5.2.1 The Irrelevance of Capital: 1945 to 1973

From the 1920s to the 1970s, capital in banking was an issue of only secondary importance in the United Kingdom. In 1918, the topic received significant public exposure for the last time. Discussions surrounding the amalgamation movement increased public attention and created political pressure. The banks raised fresh capital after the First World War. During the inter-war period, the question of capital adequacy was of little importance, most likely because the British banking system went through this period without entering a crisis. The stability of the banking sector was never publicly questioned.Footnote ⁴² Moreover, it was often believed that this stability was rooted in high liquidity requirements.

The irrelevance of capital was emphasised by the reports of several parliamentary committees. In 1929, the Committee on Finance and Industry, known as the Macmillan Committee, investigated the reasons for the depressed British economy.Footnote ⁴³ The committee also analysed joint-stock banks. Even though the liability side of the banks’ balance sheets was discussed, equity capital as a source of funding that influences the structure of the asset side was disregarded.Footnote ⁴⁴ The final recommendations concerning joint-stock banks focused entirely on liquidity ratios and the control of credit supply by the BoE’s policy on reserve ratios.Footnote ⁴⁵

Another committee was appointed in 1957 to investigate Britain’s monetary policy during the 1950s.Footnote ⁴⁶ The Radcliffe Committee discussed the background of the monetary policy, the work and organisation of the BoE, as well as the role of the banks in the economy. In the context of banking, the committee analysed the macroeconomic importance of deposits, advances, and overdrafts. The topic of capital in banking was – once again – neglected. Discussing liquidity, the committee concluded that the 30% liquidity ratio that was followed by the banks in the 1950s was probably too high.Footnote ⁴⁷

Capital in banking did not even become a pressing topic once British banks’ capital/assets ratio hit a historical low point of 2.4% in 1953. The background for this drop in the capital levels was the interest rate hikes of the 1950s. From 1932 to 1950, the Bank Rate had been at 2%. The interest rate was raised to 7% in 1957, putting pressure on market prices for government securities. Government papers still contributed about half of the total assets on the banks’ balance sheets at the time, so the falling market prices translated into heavy losses for banks. Moreover, the ability of the banks to build up reserves through retained profits was severely restricted. The earnings of the banks on advances were low due to the BoE’s credit control.Footnote ⁴⁸ As previously shown, the banks wanted to increase their capital at the time. The BoE – prioritising monetary policy – declined these requests until 1958.Footnote ⁴⁹

Figure 5.2 shows British banks’ capital/assets ratio from 1940 to 1990. The impact of the capital issuances after 1958 was substantial. The capital assets/ratios almost doubled between 1957 and 1965, to 5%. Figure 5.3 displays the capital structure of the Big Five banks from 1940 to 1973, illustrating the build-up of the nominal capital over time. The jump in the capital/assets ratio in 1969 was due to the legal disclosure of hidden reserves. A closer look at the balance sheets of the Big Five reveals that the total reserves grew by £480m in 1969, which was equivalent to almost 3% of the banks’ total balance sheets. The increase in public reserves can be attributed almost exclusively to hidden reserves, as shown by the archival research of Billings and Capie.Footnote ⁵²

Figure 5.2

Capital/assets ratio, United Kingdom, 1940–90Footnote ⁵⁰

Figure 5.3

Paid-up capital, reserves and unpaid capital in £ millions, Big Five banks, 1940–73Footnote ⁵¹

Until 1979, the BoE maintained its traditional role as an informal banking supervisor. Technically, the Bank of England Act of 1946, which nationalised the BoE, gave it the power to issue directives to banks.Footnote ⁵³ This measure, however, was never used.Footnote ⁵⁴ The regulation of financial institutions was based on a mixture of statutory and non-statutory regulations. The BoE distinguished between two types of non-statutory regulation. Self-regulation was based on following commonly accepted guidelines set up by institutions or a group of institutions. The other form of non-statutory regulation was the exercise of authority over financial institutions – a role which was derived from its role and responsibilities as a central bank.Footnote ⁵⁵

A system often referred to as the ‘ladder of recognition’ emerged on the statutory side. The status of a bank depended on the level of recognition it received. The BoE viewed the various recognitions as a ‘status ladder’ via which banks could ‘progress as their reputation and expertise developed’.Footnote ⁵⁶ Climbing the ladder of recognition and becoming a fully authorised bank of the highest standing took eight to fifteen years.Footnote ⁵⁷ The complex web of regulations also had implications for the capital of banks.

