Managing the Global Credit Crisis,
the Swiss Way

The credit crunch that began in America's sub-prime mortgage market has erupted into a full-scale global financial crisis. Major banks and other financial institutions around the world have reported losses of approximately U.S. $435 billion as of July 17, 2008. The Swiss banks have been among the worst hit due to their exposure to the US subprime home loan market. UBS, the largest Swiss bank had to write down more than $37 billion in assets since the onset of the crisis in 2006. Credit Suisse, the second largest Swiss bank has ended up writing down 10 billion Swiss francs. It is estimated that between the two banks, a whopping sum of $68 billion in company capital is required to prevent a repeat of the subprime crisis. After making necessary adjustments and provisions, both banks come out of the red, first the Credit Suisse followed by UBS, showing signs of weathering the worstever financial storm in history.

The crisis began with the bursting of the US housing bubble and high default rates on "subprime" and other adjustable rate mortgages (ARM) made to higher-risk borrowers with lower income or lesser credit history than "prime" borrowers. The term 'subprime' refers to borrowers, whose credit ratings are poor. Housing finance companies have heavily lent them money charging high interest rates. A housing boom in the US led to the flourishing of huge mortgage bonds and security markets in the US and Europe.

Then defaults and foreclosures followed. Foreclosure is the legal proceeding in which a mortgagee, or other lienholder, usually a lender, obtains a court ordered termination of a mortgagor's equitable right of redemption. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79 percent from 2006. Loan incentives and a long-term trend of rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favorable terms later. However, once housing prices started to drop moderately in 20062007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as ARM interest rates reset higher. Their numbers are mounting by the day. It is these foreclosures, which accelerated in the US in late 2006, have triggered a global financial crisis through 2007 and 2008. As the US economy faces recession for various reasons credit markets across the world are passing through a state of distress. Besides the banks, re-insurers have also suffered losses. The Swiss Re, which operates several financial products, has been forced to depend on investment sustenance from Warren Buffett's Berkshire Hathaway.

Credit Crisis & Swiss Economic Policy
Federal Councillor Doris Leuthard in an address to the International Center for International Monetary and Banking Studies (ICMB), Geneva, talks about the impact of global financial sector crisis on the Swiss economic policies. The public lecture delivered on 27 May 2008, delves deep into the issues of international financial ramifications affecting the Swiss economy. Following is the full text of Leuthard's speech.

Banks and central banks, both at the heart of this institution's interest, have been seriously tested recently. This Center was timely with its last publication, the Geneva Report on the World Economy Nr. 9: It bears the title "International Financial Stability" and it concludes by setting out practical proposals to enhance financial stability. It is certainly necessary to reflect on what needs to be done to prevent financial stability disturbances in the future. However, what the financial sector has witnessed lately does not only concern the sector alone. And if the crisis' implications for the sector itself and its regulation need to be studied, there may also be broader conclusions to be drawn for the economy as a whole.

Indeed, we need to remind us once more - especially since one of the financial institutions with the largest write downs on complex securities is Swiss - that banks have a special role in the economy. If banks are facing difficulties, even if their ultimate cause is geographically and economically far away, the local economy may also be negatively affected. Given the efficiency and strength of the Swiss financial sector, this highlights the importance of creating beneficial conditions for broad based growth across all sectors of the economy. Relying on a few choice "growth" sectors will prove risky in due time.

Fortunately, we have so far not seen any negative effects on the domestic supply of credit in Switzerland. However, generally, as the Minister of Economic Affairs, I am interested in the good functioning of the banks in the Swiss economy, including in the prevention of banking crises and its impact on the economy as a whole. Here - and especially here - the innovative journalist Emile de Girardin's bon mot on government is true: "gouverner c'est prévoir". In Switzerland the banking sector is especially important and is a strong contributor to GDP in its own right.

Banks are an important part of Swiss economic activities. And we are proud to have them here. However, in the recent credit crisis, the large internationally active Swiss banks have suffered just as their equivalents elsewhere. After an exceptional boom in credit growth and leverage in the financial system, turmoil started in advanced financial markets in summer 2007. Lower and lower risk premia and abundant liquidity made it difficult for financial institutions and individuals to find acceptable yield. This fostered the development of complex securities that appeared to limit risk through pooling and tranching of different assets.

As we know, the US subprime mortgage market offered the underlying assets of many of these complex securities. And as conditions of this market worsened, delinquencies in the US subprime market increased and prices of indices of subprime-related assets fell sharply. This led to a general reassessment of risk and ultimately to a loss of confidence among financial institutions. Trade of complex securities broke down. As banks did not trust one another anymore, I am sure that central banks, in coordinated actions, played an important role in keeping markets liquid, thereby averting much worse consequences.

