal conditions. As can be seenin chart 4 on p. 12, the risk premia charged on theinterbank market reached levels in 2008 that areextremely high, even when compared to the peaksobserved in 2007. Conditions improved consider-ably after the period of acute stress that followedthe failure of Lehman Brothers in September 2008.However, risk premia remain significantly above thelow levels observed before the onset of the crisis inAugust 2007.

Stock marketThe weakening economic outlook, increasing

risk perception and deleveraging of financial insti-tutions have led to an unexpectedly large drop instock prices. Since their peaks in 2007, stockindices have fallen (peak to trough) by about50% in Switzerland and the US, and by more than60% in the euro area and emerging markets beforerecovering somewhat in April and May 2009 (cf.chart 5).

In most countries, the magnitude of theseprice corrections was greater than during all otherpost-World War II crises.17 It is comparable with theprice correction that followed the stock marketcrash in 1929. At that time, the Dow Jones lostabout 50% in the first year and a half following itspeak, before losing another 40 percentage points inthe subsequent 12 months.

The drop in stock prices is not only remarkablefrom a historical perspective, but also in comparisonto the development of variables, like earnings, divi-

dends and interest rates, which are driving factors ofstock prices. Price/earnings ratios, for example, havefallen significantly since the onset of the crisis(cf. chart 6, p. 14) and are now below their long-term averages. This might indicate that stock priceshave overreacted, making further large and persis-tent price declines relatively unlikely. However, sincethe price/earnings ratios only reflect past earnings,another interpretation could be that the marketexpects very weak results for stock companies.

Given the comparably low stock market valua-tions and the anticipated gradual economic recov-ery as of 2010, the scope for further large and per-sistent price declines seems limited. However, ifeconomies do slide into a deep and long-lastingrecession, revised earnings expectations mightdepress stock prices further. In addition to a weakeconomy, stock prices can be negatively influencedby factors such as a renewed deterioration in marketsentiment and an ongoing deleveraging process.Taking the 90% decrease of the Dow Jones follow-ing its peak in 1929 as a very adverse reference,there is still room for further, substantial declines.

Housing marketIn 2008, the decline in US house prices accel-

erated. According to the Case-Shiller National HomePrice Index, real US house prices fell by 34% betweentheir peak in 2006 and the end of 2008 (cf. chart 7,p. 14). Compared to previous housing crises, such asin Switzerland or in Japan in the early 1990s, thiswas a remarkably fast and strong decrease.

House prices also declined significantly insome European countries. Real UK house prices, forexample, dropped by about 20% in 2008, thereby

Stock market indices Chart 5

Datastream Global Indices (January 2003 = 100)

Switzerland EMU US Japan UK Emerging markets

0

100

200

300

400

500

600

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Thomson Datastream


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exceeding the speed of the decline in US houseprices. In countries like Germany, Japan and Switzer-land, meanwhile, no material house price correctionshave been observed since the onset of the crisis.

According to the futures on the Case-ShillerIndex, the market expects that the decrease in UShouse prices will slow in 2009 and that prices willreach their turning point in 2010.18 By then, pricesare projected to have decreased by another 12%.The total expected drop in real house prices about45% is larger than what was observed in the UK(27%) and Switzerland (39%) after prices peakedaround 1990, yet smaller than the drop in Japanesehouse prices after they peaked in 1990 (48%).Empirical evidence on real estate crises indicatesthat real house prices decline, on average, for six

years and by about 36% after their peak.19 Hence,current and expected developments in the US arevery pronounced, but not exceptional by historicalstandards.

Further price corrections are also likely in vari-ous European countries. Housing markets in coun-tries such as Ireland, Spain and the UK have ex-perienced even stronger price increases in the lastdecade than the US. At the same time, recent pricecorrections in these countries have been signifi-cantly smaller than in the US. In countries wherereal house prices increased only moderately in thelast decade (Switzerland) or even declined (Ger-many or Japan), a sharp fall in prices appears rela-tively unlikely if economic growth were to graduallyresume, as expected, as of 2010.

Chart 6: Source: Thomson Datastream*Earnings are realised earnings per share.

Chart 7: Sources: BIS, Standard & Poors/Case-Shiller, IMF*Market expectations for the Case-Shiller Index as reflected by the

corresponding futures.

18 It should be noted that the reliability of the futures on theCase-Shiller Index as a proxy for market expectations of houseprices is limited, due to the low liquidity of the market for theseinstruments.19 Cf. C. M. Reinhart and K. S. Rogoff, The aftermath of financialcrises, NBER Working Paper 14656, 2009. The authors look at houseprice cycles surrounding banking crises.

