A Swiss finish

Author: | Published: 12 Mar 2015
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René Bösch and Benjamin Leisinger of Homburger explain how the country’s treatment of bank capital differs from EU standards

www.homburger.ch

Who are the relevant supervising authorities that govern financial institutions in the context of national Basel III/ CRD IV implementation and what is their remit?

Switzerland fully implemented Basel III as of January 1 2013. However, not being a member of the EU, it will not implement CRD IV.

The Swiss Financial Market Supervisory Authority (FINMA) was and still is responsible for issuing implementing regulations and, hence, also for the implementation of Basel III.

Are instruments other than common shares eligible to qualify as CET1 for banks and mutuals?

The Capital Adequacy Ordinance that implements Basel III names as instruments that qualify as CET1 the paid-in company capital, which includes nominal share capital, free reserves and retained earnings. Under Swiss company law, in addition to common shares, it would be possible to issue participation securities that in our view could qualify as CET1; participation certificates are essentially a form of non-voting stock, with which, however, no preferential rights would be associated.

According to FINMA Circular 2013/1, however, a bank that claims two or more different equity shares as CET1 of a bank, must demonstrate that these shares are treated equally regarding profit and loss sharing (also in the case of a liquidation). Additionally, for banks and financial groups supervised by FINMA that are organised as corporations and the common stock of which is traded on a Swiss or foreign stock exchange (with supervision that is equivalent to that of the Swiss stock exchange), only the common stock, and no other instrument, is eligible for CET1. Shares that do not qualify as CET1 of a bank must be allocated to additional tier 1 capital (AT1) or to tier 2 capital, provided they meet the necessary requirements.

A bank's CET1 is subject to deductions. For example, deferred tax assets, the realisation of which depends on the bank's future profitability, must be fully deducted from a bank's CET1. However, netting with associated deferred tax liabilities within the same geographical and factual taxation jurisdiction is permitted.

What instruments qualify as AT1 capital?

In its implementation of Basel III, Switzerland followed very closely the wording in the Basel III documentation in relation to AT1 capital. This means that essentially the following characteristics must be fulfilled:

(i) fully paid-in;

(ii) perpetuity;

(iii) first possibility to call the instrument at the option of the issuer no earlier than five years after issuance;

(iv) notification of holders that the supervisory authority will approve repayment, repurchase or redemption only if the issuer will have sufficient capital following that repayment, repurchase or redemption, or that the issuer will replace the instruments with instruments of the same or better quality;

(v) distributions are at the discretion of the issuer and may only be made if sufficient distributable reserves are available; and,

(vi) distributions must not increase over time in accordance with fluctuations in the issuer's specific credit risk. In addition, AT1 instruments must have a capital trigger at 5.125% CET1/RWA, meaning that if the ratio between CET1 and risk-weighted assets falls below 5.125%, the instrument must be written off or converted into equity. Finally, AT1 instruments do need to include a PONV-trigger.

How does Switzerland implement combined buffer requirements laid out in CRD IV and what is the relevant legislation/ regulation?

Again, not being a member of the EU, Switzerland will not implement CRD IV, but rather, has implemented Basel III. Switzerland implemented Basel III without any 'Swiss finish' for banks other than systemically relevant financial institutions (Sifis), thus providing for a basic capital requirement of 8% of which 4.5% must be met with CET1 and at least 6% with tier 1 capital (CET1 or AT1; the remainder can be filled with tier 2), a capital buffer of 2.5 % to be filled with CET1, and an anti-cyclical buffer of up to 2.5 % (currently, the Swiss government requires an anti-cyclical buffer of 2%).

Additionally, FINMA may require banks to hold additional capital. FINMA may exclude certain categories of banks from this obligation. This additional capital should specifically cover the risks that are not protected or that are not sufficiently covered by the minimum required capital if applying a risk-orientated approach (see also 12.1 below).