However, there were times, where the breakdown of trust was very worrying. The large Swiss banks, as many banks elsewhere in advanced economy countries, had to bear losses. Bank customers started to worry whether their money was safe even in Swiss banks. It did not help that one of them had to announce a series of write downs as the crisis evolved and valuations of assets had to be repeatedly revised downward. It appears now that, after in part very serious write downs, the Swiss banks most affected have been able to implement important corrective measures and have made progress in adjusting their asset portfolio.

While the problems in the financial sector are certainly not all dealt with yet, now is a time to start drawing the consequences - narrow and wide - for financial supervisors, central banks, and governments.

Calls for a re-regulation of the sector come from many quarters, are loud in part, and go in very different directions. But sometimes looking ahead mainly means not losing the head: Shock, fear, and anger have never been good advisors.

For the financial sector itself the Financial Stability Forum has issued an important report in April this year. It recommends among other things:

• increasing capital requirements for certain complex structured credit products.
• strengthening oversight over risk management and banks' stress testing.
• sound reporting of off-balance sheet exposures.
• better risk disclosure.
• Standards for off-balance sheet vehicles and valuation of assets.
• Changes in the role and use of credit ratings and
• Robust arrangements for dealing with stress in the financial system.

We will have to carefully assess which of these recommendations need to be implemented in Switzerland and how.

What is important here, however, is that the consequences for the financial sector are drawn in international coordination. The Financial Stability Forum's activities are therefore welcome and timely. We are dealing with a crisis, in which the depth of globalization of the financial sector has played a crucial role. Measures, including their implementation, will have to reflect that fact.

But I also feel the proposed measures will not be enough alone. I believe that current models of performance pay have led to a concentration of management on the short term. This short-termism, in turn, has fostered a gambler mentality. Indeed, the alignment of manager interests with those of shareholders through performance pay has been questioned already before by academia. As early as 2003, in an article in the Handbook of the Economics of Finance, Marco Becht, Patrick Bolton and Ailsa Röell note that the evidence in the US shows that manager pay increases when performance is good, but does not decrease in line when it worsens.

This may also be a problem in sectors other than the financial sector. I sense that high salaries combined with spectacular failings in the recent past may have weakened the trust in the free market system. Generally, I believe, that we will have to find back to a work ethic where good performance is delivered with a decent, but not outrageous salary. It seem to me that this should be possible: modern happiness research discovered surprisingly little correlation between wealth and happiness. Indeed, humans rapidly adapt to higher income levels, a phenomenon called "hedonic adaptation". If managers are not rendered much happier by and adapt too quickly to bonus payments, large incentive payments are not sustainable and hence wasteful.

What is certain, is that the trust in the Swiss banking sector as a sector of excellence has been impaired. I am conscious - and I am sure many of those present today are even painfully so - that not all of the banking sector deserves this loss. Nevertheless, as painful as it is, trust will need to be reestablished for the whole of the sector.

An element could be to work on compensation systems. I am aware that it is not easy to develop the right compensation model. It pays, however, to address the question. Both the corporate sector and academia will have a role in this important task.

Beyond these conclusions that mainly concern the financial sector, I believe the crisis in the sector should also teach us a broader lesson: the Swiss Economy should not rely on those sectors alone that are already strong.

In this crisis we have seen that part of the banking business has saved institutions and perhaps much more than that in Switzerland. At the outset I mentioned the important contribution of the financial sector to GDP. There is no doubt that Swiss banking is an asset for our economy. But while we are all proud of the strong, internationally competitive Swiss banking sector, we need to ask the question whether it is wise to have so many eggs in one basket.

What does this mean for Swiss economic policy? I believe that the case for strengthening other sectors of the economy that have hitherto been weak compared with others has never been as strong as today. It is simply good governance not just to rely on those that are already strong but to ensure conditions that enable others to gain in strength as well. This highlights the importance of the Federal Council's growth policy: The domestic economy needs to be further strengthened and opened up to foster competitiveness. We need to give the chance to the domestic economy to contribute to a more balanced Swiss economy.
As a response to the economic stagnation in Switzerland of the nineteen-nineties, the Federal Council already launched a package of 17 measures to increase trend growth in 2004. The idea was to bundle growth relevant measures across the different ministries into a consistent package. In Spring this year the Federal Council launched the continuation of its growth policy for the years 2008 to 2011. What is new now is that we are not thinking in packages anymore. Tending to the conditions of broad based growth across all branches of government is now recognized as a permanent task.