Stock market price/earning ratios* Chart 6

Datastream Global Indices, 30-year average = 100 (for emerging markets, average since 1995 = 100)

Switzerland EMU US Japan UK Emerging markets

0

50

100

150

200

250

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

House prices, years before and after peak Chart 7

In real terms (prices indexed to peak year = 100)

Switzerland (peak in 1989) Japan (1990) UK (1989) UK (2007) US (2006) US (2006, market expectations*)

50

60

70

80

90

100

110

-12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18


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Should the adverse scenario of a deep andlong-lasting global recession materialise, however,unexpectedly large housing market price adjust-ments are likely to occur due to negative feedbackloops. In this case, even countries where no wide-spread price corrections are currently expected,such as Switzerland, could be affected.

Credit qualityFalling real estate prices, the weakening eco-

nomic environment and tighter lending conditionshave led to a decline in credit quality in the US.Whereas at the beginning of the financial turmoil,mainly real estate loans were affected, the problemshave now spread to consumer and business loans.Delinquency rates on consumer and real estate loanshave already reached multi-year highs, while thoseon business loans are still below their levels of theearly 1990s (cf. chart 8). A decline in the creditquality of corporate borrowers is also indicated inMoodys ratio of downgrades to upgrades of US com-panies. This ratio increased substantially in 2008,reaching its previous peak of 2003.

According to the European Central Bank (ECB)and the Bank of England, the balance sheets ofEuropean companies remained resilient in 2008.20

However, due to the contracting economy, decreas-ing house prices, high leverage of borrowers andtighter lending conditions of banks, European com-panies and households have become more vul-nerable. This is also indicated by Moodys ratio ofdowngrades to upgrades of European companies. Aswith the US, this ratio has recently increased to itsprevious peak level of 2003.

The overall credit quality of Swiss borrowersremained robust in 2008. In Switzerland, houseprices remained relatively stable overall, whileunemployment rates started to increase slightlytowards the end of 2008, but maintained a lowlevel. As a result, the credit quality of Swiss house-holds did not deteriorate. On the contrary, for thefirst time in eight years, the number of householdinsolvencies decreased in 2008. The number of cor-porate insolvencies, however, increased in thefourth quarter of 2008.

In the near future, a further and substantialdecrease in overall credit quality is anticipated.The development of corporate bond spreads, forexample, indicates that market participants expectdelinquency rates among US and European compan-ies to reach levels that are far higher than at theirprevious peak in 2002 (cf. chart 9, p. 16).

According to IMF estimates, commercial bankloan charge-offs in the US and Europe will alsoexceed the levels reached in the 19911992 reces-sion, even though they should remain below thelevels experienced in the US during the GreatDepression.21 Reasons for the anticipated deteriora-tion in creditworthiness are the expected furtherdeepening of the recession and the fall in houseprices in many countries. In addition, according tothe lending surveys of the ECB and the FederalReserve, banks in the euro area and the US tight-ened their lending standards in 2008. Companiesthat rely on bank credits are therefore being con-fronted with increasing refinancing difficulties.Nevertheless, under the condition that economicoutput will gradually recover in 2010 and the house

US delinquency rates Chart 8

Business loans Real estate loans Consumer loans

%

2

3

4

5

6

7

8

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

20 Cf. ECB, Financial Stability Review, December 2008, and Bankof England, Financial Stability Report, October 2008.21 Cf. IMF, Global Financial Stability Report, April 2009. US charge-off rates are expected to peak at 4.4% vs. below 2% in the 1990sand about 5% during the Great Depression. European charge-offrates are expected to peak at 2.9% vs. about 1.5% in the 1990s.

Source: Federal Reserve


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price decrease will slow, default rates might alreadypeak in 2010. This is also indicated by the afore-mentioned IMF estimates.

According to bond spreads, the increase indefault rates in Switzerland might be lower than inthe US or some European countries (cf. chart 9). Therelative optimism of market participants regardingfuture default rates in Switzerland might reflect theoverall soundness of the Swiss credit and housingmarkets, which have experienced moderate growthrates in the last decade. Furthermore, in contrast tothe observations made in the EU and the US, creditstandards remained almost unchanged in Switzer-land for most of 2008 and were only slightly tighterin the fourth quarter of 2008 and the first quarter of2009, according to the SNB lending survey.

The SNBs baseline scenario assumes thatdelinquency rates in the US and Europe will peaksoon. However, if these economies do not graduallyrecover in 2010, a stronger and longer-lastingincrease in delinquency rates could become likely.The future development of the creditworthinessof households also depends on the development ofhouse prices. If prices continue to fall in the US anddrop strongly in some European countries, delin-quency rates among households might increase farabove the already high levels that are expected tobe reached in the baseline scenario. Although theoutlook for the credit quality of Swiss borrowersappears less worrisome, a deep and long-lastingrecession in Switzerland would also lead to highdelinquency rates among Swiss companies andhouseholds by historical standards.