In addition to the rules that apply to all banks, the Swiss rules require that Sifis maintain a base capital of 4.5% of their RWA in the form of CET1. Sifis must also have a capital buffer of 8.5% of their RWA. Up to a maximum of 3% of that buffer may be in the form of convertible or write-down instruments that must meet the requirements for AT1 or tier 2 instruments and provide for conversion or write-down when the ratio of its eligible CET1 to its RWA falls below 7% (so-called high trigger instruments). At least 5.5% must be in the form of CET1. Together with the base capital, therefore, Sifis must have a CET1 capital of at least 10%. Moreover, Sifis must meet a progressive component requirement that is dependent on their size (leverage ratio exposure) and their market share in the bank's domestic systemic relevant business, but which amounts to at least 1%. The progressive component must be satisfied with convertible or write-down instruments that meet the requirements for AT1 or tier 2 instruments and provide for conversion or write-down at 5% CET1/RWA at the latest (so-called low-trigger instruments). Alternatively, a Sifi may opt to satisfy the progressive component requirement with CET1. Added together, Sifis must have regulatory capital of up to 19% (assuming 6% in the progressive component) or even more of their RWA of which at least 10% must be in the form of CET1. Sifis must also fulfil particular capital adequacy requirements relative to their total commitment, the so-called leverage ratio (see section 9 below). Finally, as for all banks, the Swiss capital requirements for Sifis provide for a supplemental counter-cyclical buffer of up to 2.5% of their RWA in the form of CET1 (which is currently set at 2%).

What capital triggers are expected/ are in place for AT1 securities and what is the relevant legislation/ regulation?

The capital trigger for AT1 securities is set at a minimum ratio of 5.125% between CET1 and risk-weighted assets. This requirement is set forth in the Capital Adequacy Ordinance.

How is the PONV defined?

The Capital Adequacy Ordinance does not define the point of non-viability, or 'PONV', but solely refers to the point of threatening insolvency. However, we believe that the PONV should refer to a situation where customary measures to improve the capital adequacy are inadequate or unfeasible and, therefore, the conversion or write-down of debt instruments is an essential requirement to prevent an issuer from becoming insolvent, bankrupt, or unable to pay a material part of its debts or from ceasing to carry on its business. In addition, the receipt of an irrevocable commitment of extraordinary support from the public sector that has or will have the effect of improving the bank's capital adequacy (not liquidity) will also constitute a PONV.

What is the status of Switzerland's treatment of stress tests? Have plans for upcoming tests been announced, and/ or are results of previous stress tests outstanding?

Neither Swiss legislation nor regulation provides formally for external stress testing. Notwithstanding this, FINMA and the Swiss National Bank may and regularly do require banks to perform stress tests, however, without those tests becoming public or the authorities reporting or commenting publically on them. There is no information available on any parameters or methodologies applied in these tests.

Which national body is conducting the tests?

FINMA, as the competent supervisor over banks, would be the competent body, but the Swiss National Bank may also require tests, based on its authority to supervise the stability of the financial system (macro-prudential supervision) and to assure that banks retain sufficient liquidity and reserves.

How will Switzerland's supervisory authority change in the next 12 months, if at all?

Switzerland was a fast mover after the global financial crisis and has achieved an overhaul of its financial supervisory regime since then. It has implemented legislation to address the too-big-to-fail conundrum and other aspects that ensued from the crisis. While there are plans to amend the banking laws, those plans relate to a more formal overhaul of the Banking Act rather than a substantive one. The one important plan that exists is to subject external asset managers to prudential supervision.

Are AT1s and/ or tier 2 CoCos tax deductible?

Under Swiss income tax laws, interest payments under AT1s and tier 2 contingent convertible securities (CoCos) and write-down securities are tax deductible.

Are coupon payments from AT1 and/or tier 2 CoCos subjected to withholding tax?

Generally, debt instruments issued by Swiss companies, including banks, are subject to Swiss withholding tax. However, the legislator introduced in 2012 a temporary exemption for interest payments on AT1 and tier 2 CoCos and write-down notes if they have been approved by FINMA. This exemption expires on December 31 2016, and was intended to be replaced by a different system (see below, 6.3). Instruments issued before that date, however, will be grandfathered.

To what extent have local rules been changed or are expected to change to enhance tax efficiency of AT1 and tier 2 securities?

The exemption from the Swiss withholding tax for AT1 and tier 2 CoCos and write-down notes is only temporary, lasting only until the end of 2016 if not re-enacted or adopted for an indefinite period. However, aside from that, there are general initiatives to abolish the Swiss withholding tax regime, probably replacing it with a paying agency deduction system.

What is the tax treatment in terms of the capital gains on a write down or conversion?

Capital gains in the case of write-down or conversion of the AT1 or tier 2 securities would generally qualify as taxable income. As a matter of practice, issuers obtain respective rulings from the tax authorities.

What type of loss absorbency features are, or will be required for AT1 and for tier 2 securities, and what is the relevant regulation?

For debt instruments to qualify as AT1 instruments, they must provide for a capital trigger at 5.125%, falling below which the instrument must either be fully written-off or must be converted into CET1 equity securities, for example, shares. In addition, a PONV-trigger must be included, again requiring the write-off or the conversion into CET1 equity securities. For tier 2 securities that do not qualify as conversion capital under Swiss capital rules for Sifis (that is, that do not have a capital ratio-related trigger at 5% (low-trigger) or 7% (high-trigger) CET1/RWA at the latest), merely a PONV-trigger is required.