The program for the next years contains measures on three levels: foreign economic policy, the federal level, and the cantonal level. On these three levels we are pushing measures in three lines of action:

First, we want to bring down the high price level in the Swiss economy. This will not only benefit consumers, but also businesses in Switzerland, since the input for their production will become less expensive.

• The Federal Law on Technical Barriers to Trade is an important measure in this line of action. The current revision aims at strengthening the harmonization of products' requirements to EU requirements. This will facilitate imports out of the EU into Switzerland, fostering competition in the small Swiss market. An essential element of this package is the autonomous introduction of the "Cassis de Dijon" principle. According to this principle, any product that has been lawfully placed on the market of one of the EU member countries shall be deemed acceptable for the Swiss market. However, the Federal Council will retain the possibility to make exceptions to this principle, if this proves necessary to protect an overwhelming public interest. Last October, the Federal Council decided to limit exceptions to 18 cases after having assessed more than 100. In most cases, Swiss specific product requirements have been found unnecessary, although they have imposed administrative burdens and costs on both consumers and businesses during previous years.

• Another important project is to negotiate a free trade agreement for agricultural and food products with the European Union. It is quite obvious that the process of further opening agricultural markets will continue in the near future. The current WTO negotiations clearly point into this direction. In view of this perspective it is important to quickly provide new opportunities for Swiss farmers to export their innovative and high-quality products in a structured way. And opportunities there are: With the recent reciprocal opening of the cheese market between Switzerland and the EU we have seen an increase of Swiss cheese exports by 14 percent within three years!

Second we want to improve conditions for businesses in Switzerland.

• Eminently important in this respect is a successful conclusion of the Doha round of WTO negotiations. We earn every second Swiss Franc abroad. Our economy depends on open markets for goods and services and on rules which are enforceable. Presently, the negotiations are moving. I expect an improvement of market access for goods and services. I also expect, that we will have to cut tariffs in the agricultural sectors. This will not be easy for Swiss agriculture. But we should not deceive ourselves: for Switzerland the WTO is crucial. It is no option to stand aside. We know that and the world knows that.

• We will also continue our policy of concluding free trade agreements both as part of EFTA and bilaterally. Including the longstanding Free Trade Agreement of 1972 between Switzerland and our most important trade partner the EU and the EFTA Convention, the Swiss economy is benefiting from 19 free trade agreements concluded with partners around the world. Examples are Canada, the Republic of Korea, Mexico and a number of eastern European and Mediterranean countries. More such agreements are currently under negotiation, including with Japan, India, Columbia and the Gulf Cooperation Council.

• We will reform the value added tax. Procedures will be simplified and rendered more customer-friendly. Businesses will be offered more legal security. Moreover, we are aiming for a single tax rate, thereby reducing distortions in the economy.

• At the same time, we will continue our program of simplifying procedures and regulations for businesses in general. Simplifying the life of Swiss entrepreneurs in a hundred small steps will also have a positive impact and is a permanent task of government.

The third line of action is tending to the most precious of capitals, human capital.

• The most pressing issue here is the continuation of the agreement on free movement of persons with the European Union and its extension to Bulgaria and Romania. The ability to access critical talents also abroad enables businesses to seize opportunities they could not tackle otherwise and create additional complementary jobs. In the years 2006 and 2007 150'000 new jobs were created in Switzerland with the support of the beneficial economic environment. This would not have been possible without the free movement of persons with the EU. Therefore, the continuation of the current agreement and its extension need to be ensured.

As is well known, the refusal of the former would result in the automatic cancellation of the bilateral agreements I. It is also beyond doubt that the EU will not accept a different treatment of its two new members in the long term. I need not go into detail on what the cancellation of the bilateral agreements would mean for Switzerland.

• Other relevant measures in this line of action are the creation of a coherent higher education landscape, the development of a policy of life long learning, and an adjustment of the pension system to demographic changes.

Winston Churchill once said: a pessimist sees the difficulty in every opportunity while an optimist sees the opportunity in every difficulty. The crisis in the financial sector is an important difficulty, especially when the sector is such an important part of the economy as in Switzerland. Reclaiming the trust in Swiss banking and realizing the projects of the Federal Council's growth policy will no doubt also offer serious difficulties.

Now let us see the opportunities in both:

The difficulties in the usually strong Swiss financial sector are a valuable reminder to us that other sectors of the economy should also be strengthened. And the difficult tasks both of regaining trust in banking and of implementing the Federal Council's growth policy will offer us the prospect of a prosperous and more diversified Swiss economy.

Gouverner c'est prévoir: Let us be optimists in both and seize the opportunities we are offered.
Thank you for your optimist support!