International financial institutionsThe fall in many asset prices has led to high

trading losses for a large number of internationalfinancial institutions in Switzerland and abroad. Inaddition, they have been faced with a deteriorationin the quality of their loan portfolios, as well assevere and mounting refinancing difficulties. Asa result, many of them reported record lossesin 2008 and were forced to raise additional capital.In the meantime, write-downs and credit losses ofbanks around the globe have added up to almostUSD 1,500 billion. At the same time, they raisedabout USD 1,200 billion in new capital, includingsubstantial amounts of public money.22

As a consequence, the market participantsassessment of the value and solidity of these finan-cial institutions has deteriorated. The risk and li-quidity premia that banks have to pay on the moneymarkets (cf. chart 4, p. 12) have increased, theirmarket value has dropped and the credit defaultswap (CDS) premia on their debt has increased sub-stantially since early 2007 (cf. chart 10, p. 17).

Insurance companies were affected, too. Asa result, stock prices of many insurance companies in particular in Switzerland decreased significant-ly and the CDS premia on their debt spiked. Ameri-can International Group (AIG), a large internation-al US-based insurance company, even had to besupported by the public sector. This support wasmotivated by financial stability concerns, given thecompanys large-scale involvement in the insuranceof credit risk, in particular through the issuanceof CDSs.

Credit spreads Chart 9

Credit spreads between corporate and government bonds

Switzerland* EMU** US***

Basis points

0

100

200

300

400

500

600

700

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Thomson Datastream* Yields (spot rates) for Swiss investment grade corporate bonds

and for Swiss Confederation bonds, calculated by the SNB.** Euro-Aggregate Corporate (investment grade, EUR-denominated)

and Euro-Aggregate Government AAA indices, Barclays Capital.*** US Corporate (investment grade, USD-denominated)

and US Treasury indices, Barclays Capital.

22 Source: Bloomberg


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Although the increasing role played by insur-ance companies in the credit risk market has allowedthat risk to be spread more widely, it has also createda direct and important contagion channel betweenthe insurance and banking sectors. In Switzerland,this contagion channel is relatively narrow, however,as the Swiss insurance sector does not insurea material share of the credit risk in the Swiss bank-ing sector. Hence, while the negative developmentsaffecting this sector in Switzerland have added tothe general deterioration of financial and economicconditions, they do not represent a direct threat tothe stability of the Swiss banking sector.

The outlook for large international financialinstitutions abroad remains gloomy. The IMF esti-mates that, from 2007 to 2010, aggregate write-downs on global holdings of US, European andJapanese loans and related securities will be aboutUSD 4.1 trillion. Banks are expected to bear aboutUSD 2.5 trillion of these write-downs.23 Given thatbanks have already realised write-downs and lossesof about USD 1.5 trillion, they would still have towrite down about USD 1 trillion. Since these esti-mates are based on a broad range of assumptions,the results are highly uncertain and should beinterpreted with caution. Nevertheless, the resultsindicate that potential future losses of banks arevery high.

An estimate of potential future losses of thelargest US banks is provided by the Federal Reserveand other US bank supervisors within the contextof the Supervisory Capital Assessment Program(SCAP).24 In the adverse scenario, the 19 largest US

bank holding companies (BHC) would suffer lossesof USD 600 billion in 2009 and 2010. It is impor-tant to note that, due to the smaller sample (19 USBHCs vs. global banks), the shorter time horizon(two vs. four years) and the different focus (esti-mates vs. adverse scenario), the potential lossescannot be compared directly with the IMF esti-mates. However, the SCAP results also suggest that,should the environment continue to deteriorate,banks will suffer further, substantial losses.

Since the beginning of the crisis, most finan-cial institutions were able to cover a large part oftheir losses by raising additional capital, in manycases with substantial government assistance.However, a further strengthening of the capitalbase might be necessary particularly in the bank-ing sector in order to ensure an adequate level ofresilience against potential adverse macroeconomicdevelopments. For the largest US BHC only, SCAPestimates show that capital requirements willamount to USD 75 billion.

Sovereign riskAs a consequence of the crisis, the perceived

credit risk on sovereign debt increased substantiallyin 2008. Fiscal stimulus packages and measures tostabilise the financial sector are very costly andhave increased the risk exposure of the public sec-tor. Furthermore, with economic output contractingsharply, tax revenues are expected to decrease.In addition, the higher risk perception has led toa sharp drop in capital inflows for several emergingmarkets. These developments are reflected by the

Source: Bloomberg 23 Cf. IMF, Global Financial Stability Report, April 2009.24 Cf. Federal Reserve, The Supervisory Capital Assessment Program:overview of results, 7 May 2009.

Bank credit default swap prices Chart 10

Premia for credit protection on issuer bank (five-year senior, average of largest banks in the country)

EMU US Japan UK

Basis points

0

50

100

150

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250

300

350

400

2002 2003 2004 2005 2006 2007 2008 2009


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significant increase in the premia charged in themarkets as an insurance against the default on sov-ereign bonds. While this also impacted G10 coun-tries, emerging markets, such as Argentina, Russiaor Ukraine, were particularly affected. Some euroarea countries also saw CDS premia increase sub-stantially (cf. chart 11). In most countries, CDSpremia have come down since their peaks in late2008/early 2009. However, they are still muchhigher than before the onset of the current crisis.