The recognitions were based on lists that were related to the respective acts. The Exchange Control Act of 1947 tasked the Bank of England with maintaining a list of banks that were authorised to deal with foreign exchange.Footnote ⁵⁸ Thus, these banks were referred to as ‘authorised banks’. The Companies Act 1948 created a list of banks that were allowed to have hidden reserves.Footnote ⁵⁹ These banks were the ‘Schedule 8’ banks and were perceived as banks of the ‘highest standing’.Footnote ⁶⁰

Other acts were also applicable to banks, such as the Prevention of Fraud (Investments) Act of 1958, which stipulated a licence requirement for banks dealing with securities for customers.Footnote ⁶¹ Another example was the Protection of Depositors Act of 1963, which restricted the use of the term ‘bank’ when advertising for deposits.Footnote ⁶² Initially, the banks allowed to use ‘bank’ in advertising were the same as the ‘Schedule 8’ banks. In 1967, however, a section was amended in the Companies Act 1967 for banks exempted from the depositor protection legislation.Footnote ⁶³ The amendment created another list: the ‘Section 127’ banks.

Another recognition was based on Section 54 of the Income and Corporation Taxes Act 1970, which allowed banks to pay and receive interest gross of tax.Footnote ⁶⁴ Yet another recognition was based on the Companies Act of 1967, which allowed the Department of Trade to recognise institutions that conducted banking business (‘Section 123’ banks). Besides these recognitions, there were also minor forms of recognition, such as membership in the British Bankers Association, having obtained a clearing code from the Committee of London Clearing Banks, or being included in the Bankers Almanac.Footnote ⁶⁵

The large number of recognitions often came with certain requirements, some of them also in connection with capital. The Section 123 list, for example, required banks to hold capital of at least £250,000 and to conduct a range of banking services, such as issuing cheque books and offering current and deposit accounts. Inclusion in the Section 127 list required capital of £1m, offering a variety of banking services, having adequate liquidity, and good quality of management and a good reputation.Footnote ⁶⁶ For the Big Five banks, these capital requirements in absolute terms (rather than ratios) were irrelevant, given their large capitals in absolute terms (see Figure 5.3).

A government department – the Department of Trade – was responsible for granting legislative approvals for the various lists. The BoE, as an informal supervisor, however, was always consulted when banks were added to the lists. In this role, the BoE monitored liquidity and solvency ratios and conducted regular interviews with the banks. The actual supervision was usually conducted in informal meetings between representatives of the bank and the BoE’s Discount Office when banks submitted their accounts.Footnote ⁶⁷

The capital ratio used by the BoE during the 1950s to measure solvency was the ‘ratio of free resources’. The minimum ‘ratio of free resources’ ranged between 1:10 for newly established banks to 1:30 for discount houses. These ratios were not applied as target ratios in a strict manner but acted as signal that would alert the supervisors.Footnote ⁶⁸ For liquidity purposes the BoE observed the ‘quick assets ratio’.Footnote ⁶⁹

Given the complicated regulatory framework, it was not surprising that its complexity was about to be identified as a deficiency of the system. Moreover, as it turned out, the legislation failed to target new forms of financial institutions: the so-called secondary banks.

5.2.2 The Relevance of Capital: The Secondary Banking Crisis

The 1960s and 1970s were marked by structural change in Britain’s banking sector, which had a lasting impact on competition, the market participants, and their balance sheets. After the Second World War, investments in government debt gradually lost importance. Towards the end of the 1950s, government investments were no longer the largest balance sheet item on the asset side. Advances became the most important asset item again, for the first time since 1929.

