The IT outage that disrupted the whole planet last July was a painful reminder that technology is not 100 percent reliable. Similarly, financial standards do not protect against all risks, Philip Adler writes in his article on finews.first.
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The season of the first-half results for Swiss banks is in full swing. These announcements can sometimes seem like an alphabet soup, with terms like CET1, LCR and NSFR representing financial ratios that are meant to help assess a bank’s solvency. If you have ever been left scratching your head by these terms, this article contains everything you ever wanted to know about these ratios but were afraid to ask.
For both regulators and analysts, assessing the solvency of banks is part of their job description. To help them, they have a whole set of ratios at their disposal. The best known is probably the capital ratio, which measures the relationship between a bank’s available capital – mainly consisting of its ordinary share capital and retained earnings, minus any goodwill – and its total risk-weighted assets.
The minimum capital ratio is 10.5 percent for a smaller local bank, and 12.8 percent for an international systemically important bank. FINMA can also raise the requirement on a case-by-case basis. Available capital is there to absorb financial losses and keep a bank stable in the event of a crisis.
«The LCR measures a bank’s ability to cope with a bank run»
The aim of the Liquidity Coverage Ratio or LCR is to ensure that a bank has enough of a liquidity buffer to deal with large cash outflows over 30 days. The LCR therefore measures a bank’s ability to cope with a bank run and must be over 100 percent.
The Net Stable Funding Ratio or NSFR assesses a bank’s long-term liquidity and therefore its structural resilience, showing whether it can maintain a stable funding profile over one year. The NSFR must also be over 100 percent.
Finally, a bank’s leverage ratio measures its solvency by comparing its core capital with its total non-risk-weighted assets, i.e. its outstanding debt. It must generally be over 3 percent, ensuring that the bank is not taking too many risks.
For all of these ratios, asset- and wealth-management banks usually have figures well over the required minimums because of their business models and the way they are managed.
«Same rules for all banks would probably have prevented the collapse of Silicon Valley Bank»
Supervisory authorities therefore have several tools available to them. However, there are regional differences. Europe – including the UK and Switzerland – has adopted uniform regulations, but that is not the case in the US. While all European banks must meet the higher ratio requirements set out in the Basel III agreements, some smaller US banks only have to meet the Basel I requirements. Applying the same rules to all banks would probably have prevented the collapse of Silicon Valley Bank: its LCR was high enough, but its NSFR was not, which should have been a red flag.
As shown by the adoption of Basel III in response to the 2008 financial crisis, the supervisory authorities are constantly adapting and their requirements change in line with events and technological progress. For example, Swiss rules on granting mortgages were tightened following the 1990s real estate crisis.
Although the resulting rules are often criticized by proponents of property ownership, they very likely helped prevent the market from overheating and avoided a wave of defaults – and therefore personal bankruptcies – when interest rates rose in late 2021.
«Many pitfalls can be avoided through a good dose of common sense»
Given the extent of economic and geopolitical difficulties in recent years, it is safe to say that the banking regulators have done their job. Thanks to the various ratio requirements and the stress tests introduced by central banks and regulators to simulate banks’ ability to withstand extreme economic and financial conditions, it is clear that risks relating to banks’ capital and ability to absorb losses are being adequately assessed. We are likely to see another example of the regulators’ adaptability soon with respect to liquidity risk, given the current review of what counts as a high-quality liquid asset (HQLA) in the LCR calculation.
Although some fear new technologies, they should make it easier for banks to have a comprehensive, real-time overview of their balance sheet position. They should also be of assistance to regulators and central banks, helping them to be even more accurate and responsive in fulfilling their supervisory role. Innovations are not a risk in themselves: it all depends on how they are used.
Of course, the IT outage that disrupted the whole planet last July was a painful reminder that technology is not 100 percent reliable. Similarly, financial standards do not protect against all risks. Undoubtedly, the best way of dealing with the emergence of hitherto unknown dangers is to have responsive institutions, central banks, regulators, and politicians.
Naturally, many pitfalls can be avoided through a good dose of common sense and a conservative attitude. After all, as the saying goes, you can never be too careful.
Philip Adler is the Global Head of Treasury & Trading at Geneva-based Union Bancaire Privée.
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