The deteriorating financial strength of somecountries might reduce their governments abilityor willingness to take further fiscal and financialsector stabilisation measures. This, together withhigher risk of default on sovereign debt, representsan additional threat to global financial stability.

OutlookThe general economic and financial conditions

for the Swiss banking sector are expected to deteri-orate moderately in the near future. The GDP out-look for 2009 is negative for all major economies.In addition, house prices are expected to decreasefurther in the US and some European countries.These developments are likely to translate intoincreasing default rates on consumer and corporateloans. While the situation appears less serious inSwitzerland, default rates are expected to rise

significantly here too. Measures by governmentsand central banks should, however, help economiesto gradually recover as of 2010 and restore confi-dence in the financial sector. As a consequence,default rates are expected to peak in 2010 and thescope for further material price corrections on thefinancial markets appears limited.

The materialisation of this baseline scenario,however, depends to a large extent on the successof the efforts made to revive economic activity andto restore and maintain confidence in the financialsector. Should such efforts fail, there is a risk ofa substantially more adverse scenario, where globalrecession could be deep and long lasting. In sucha scenario, conditions for the stability of the Swissfinancial system would deteriorate even further.Default rates on consumer and corporate loans couldreach levels in excess of previous historical peaks.Furthermore, the likelihood of large and broad-basedprice corrections affecting many classes of financialassets would increase, both in Switzerland andabroad.

Large international financial institutions shouldtake the necessary steps to ensure that they areresilient enough to withstand such adverse devel-opments. This should prevent the crisis from escal-ating to new heights if such a scenario were tomaterialise.

Sovereign credit default swap prices Chart 11

Premia for credit protection (five-year senior)

Brazil Greece Ireland Poland Russia Argentina (rhs) Ukraine (rhs)

Basis points

0

200

400

600

800

1 000

1 200

A M J J A S O N D J 08 F M A M J J A S O N D J 09 F M A M

0

1 000

2 000

3 000

4 000

5 000

6 000

Source: Thomson Datastream


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Prior to 2007, the world economy is characterised byrapid growth in economic activity and asset prices, highlyliquid financial markets and low levels of perceived eco-nomic and financial risk. The US housing market is boom-ing. Financial institutions are very active in these years,securitising US mortgages of all qualities into mortgage-backed bonds, which in turn are increasingly used as under-

lying assets for more complex mortgage-backed securities.The resulting securities are sold worldwide, and in particu-lar to banks and financial institutions. At the same time,many financial institutions, among them Credit Suisse andUBS, increase their risk-taking, leverage and profitabilityin these years. Demand for mortgage-backed securities isstrong.

Box 2. Chronology of the financial crisis

Phase 1: Prior to 9 August 2007Falling US house prices and increasing financial market nervousness.

Economic growth loses momentum in late 2006 andhouse prices in major US cities stall. In early 2007, aneffective US housing market bust leads to an increase indelinquency rates in the sub-prime segment of the US mort-gage market. Prices of mortgage-backed securities begin tofall. The US housing market bust is instantly propagated tofinancial institutions around the world through securities

backed by US mortgages. By early summer, the first casual-ties among financial institutions occur. Concerns amongmarket participants regarding the magnitude and concen-tration of the exposures of financial institutions andnotably those of the Swiss big banks to the US housingmarket escalate in the first week of August. By 9 August,a crisis of confidence has developed on the interbank moneymarkets, and liquidity in many markets has dried up.

Key events:February 2007:

Prices of sub-prime mortgage-backed securities startfalling.

May 2007:

UBS announces the reintegration of one of its hedgefunds (Dillon Read Capital Management) into its invest-ment bank, after suffering losses related to the US mort-gage-backed securities market.

June 2007: Moodys, a rating agency, downgrades a range of sub-

prime mortgage-backed bonds. Two hedge funds of Bear Stearns, a US investment bank,

collapse due to losses related to sub-prime securities. The SNB raises the target range for the three-month Libor.

July 2007: UBS replaces its CEO. Several more hedge funds fail due to sub-prime-related

losses. HSBC, a British banking group, announces sub-prime-

related losses, and IKB, a German Landesbank, reportssubstantial sub-prime-related losses in one of its specialinvestment vehicles (SIVs).

August 2007: In the first week of August, IKB brings the troubled SIV

on to its balance sheet, and is in turn rescued by theGerman government.

Rumours about other institutions notably Northern Rock,a UK mortgage lender intensify.

On 9 August, BNP Paribas, a French banking group, freezesthree funds due to losses related to US sub-prime mort-gage markets.

US house prices continue to fall over the comingmonths, and as a result, security prices backed by US mort-gages also decline. Risk premia increase across the board,and stock prices embark on a long decline. Gradually, largebanks and financial institutions across the world reveal major write-offs and losses as a consequence of exposure tothe US real estate market. These write-offs reach a total ofUSD 504 billion in September 2008.25 Many banks take mea-sures to increase their capital base. In late 2007, NorthernRock (UK) nearly collapses, as does Bear Stearns (US) inearly 2008, in both cases following a loss of market con-fidence that severely reduces their capacity to fund theiroperations. Fannie Mae and Freddy Mac, the big US govern-

ment-sponsored mortgage lenders, nearly fail due to severecapital deficiency in late summer 2008. In all of these cas-es, different types of public sector intervention and supportprevent outright bankruptcy and failure.