Must all regulatory capital instruments – including tier 2 – be loss absorbing?

Yes. In order to qualify as regulatory capital instruments, all instruments must be loss absorbing, that is, they must at least provide for a PONV-trigger.

Are there any additional local rules that would affect an issuer's ability or its discretion to pay a coupon?

In addition to the issuer's discretion to pay a coupon, an issuer must have sufficient distributable profits or freely available reserves to pay a coupon. Whether or not an issuer has such distributable profits or freely available reserves must be determined by reference to Swiss company law.

How are MDAs calculated, and what happens in case of a breach?

In Swiss law, there is no banking-related mechanism or formula to calculate the maximum distributable amounts (MDA) in certain situations. Rather, Swiss company law only refers to distributable profits and freely available reserves. This amount must be calculated for a relevant bank by reference to Swiss company law set forth in the Swiss Code of Obligations and the Swiss Code of Obligations' accounting rules. However, if an institution's capital falls below the target level as individually defined by FINMA on a non-public basis, FINMA may order it to reduce or refrain entirely from dividend payments, share buybacks and discretionary remuneration components or to carry out a capital increase. The banks are subject to regular reporting duties as to their capital adequacy and, in the case of a breach of the minimum requirements, must immediately inform FINMA and its auditor. However, these breaches are normally not made public, neither by the bank nor by FINMA, unless FINMA orders draconian measures.

In the Regulatory Consistency Assessment Programme (RCAP), assessment of Basel III regulations – Switzerland of June 2013, the regulation in Switzerland on the distribution constraints was held to be 'partially compliant', but the lack of full compliance labelled as 'not material'.

Is it expected that the leverage ratio will be implemented sooner than Basel III/ CRD IV requires? What are the relevant ratios and dates?

Switzerland implemented a leverage ratio for Sifis as of January 1 2013. Swiss systemically relevant banks must fulfil particular capital adequacy requirements relative to their total commitment. This leverage ratio requirement is determined by reference to capital requirements and is, therefore, indirectly subject to phase-in arrangements. The target ratio is 4.56% (assuming a total capital requirement of 19%, that is, with no capital relief in the progressive capital component).

However, the introduction of a leverage ratio has been proposed in accordance with Basel III also for all other banks. FINMA may oblige banks to report their Basel III leverage ratio to them during an observation period, and FINMA collects the data to calculate the leverage ratio on a stand-alone and consolidated basis. The intention is for banks and securities dealers to disclose the leverage ratio from 2015 on. It is not yet clear whether Switzerland will follow the timetable indicated in Basel III or whether it will actually move faster than is required by Basel III.

What is Switzerland's position on whether AT1's can count towards financial institutions' leverage ratio?

Under the prevailing rules applicable for Sifis, AT1 instruments may count towards an Sifi's leverage ratio, and even tier 2 instruments, if they constituted conversion capital (CoCos or write-down notes) within the meaning of the provisions in the Capital Adequacy Ordinance in relation to Sifis and were either part of the buffer capital or the progressive component. The proposed leverage ratio for all banks would allow counting AT1 towards the leverage ratio.

Have local authorities specified how mutuals can comply with regulatory requirements?

Switzerland has addressed the question of how cooperatives can and have to comply with regulatory requirements (they also did so for cantonal banks and private banks not being organised as corporations), but they have not extended this guidance to other mutuals.

Have additional rules and regulations been issued in relation to Sifis?

Yes, in early 2012 Switzerland adopted a too-big-to-fail legislation that imposes additional requirements on Sifis in relation to capital, liquidity, large exposures and emergency planning. These additional requirements came into effect on January 1 2013. In Switzerland, UBS, Credit Suisse, Zürcher Kantonalbank and Raiffeisen have been identified by the Swiss National Bank as systemically relevant. UBS and Credit Suisse qualify as global systemically important banks according to the Financial Stability Board.

What, if any, examples are there of regulatory intervention (eg cases of nationalisation or restructuring) of failing institutions?

Under Swiss banking laws, FINMA as the prudential regulator over banks has the power to intervene and order protective measures in the case of a threatening insolvency or liquidity shortage, or if the institution does not fulfil the capital requirements after having been so reprimanded. Protective measures may include the giving of directions to the bank's governing bodies, appointing a special agent for the bank, discharging members of the senior management or the boards, ordering a halt on payments by the bank or putting the bank either into restructuring or liquidation proceedings. However, by operation of law, FINMA does not have any nationalisation powers.