The 1960s also brought about the first mergers in four decades. The National Provincial Bank acquired the District Bank in 1962. In 1968, the Westminster Bank merged with National Provincial. In 1969, Martins Bank was acquired by Barclays. Moreover, the British clearing banks developed from domestic to international institutions within a few years, and the number of international banks in London grew rapidly. The clearing banks’ balance sheets expanded by, on average, 8.9% p.a. during the 1960s and 20.0% p.a. in the 1970s.Footnote ⁷⁰

Domestically, policy changes aimed to replace the system of direct control by the BoE with market-guided mechanisms. The implementation of the ‘Competition and Credit Control’ (CCC) paper lifted many constraints on the banks in 1971, suggesting a new approach towards monetary policy.Footnote ⁷¹ Under the CCC policy, the clearing banks gave up their cartel, which had previously fixed the rates paid on deposits and set minimum rates for advances. In return, the clearing banks were allowed to enter the newly emerged wholesale market.Footnote ⁷² This change allowed them to place funds and raise deposits at other banks, which had previously had to be done through subsidiaries. Moreover, the paper suggested that a universal reserve ratio and adjustments in interest rates and open market operations should replace the existing quantitative control of lending through cash and liquidity ratios.Footnote ⁷³

In contrast to the previous system of credit control, not only clearing banks but all banks would be subject to reserve ratios. Thus, a new type of bank – the secondary (or fringe) banks – was also to be affected by CCC. The BoE already considered that the fringe banks should be invited to adhere to a 10% reserve ratio. However, these attempts were halted by the advent of the secondary banking crisis in 1973.Footnote ⁷⁴

The fringe banks emerged in the late 1950s and early 1960s. These institutions borrowed on the wholesale market and lent mostly for properties. Both the fringe banks and the wholesale market grew rapidly during the period of expansionary monetary policy between 1971 and 1973.Footnote ⁷⁵ Moreover, the fringe banks competed with the traditional clearing banks in the lending and deposit markets. During 1973 and 1974, falling housing prices put many smaller financial institutions under threat of bankruptcy and the BoE, together with the London and Scottish clearing banks, launched various rescue operations to stabilise the market.Footnote ⁷⁶

Several issues became apparent as a result of the secondary banking crisis, and some of them would affect the banking legislation to come. Firstly, many financial institutions were not supervised at all. There was only informal supervision of recognised banks by the Bank of England. Fringe banks and foreign banks were out of the supervisory scope. With the secondary banking crisis, the ‘old’ system based on the informal control of a small number of clearing banks came to an end. Secondly, after a long period of financial stability, awareness of the importance of protecting depositors grew as a result of the crisis. Lastly, the system of the ladder of recognition was too complex and, therefore, hard to understand for the public.Footnote ⁷⁷

During 1974 and 1975, it became apparent within the BoE that new legislation was both ‘inevitable and desirable’, as Peter W. Cooke, at the time responsible for banking supervision at the BoE, noted.Footnote ⁷⁸ The bank also reorganised its system of supervision internally. Until 1974, the Discount Office had been responsible for banking supervision. As a result of the secondary banking crisis, a new supervisory office – the Banking Supervision Division (BSD) – was formed.Footnote ⁷⁹

As the protection of depositors was questioned, the topic of capital adequacy received attention as well. In 1974, the BoE created a working group to reconsider the purpose of capital, as well as to discuss methods to assess capital adequacy and liquidity. The working group consisted of representatives of the London and Scottish clearing banks and officials from the BoE.

The working group published its results in a paper titled ‘The Capital and Liquidity Adequacy of Banks’ in 1975.Footnote ⁸⁰ This was the first time since the First World War that the topic of capital had received wider public attention. Moreover, it was also a novelty for the BoE to openly discuss methods for measuring capital adequacy. Until 1975, capital adequacy had been part of the supervisory practice but was only discussed directly between banks and the BoE. The working paper described the existing approaches towards capital adequacy and showed in which direction capital measures were to be developed.