In Switzerland, UBS makes a series of announcementsof losses attributable to the drop in the market value of itslarge holdings of securities backed by US sub-prime mort-

Phase 2: 9 August 2007 to 15 September 2008

Three waves of money market stress.

gages. UBSs disclosed gross losses on these positionsamount to USD 44.2 billion by September 2008. 26 The bankincurs an annual net loss of about CHF 4.4 billion for 2007,and CHF 11.9 billion in the first half of 2008. UBS takesmeasures to significantly strengthen its capital base duringthis period. By September 2008, it has raised about CHF28.3 billion of fresh capital from private investors since thebeginning of the financial crisis.27 UBS also sells off part ofits exposures to the US real estate market. Credit Suissestays profitable in 2007, but suffers a loss of CHF 0.9 bil-lion in the first half of 2008. By September 2008, Credit Su-isse has gradually disclosed what amounts to USD 10.1 bil-lion of gross losses and write-downs related to the crisis. 28

In contrast, Swiss banks with a domestic business focusprove not to be substantially exposed to the US real estatemarket, and are therefore not materially affected by the fi-nancial turmoil at this point.

The magnitude of banks disclosed exposures on theUS sub-prime mortgage market, and the uncertainty regard-ing exposures that have not yet been disclosed, give rise

25 Source: Bloomberg 26 Source: Bloomberg27 Source: Bloomberg28 Source: Bloomberg


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to money market stress during this period. As can be seenin chart 4 on p. 12, it is possible to distinguish three wavesof loss of confidence in the interbank money market overthe 13 months from August 2007 to September 2008, asexpressed by surges in money market spreads. The firstwave hits global money markets in August and September2007, and the second in November and December 2007.After relative calm in money markets in early 2008, thethird wave gathers momentum in late February, and breakson Wall Street with the rescue of Bear Stearns by the Feder-al Reserve in mid-March. This third wave subsides duringApril, after which money markets remain relatively calm un-

til September. Each of the three waves triggers extraordi-nary liquidity operations by central banks. In order to keep

money markets functioning, some central banks provide ad-ditional liquidity to the banking sector over longer timehorizons and against a broader set of collateral than usual.During the money market stress surrounding the near-col-lapse of Bear Stearns in March 2008, the Federal ReserveBank of New York decides to provide liquidity (indirectly) tosecurities dealers. Moreover, as part of concerted actionsbetween central banks, the SNB for the first time inits history engages in currency swaps with the FederalReserve to provide US dollar liquidity to market participantsin December 2007. The central bank currency swaps andliquidity operations are repeated regularly throughout this

period.

February 2008: UBS confirms a 2007 net loss of about CHF 4.4 billion. Credit Suisse announces an annual profit of CHF 8.5 bil-

lion for 2007, and shortly thereafter discloses preliminaryfindings of additional US real estate-related write-offs ofUSD 2.9 billion.

March 2008: A wholesale run on Bear Stearns occurs and its stock

price plunges. Bear Stearns faces difficulties in fundingits operations, even against high-grade collateral on thesecured funding market. It is rescued by the Fed and JP

Morgan Chase, a US banking group, the following day. The Fed announces exceptional temporary measureswhereby primary brokers are given access to its lendingfacilities.

The SNB and other G10 central banks announce coordi-nated liquidity operations. The SNB renews its USD liq-uidity operations with repo counterparties.

Credit Suisse announces adjustments in connectionwith US sub-prime-related losses amounting to about CHF1.18 billion in Q4 2007 and CHF 1.68 billion in Q1 2008.Annual net profit for 2007 is revised to CHF 7.76 billionand net profit in Q4 to CHF 0.54 billion.

April 2008: Major US banks announce losses and write-downs for

Q1 2008, and several banks announce measures to raise

additional capital. UBS announces about USD 19 billion of gross losses andwrite-downs on US real estate and related structuredcredit positions, and a net loss of about CHF 12 billion inQ1. UBS simultaneously announces an ordinary capitalincrease of about CHF 15 billion and the departure of itsChairman.

S&P, Moodys and Fitch downgrade UBS. Credit Suisse announces a Q1 net loss of CHF 2.1 billion,

and write-downs in the order of CHF 5.3 billion. The SNB renews its repo operations in USD, providing USD

6 billion in temporary liquidity to Swiss money markets.May 2008:

AIG and Citigroup announce measures to raise additionalcapital.

The SNB increases the amount of its USD repo auctions. UBS sells USD 15 billion worth of US real estate-relatedassets to BlackRock, a US asset manager.