There are no recent examples where FINMA had to intervene and make use of its broad powers.

Does local regulation specify pillar 2 requirements, and what are those?

In 2011 FINMA issued a circular addressing pillar 2 requirements for banks. Under that circular, banks will fall into one of five categories, in accordance with their size in terms of balance sheet, assets under management, privileged deposits and required capital under pillar 1. For each of these categories, a target capital ratio is determined, ranging from 10.5% for small banks (as opposed to a minimum of 8% provided for by the Capital Adequacy Ordinance) to 14.4 % (9.2% CET1; 2.2% AT1; 3.0% tier 2) for large banks that do not qualify as Sifis. The circular also defines intervention levels at which FINMA may intervene with the bank. Large banks qualifying as Sifis are not subject to this circular as they have to hold a higher share of risk-bearing capital over and above the minimum requirements under pillars 1 and 2. The RCAP, assessing compliance with the Basel III framework for Switzerland in June 2013, graded Switzerland as compliant with the pillar 2 supervisory review process. The assessment stated that Switzerland implemented all four key principles of pillar 2 in close alignment with the Basel III standards.

If so, what are the disclosure requirements around pillar 2, if any?

Finma requires that the methodologies used for calculating capital adequacy requirements be specified in the qualitative information disclosed, if material at the time of the annual accounts. The additional disclosure obligations required by Basel III are explicitly referred to as well. Compliance with those disclosure obligations is subject to the annual verification of the external auditors.

There are no special requirements in place providing for a bank's duty to disclose specific information, for example, the size of their buffers, in road shows or transaction or disclosure documents.

Large banks meeting certain requirements must also quarterly publish their CET1, tier 1 (CET1 and AT1) and ordinary regulatory capital ratios (tier 1 and tier 2) of the group and the most important bank subsidiaries and subgroups in Switzerland and abroad that have to comply with capital requirements and the minimum required capital.

Additionally, Sifis must quarterly report their ratios regarding CET1 and high- and low-trigger conversion capital. For the conversion capital, Sifis are required to disclose which of their conversion capital instruments have an AT1 and which have a tier 2 host instrument.

Are there any local provisions that could trigger early redemption?

No. There are no such local provisions. Generally, in line with Basel III, regulatory capital instruments qualifying as AT1 or tier 2 may be redeemed or repurchased in the case of the occurrence of a tax event or regulatory event. That redemption or repurchase is, however, still subject to FINMA approval.

Do local rules specify the use of credit default swaps or other tools to hedge against default or other credit events in order to lower regulatory capital requirements?

Minimum standards that should be met before capital relief will be granted in respect of any form of collateral are not explicitly stated in the Capital Adequacy Ordinance. However, FINMA has formulated certain minimum requirements in its FINMA Circular 2008/23 'Risk Diversification – Banks', in order for the credit derivative to be recognised. For instance, the credit risk must actually be transferred to the protection provider, and certain minimum criteria must be met.

Has the BRRD been implemented and if so, how? If not, what plans for implementation have been made?

Because Switzerland is not a member of the EU, the BRRD will not be implemented. However, Switzerland has overhauled its bankruptcy and liquidation laws applicable to banks, providing for a modern resolution framework based on the principles or guidelines of the Financial Stability Board. The relevant rules are set forth in the Swiss Banking Act and the Ordinance of FINMA on the Insolvency of Banks and Securities Dealers (BIO-FINMA). In restructuring proceedings, FINMA has a variety of tools, including bail-in and the transfer of assets, to try to successfully restructure the bank. Finma will initiate liquidation proceedings if a restructuring appears unlikely to succeed or has already failed. In this event, FINMA revokes the bank's banking licence, orders its liquidation, publicly announces the opening of liquidation proceedings and appoints a liquidator.

There are no requirements to hold eligible liabilities for bail-in, yet. Switzerland is awaiting guidance from international bodies in this respect.

About the author
 

René Bösch
Partner, Homburger

Zurich, Switzerland
T: +41 43 222 15 40
E: rene.boesch@homburger.ch
W: www.homburger.ch

René Bösch heads the financial services practice team. He advises on banking law and financial services regulation and specialises in offerings of debt and equity-linked securities, regulatory capital instruments for banks, as well as hybrid financial instruments.


About the author
 

Benjamin Leisinger
Associate, Homburger

Zurich, Switzerland
T: +41 43 222 12 96
E: benjamin.leisinger@homburger.ch
W: www.homburger.ch

Benjamin Leisinger’s practice focuses on banking, finance and capital markets law. His areas of expertise also include corporate and commercial law.