At this time, similar discussions on capital adequacy were also underway in the EEC. The United Kingdom joined the EEC in 1973 and, as Peter Cooke pointed out, tried to influence the debates at the European level towards their interests.Footnote ⁸¹ With regards to capital adequacy, the British definitions were already quite close to those established by the EEC.

The working paper of 1975 described two methods of assessing capital adequacy. The first approach was based on the ’free resources ratio’, measuring the ‘free capital resources’ as a percentage of the liabilities. A second approach was the ‘risk assets ratio’. This new approach related the riskiness of different asset categories to the amount of capital resources. According to the working group, cash and balances with the BoE, advances to (or guaranteed by) the United Kingdom’s public sector, and advances to banks listed in the United Kingdom were regarded as risk free. Thus, such assets would not require banks to hold capital.Footnote ⁸²

The working paper also defined capital. There were two types of capital. The ‘free capital resources’ were defined as capital minus the book value of infrastructure, also referred to as ‘fixed assets’. This definition was closely related to the idea of the purpose of capital at the time. Capital was perceived as necessary to cover fixed assets, and fixed assets were considered the most illiquid asset, especially in times of crisis. The remaining amount of capital should ‘protect depositors from losses as a result of business risks’ and ‘engender the confidence of potential depositors and trading partners’.Footnote ⁸³

A second form of capital, which was used to calculate the solvency ratios, was ‘capital resources’. Besides paid-up share capital and reserves, the ‘capital resources’ also included provisions and loan capital. This was a comprehensive definition of capital. Loan capital was medium- to long-term subordinated debt. According to the view at the time, subordinated debt (in earlier years called ‘loan stock’) ranked after any other debt in the case of bankruptcy constituted an ‘additional line of defence’ for depositors.Footnote ⁸⁴

The inclusion of provisions as a part of capital and the use of subordinated debt is debatable. One can argue that non-specific provisions are a form of capital as they are comparable to general reserves and augmented by retained profits. Specific provisions, however, usually relate to an expected loss and therefore do not serve as a general loss absorber. Yet both forms of provisions were defined by the working paper as being a part of capital resources. Thus, the working group opted for an all-encompassing definition of capital. No ratio that included ‘hard’ capital, consisting of share capital and reserves alone, was discussed.

The working group deliberately avoided specific minimum ratios, arguing that quantification would reduce the flexibility to consider the different circumstances of individual banks. Nevertheless, it should be possible ‘to develop over time broad numerical standards for the different groups of banks which may be used as yardsticks’.Footnote ⁸⁵ Being the product of a joint working group by the BoE and the clearing banks, it is not surprising that much of the paper gives the impression of being a compromise. Regarding numerical capital requirements, the paper explicitly states that ‘the special position which the clearing banks occupy in the financial system is recognised’.Footnote ⁸⁶ Nevertheless, it must be remembered that this approach towards capital adequacy was in keeping with the BoE’s general principles and understanding of regulation and supervision at the time. It was flexible, avoiding rigid rules. It allowed each bank to be judged individually in a personal manner. Moreover, it was an outcome of the Bank’s participative approach.Footnote ⁸⁷

The working paper set the course for the perception of capital in the 1970s and 1980s. Subordinated debt was accepted as an essential part of the capital. In the BoE’s statistical publications on the banking market, no differentiation was made between the various types of capital. The Bank’s Quarterly Bulletins (Statistical Annexes) reported total capital resources only. The same applies to the international statistics provided by the OECD at the time.Footnote ⁸⁸ For a detailed assessment of a ‘narrowly defined’ capital base consisting of share capital and reserves only, one has to turn to the annual statements of individual banks.

Now that capital adequacy had finally emerged as a topic, was it viewed as an essential source of stability for British banks? Before the 1970s, the focus was clearly on liquidity, which was linked to the fact that credit control – or, more broadly, monetary policy – can be exercised through liquidity requirements. In 1975, George Blunden, at the time responsible for banking supervision at the BoE, still highlighted that ‘liquidity is probably even more important than capital adequacy’. Blunden argued that the secondary banking crisis had been a liquidity problem and not one of inadequate capital.Footnote ⁸⁹ The developments in the working groups on the European and international levels, however, seem to have shifted the focus from liquidity to solvency.