UBS reports a Q1 net loss of CHF 11.5 billion, in linewith its 1 April 2008 pre-announcement, and aroundUSD 19 billion of losses on US real estate and certainstructured credit positions.

Key events:August 2007:

The SNB and other central banks commence extraordinarytemporary liquidity provision to the markets on 9 and 10August.

September 2007: Northern Rock is faced with a bank run following rumours

that it has received emergency liquidity assistance fromthe Bank of England. The run ceases a few days laterwhen the government guarantees all Northern Rock de-posits.

October 2007: UBS issues a profit warning, and later announces a Q3loss of CHF 830 million and write-downs related to USsub-prime exposure in the order of CHF 4.2 billion.

Standard & Poors (S&P), a rating agency, downgradesUBS.

November 2007: Major US banks report losses due to sub-prime exposure

in the first half of November; some of them also an-nounce measures to raise new capital.

Moodys downgrades UBS. Credit Suisse announces Q3 profits of about CHF 1.3 bil-

lion, despite write-downs of about CHF 2.2 billion.December 2007:

UBS announces further write-offs of USD 10 billion relat-

ed to US sub-prime exposure, and measures to raiseCHF 13 billion of fresh capital through a mandatory con-vertible notes issue (accepted by UBS shareholders inFebruary 2008).

Fitch, a rating agency, downgrades UBS. Coordinated liquidity operations by major central banks

are announced. The SNB provides temporary USD liquidityto repo counterparties.

Bear Stearns announces a loss for Q4, its first ever quar-terly loss.

January 2008: The SNB renews its USD liquidity operations with repo

counterparties. Socit Gnrale, a French financial services company,

discloses an unauthorised trading loss of about USD 4.9

billion. Major US banks announce losses and write-downs for2007, and several also announce related measures toraise capital.

At the end of the month, UBS warns of new write-offs,implying a Q4 net loss of about CHF 12.5 billion anda net loss for 2007 in the order of CHF 4.4 billion.


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June 2008: S&P downgrades major US banks (Merrill Lynch, Lehman

Brothers, JP Morgan Chase). Lehman Brothers reports a USD 2.8 billion Q2 loss, the first

loss in the companys 14-year history under public owner-ship. Measures to raise new capital are also announced.

July 2008: Freddy Mac and Fannie Mae, the big US government-spon-

sored mortgage lenders, announce substantial write-downs and are given access to credit lines with the Fed.Short-selling of certain shares, especially those of FannieMae and Freddy Mac, is banned, and a housing bill is

passed, notably allowing for the US government to pro-vide equity or debt to the two troubled institutions.

Major US banks report weak results for Q2 2008 andfurther write-downs associated with real estate-relatedpositions and leveraged loans.

Moodys downgrades UBS. Credit Suisse reports Q2 net profits of CHF 1.2 billion and

strong net new money inflows.

August 2008: Fannie Mae and Freddy Mac announce Q2 losses, a cut

in dividends and increases in loss provisions. The USSecurities and Exchange Commissions (SEC) ban onshort-selling comes to an end.

Moodys downgrades Fannie Mae and Freddy Mac. More large international banks announce weak or nega-

tive Q2 results and further write-downs associated withreal estate-related positions.

UBS reports a Q2 net loss of CHF 358 million, and associ-ated realised and unrealised gross losses of USD 5.1 bil-lion on mainly US residential real estate-related securities

and other credit positions. UBS also reports substantialnet new money outflows.

First half of September 2008: The US government effectively nationalises Fannie Mae

and Freddy Mac, by placing them into conservatorship.

After some months of relative calm, the financial tur-

moil takes a dramatic turn for the worse on 15 September2008, when Lehman Brothers, the US investment bank, goesinto bankruptcy. In the immediate aftermath of the default,money market spreads surge to a level which dwarfs the threeprevious waves a financial tsunami (see chart 4, p. 12).Stock prices plunge in September 2008 and then continuetheir previous decline into 2009.

The crisis takes on a new dimension in the real econo-my as well, as the financial turmoil increasingly spills overinto economic activity. Industrialised economies, in particu-lar, are slowing down, and generally enter into recession dur-ing the latter part of 2008. Commodity prices and worldtrade plunge, propagating the downturn to emerging marketsand developing countries which were previously shieldedfrom the financial turmoil. In March 2009, the International

Monetary Fund forecasts that the world as a whole will enterrecession in 2009 for the first time since World War II. Whilethe Swiss real economy has remained strong in the previousphases of the financial turmoil, it now succumbs to the fal-tering growth in its main export markets. Switzerland entersrecession in the second half of 2008, and deflationary pres-sures emerge. A number of current and leading Swiss and in-ternational indicators improve in the spring of 2009, how-ever, suggesting that the contraction in economic activity isbecoming less sharp.

