by Simon Amrein (European University Institute)
The regulation of capital has become a cornerstone of banking legislation in almost every country around the world. The last financial crisis has revived interest in the topic.
Various expert groups have identified low capitalisation in banking as a weakness of the financial system. Historically, banks in Switzerland had significantly influenced the regulation of capital, leading to lower capital requirements. It allowed them to grow rapidly and contributed to the leveraging of the banking sector.
Proportionally to total assets, equity capital has experienced a major change since the nineteenth century: Whereas balance sheets of US banks in 1850 consisted of 40% equity capital, the figure dropped to about 7% in 2000. Similar declines can be observed in other countries, such as Germany, Switzerland and the UK. During the last financial crisis, the equity capital to total assets ratio (capital/assets ratio) of large international banks dropped even lower, in some cases to below 3%.
The evolution of capital/assets ratios in banking is historically well documented. But there has been relatively little research on how capital was regulated over time and the role of regulators, supervisors and banks in developing the regulatory framework.
When a quarter of the banking market fails to comply with regulation
Analysis of banking legislation in Switzerland from 1934 to 1991 shows that capital requirements were eased through lower capital requirements and broader definitions of capital. Banks themselves were highly involved in shaping the design of the regulation within which they operated.
A new dataset provides insights into the so-called capital coverage ratio, comparing the actual capital of banks with the required capital according to regulation. By 1963, the three largest Swiss banks did not meet the statutory capital requirements anymore. Measured in total assets, the three banks represented about a quarter of Switzerland’s banking market.
Archival material shows that the banks entered into a series of negotiations with Switzerland’s banking supervisor, the Federal Banking Commission. The regulation of capital was changed several times between the 1960s and the 1990s.
Besides lowering the capital ratios, banks also lobbied for the extensive use of undisclosed reserves and subordinated as part of their regulatory capital. The regulatory changes coincide with significant improvements of the capital coverage ratio, showing that the banks’ lobbying was successful.
Regulatory changes enabled the growth of Swiss banking
Switzerland became one of the globally leading financial centres during the 1960s. Domestic banks thrived, and the balance sheets of the big Swiss banks – of which UBS and Credit Suisse still exist – grew by up to 20% per year.
Without changes in capital regulation, the balance sheets of Swiss banks would have been up to 35% smaller. Therefore, the evolution of the big Swiss banks into global financial players would have been severely hampered.
This research provides insights into regulatory and supervisory practice and shows that banking regulation has to be viewed in a historical context.