5.2.3 The Banking Acts of 1979 and 1987

By the mid-1970s, it was clear that British banking needed a new regulatory framework. The Banking Act was introduced in 1979 and represented the first legislation since the mid-nineteenth century that specifically regulated banks. The previous regulation, based on general Companies Laws and several pieces of legislation affecting different areas of banking, was mostly replaced. With regards to bank capital, however, the new Act did not introduce specific capital ratios. The Banking Act was in the tradition of British banking supervision, leaving the Bank of England as a supervisor with substantial discretionary flexibility.

The 1979 Act was primarily concerned with deposit-taking. Other areas, such as foreign exchange, securities dealing, and payment services, were left aside. All deposit-taking institutions had to be authorised by the BoE. The Act differentiated between licensed and recognised institutions. Both types of institutions were allowed to take deposits. The main difference was the type of supervision. The Act ensured that the supervision of recognised banks could continue mostly on a non-statutory basis – as was already the case.Footnote ⁹⁰

The Banking Act set minimum capital requirements of £250,000 for licensed institutions and £5m for recognised institutions.Footnote ⁹¹ There were no prescribed capital ratios, but a general statement on capital adequacy for licensed institutions:

Subparagraph 2 was defined as follows:

The paragraph on solvency for recognised institutions was formulated similarly, but was slightly less detailed.Footnote ⁹⁴ The Banking Act defined ‘net assets’ as paid-up capital and reserves. The definition of capital also opened the door for the use of other forms of capital, referred to as ‘other financial resources’. In practice, this meant subordinated debt and guarantees from third parties.Footnote ⁹⁵

The BoE further detailed the capital adequacy regime in another joint working paper with the British Bankers’ Association (BBA), which succeeded the Committee of London Clearing Bankers as a representative body in the discussions with the bank. The paper, titled ‘The Measurement of Capital’, described the methods and criteria that the bank employed when assessing the capital adequacy of financial institutions and was published in 1980.Footnote ⁹⁶

The discussions between the involved parties for the working paper were also the basis for the articles on capital adequacy in the Banking Act 1979. When developing the paper, Peter W. Cooke, Head of Banking Supervision at the BoE, stressed that the Bank aimed to develop a strict method for the measurement for capital adequacy. Referring to the attempts to harmonise capital adequacy in Europe, Cooke also stressed that other countries would not accept a system of ‘excessive vagueness’. At the same time, Cooke highlighted that the BoE would judge the assessment resulting from the application of the measurement methods in a flexible way.Footnote ⁹⁷ The representatives of the BBA emphasised that the BoE’s proposals were generally acceptable, but they were concerned about moving towards a ‘more inflexible, formalised system of supervision’.Footnote ⁹⁸

The final paper on the ‘Measurement of Capital’ published in 1980 took the banks’ as well as the BoE’s concerns into account. It once again confirmed that the regulation and supervision of capital adequacy should be flexible, considering the individual characters of the institutions. It also took a clear stance against fixed minimum ratios, which – according to the paper – could be an incentive for overtrading. The paper also argued that capital ratios should not be public knowledge as this could weaken the ability to issue new capital when a bank is in crisis.Footnote ⁹⁹

The BoE clearly preferred opaqueness over transparency, adding that ‘the Bank’s views on capital adequacy have been discussed with individual banks in confidence for some time past. This will continue.’Footnote ¹⁰⁰ In the internal discussions leading to this final statement, the BBA lobbied strongly for this policy. According to the representatives of the banks, publishing a capital ratio ‘could lead to banks carrying more capital than was absolutely necessary in order to avoid a run on confidence’.Footnote ¹⁰¹ The BBA also warned about a ‘potential risk of misunderstanding’ if detailed information on capital adequacy were to be published, as this could undermine ‘confidence in international banking’ and harm the availability of credit.Footnote ¹⁰²