Large numbers of financial institutions throughoutthe world experience severe stress in the months followingthe Lehman Brothers bankruptcy. This stress results partlyfrom direct exposures to Lehman Brothers, but mainly fromthe extreme difficulty experienced in funding operations in

the frozen markets. Government involvement with bank res-cues also takes on a whole new dimension in the monthsfollowing the Lehman Brothers bankruptcy, as numeroussystemically important institutions such as Citigroup, Bankof America and American International Group in the US, aswell as the Royal Bank of Scotland in the UK, are rescuedby their national authorities, often through partial or full

nationalisation. In addition to the turbulent market condi-

tions and high money market spreads, the persistent fall inUS house prices continues to cause losses and write-downsin institutions with exposure to US real estate in this peri-od. By the end of May 2009, financial institutions world-wide have disclosed almost USD 1,500 billion of losses re-lated to the financial crisis.29 In addition, the real economicdownturn starts causing losses on consumer and businessloans during this period.

The two big Swiss banks continue to be adversely af-fected by the crisis. UBS reports further substantial losses re-lated to the US real estate market, leading to a net loss for2008 of CHF 21.3 billion and a further net loss of CHF 2 bil-lion in the first quarter of 2009. Up to the end of May 2009,UBS has disclosed a total of USD 53.1 billion30 of gross lossesand write-downs related to the US mortgage market. More-

over, UBS reports substantial net new money outflows in thisperiod. The fragility of UBS, combined with the turbulentmarket environment, leads to a joint package of supportmeasures for UBS by the Swiss government, the SNB and FIN-MA in the autumn of 2008. These measures provide for UBSto transfer a portfolio of illiquid assets of up to USD 60 bil-lion from its balance sheet to a fund controlled by the SNB,combined with a capital injection of CHF 6 billion decidedby the Swiss government. The transfer of assets is completedin April 2009. The final amount of transferred assets totalsCHF 38.7 billion. Credit Suisse also reports further losses re-lated to exposures to the US real estate market, although toa smaller degree than UBS. By the end of May 2009, CreditSuisse has disclosed a total of USD 17.1 billion31 of such loss-es. Moreover, and largely due to the adverse trading condi-

tions that prevail in September 2008, Credit Suisse suffersa net annual loss of CHF 8.2 billion in 2008, but returns toprofitability in the first quarter of 2009 with CHF 2 billionnet income. Swiss banks with a domestic business focus con-tinue to be very little affected by the financial turmoil andreal economic downturn, as the general quality of Swisscredit continues to be strong.

Phase 3: 15 September 2008 to presentThe money market panic of 2008 and its aftermath.

29 Source: Bloomberg30 Source: Bloomberg31 Source: Bloomberg


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A period of intense policy activity follows the LehmanBrothers bankruptcy and associated financial and economicstress. Central banks extend liquidity on a massive scale,with longer maturity and against a wider range of collateral.Currency swaps between central banks are used to ensure theliquidity of foreign currency in international markets, andpolicy rates are cut in order to counter the emerging threatof deflationary pressures. Policy rates generally move towardsthe zero lower bound in the spring of 2009, resulting ina shift to alternative or unconventional monetary policymeasures, such as balance sheet expansion through assetpurchases. In Switzerland, the SNB addresses the money mar-

ket crisis in the immediate aftermath of the Lehman Brothersfailure with massive and prompt liquidity operations in USdollars, through currency swaps with the Federal Reserve. TheSNB also supports the liquidity of Swiss francs in EasternEuropean markets through currency swaps against euros withthe affected central banks. Looming deflationary pressuresare addressed with a series of cuts in the target range for theSwiss franc Libor. The range reaches 00.75% in March 2009,at which point the SNB deploys a set of unconventional mea-

sures to address deflationary tendencies and increase liquidi-ty in Swiss markets. These measures consist of offering repooperations at longer maturities, purchasing Swiss corporatebonds, and intervening in currency markets in order to preventa further appreciation of the Swiss franc against the euro.

Fiscal policy also becomes very active in this period.Governments across the world announce sizeable fiscal stim-ulus programmes to support faltering domestic demand, bankrecapitalisation schemes, state guarantees for bank debt andmeasures to strengthen deposit insurance schemes. The fiscalcost of these measures is high. Government budget deficitsand public debt grow with exceptional speed by historical

standards. In Switzerland, the government agrees on two fis-cal stimulus packages, one in November 2008 and a secondin February 2009. These fiscal measures remain relativelymodest by international standards.

Moreover, as part of the package of measures tostrengthen the financial system announced in autumn 2008,capital requirements for big banks are tightened, effective asof 2013, and the Swiss deposit guarantee scheme is expand-ed with immediate effect (cf. box 1, p. 9).

Key events:Second half of September 2008:

Lehman Brothers files for Chapter 11 bankruptcy. Bank of America, a US bank, agrees to take over Merrill

Lynch. American International Group (AIG), a large international

US-based insurance company, receives a capital injectionfrom the government.

HBOS, a financial services group in the UK, is taken overby Lloyds TSB, a UK banking group, after a run on HBOSsshares.

Goldman Sachs and Morgan Stanley, the only two remain-ing US investment banks, convert to commercial bankholding companies.

Multiple financial institutions worldwide fail, or are res-cued by the authorities in partial or full nationalisations.

Government authorities around the world, including inSwitzerland, place bans on short-selling of stocks.

Major central banks cooperate to increase dollar liquidity

in international money markets. The SNB announcesnew overnight USD repo auctions to take place daily fora maximum of USD 10 billion.

UBS announces that its direct and counterparty expo-sures to Lehman Brothers, net of hedges, are substantiallyclosed out.

October 2008: Partial or full nationalisations of financial institutions

continue worldwide. Governments across the world announce financial mea-

sures to prop up national banking systems. Coordinated liquidity operations in USD by major central

banks, including the SNB, are further expanded. More-over, the SNB and other major central banks announcejoint interest rate cuts.

Run on Icelandic bank shares and currency. The Icelandicgovernment introduces sweeping new measures to deal withthe ailing banking sector and nationalises its largest banks.

Iceland, Hungary and Ukraine receive official monetaryassistance from different international donors, notablythe IMF, the EU and the World Bank.

The Swiss government, the SNB and the Swiss FederalBanking Commission announce a package of measures tostabilise the Swiss financial system, including the possi-bility for UBS to transfer a portfolio of illiquid assets to

a fund entity managed by the SNB (the SNB StabFund),a CHF 6 billion recapitalisation of UBS decided by thegovernment, a tightening of capital requirements for thebig banks, and a strengthening of the deposit guaranteescheme.

Fitch downgrades UBS. Credit Suisse announces a CHF 1.3 billion net loss in Q3,

mainly attributed to exceptionally adverse trading condi-tions in September.

The SNB issues SNB Bills a new monetary policy instru-ment for the first time.

November 2008: Further interest rate cuts and fiscal stimulus measures

are announced around the world, and more financial in-stitutions are rescued by governments.

The US Federal Reserve Board announces the beginningof purchases of asset-backed securities notably mort-gage-backed bonds.

The G20 meeting produces support for world trade andquick regulatory reform.

The package of measures to stabilise the Swiss financialsystem is approved by parliament and implemented.

The SNB makes two additional cuts in the target range forthe three-month Libor during the month.

UBS announces Q3 results of a CHF 296 million profit, withrealised and unrealised gross losses of USD 4.4 billion onexposures related mainly to US real estate. UBS, moreover,adopts a new compensation model for top management.

The first Swiss federal fiscal stimulus package is intro-duced.

December 2008: The National Bureau of Economic Research declares that

the US economy entered into recession in 2008. Further interest rate cuts and fiscal stimulus measures

are announced around the world, and more financial in-stitutions are rescued by governments.


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S&P downgrades a number of international banks ona worsening economic outlook

A complaint is filed against Bernard Madoff for an allegedUSD 50 billion Ponzi scheme.

The SNB projects that Switzerland will be in recessionin 2009, and lowers the target range for the three-monthLibor.

UBS transfers the first tranche of illiquid assets amount-ing to USD 16.4 billion to the SNB StabFund.

The SNB acts as a mediator in a transaction which allowsUBS and Credit Suisse to obtain funding from smallerSwiss banks against Swiss Pfandbriefe (covered bonds).

S&P downgrades UBS and Credit Suisse.January 2009:

The IMF projects world growth to fall to 0.5% in 2009, itslowest rate since World War II.

Policy measures to counter the crisis continue to be an-nounced around the world.

Bank of America and the Royal Bank of Scotland arebailed out by their national governments.

The UK government instructs the Bank of England to buyup to GBP 50 billion of assets directly from firms paving the way for quantitative easing.

The Fed announces the extension of existing liquidityprogrammes and swap lines between the Fed and othercentral banks.

The new administration, led by Barack Obama, is inaugu-

rated in the US. Major US banks announce generally weak or negative quar-

terly results for Q4 2008, and further write-downs associ-ated with real estate-related exposures, and increasingly more general credit fallouts and loan loss provisions.

The SNB announces that it is cooperating with the Euro-pean Central Bank, the National Bank of Poland and MagyarNemzeti Bank to provide CHF liquidity to European markets.

Fitch downgrades UBS and Credit Suisse.February 2009:

The US Treasury presents its Financial Stability Plan, andUS financial authorities announce that they will conductstress tests of large US banks.

Central banks further extend their cooperation to provideUSD liquidity in international markets.

Major European banks announce mixed Q4 and annual re-sults for 2008, and increasingly cite provisions for creditlosses due to a deteriorating credit environment.

Citigroup is bailed out by the US government. The second Swiss federal fiscal stimulus package is intro-

duced on the back of a worsening economic outlook. The SNB continues USD liquidity operations, and an-

nounces that it will issue SNB Bills in USD. The ordinance on mortgage bonds (Pfandbriefverordnung)

is revised, allowing the two big banks to raise furtherfunding against Swiss Pfandbriefe.

The SNB and UBS announc

Documents

Financial Stability Report of the Swiss National Bank