The paper on ‘The Measurement of Capital’ endorsed the same two capital ratios as the first paper in 1975. The ‘free resources ratio’ ratio was slightly adapted and now termed the ‘gearing ratio’. For the second ratio – the ‘risk assets ratio’ – the BoE stressed that this was more useful and was the concept of reference going forward.Footnote ¹⁰³ The definitions of the risk assets were much more detailed than in 1975. The paper stated exact weights for different asset classes. Balances with the BoE, for example, had zero weight; loans had a 100% weight. Interestingly, there was also a 200% weight for property owned by a bank, which was probably due to the still recent experience of collapsing property prices at the time.Footnote ¹⁰⁴ The BoE and the BBA spent much time discussing these risk coefficients in the working group. The BBA aimed for a more comprehensive system with many different risk categories. For advances, for example, the BBA argued that several risk groups should exist, and one risk category alone would not lead to meaningful results. In addition, the BBA argued strongly for the use of the ‘risk assets ratio’ and questioned the validity of the ‘gearing ratio’.Footnote ¹⁰⁵

One important area that had changed until 1980 compared to the preceding working paper on bank capital in 1975 was the definition of capital. Provisions for expected losses were excluded from the capital, which was an outcome of the EEC’s Advisory Committee recommendations, formulated after the EEC Banking Directive in 1977. However, the importance of subordinated debt as a form of capital had grown substantially. While it was still clear that subordinated debt could not absorb losses, it was increasingly emphasised that it could also be used to finance fixed assets.Footnote ¹⁰⁶ In 1975, this role was attributed only to equity capital. The working paper of 1980, therefore, manifested the rise of subordinated debt as a substitute for capital.Footnote ¹⁰⁷

The working papers of the BoE and the regulation of capital and liquidity in the Banking Act were mostly the results of technical discussions between BoE officials and bank representatives. However, on a broader level, questions were also raised about the regulation and supervision of British financial markets. In 1980, a report by the Committee to Review the Functioning of Financial Institutions (Wilson Committee) was published. As well as its general analysis of the financial system, the committee also discussed the capital levels of the banks. It concluded that capital ratios had been falling during the first half of the 1970s, mainly because inflation had driven the balance sheet growth. The Wilson Committee also noted that the fall in capital ratios would have been even more severe if there had not been an extensive ‘raising of loan capital’, which underlines the importance of subordinated debt.Footnote ¹⁰⁸

Various interest groups submitted reports to the Wilson Committee, among them the Committee of the London Clearing Bankers. The clearing banks highlighted their opinion that simple capital/deposits ratios had lost importance, emphasising instead the trend towards ‘measures that reflect the varying degrees of risk attached to different assets’.Footnote ¹⁰⁹ The Committee of the London Clearing Bankers clearly favoured a ‘risk assets ratio’. The clearing banks argued that treasury bills could be financed fully with deposits, as risks of price fluctuations or defaults were negligible. At the other end of the scale, properties could fluctuate and were difficult to sell in a crisis. These characteristics would have to be considered by a capital adequacy framework.Footnote ¹¹⁰

The BoE’s working papers on capital adequacy in 1975 and 1980, together with the Banking Act 1979 and the EEC’s Banking Directive 1977, had set the stage for the assessment of capital adequacy. The initial catalyst that had brought the topic of capital adequacy back onto the domestic agenda was the secondary banking crisis. However, the development of the framework for assessing capital adequacy on a domestic level interacted with international developments.

The Banking Act of 1979 was replaced by a new Banking Act in 1987. The new Act was mostly the consequence of the rescue of Johnson Matthey Bankers by the BoE in 1984. The bank’s failure was followed by another parliamentary report in 1985, which reviewed banking supervision in the United Kingdom.Footnote ¹¹¹ The Act of 1987 brought many changes: it ended the two-tier system of recognised and licensed banks, among other things, and increased the power of the BoE as a supervisor. With regards to the regulation of capital, however, not much altered.

The Banking Act 1987 still required each bank to ‘conduct its business in a prudent manner’. This meant that ‘net assets’ and ‘other financial resources’ would have to be considered appropriate by the BoE.Footnote ¹¹² The amount of capital that a bank needed to maintain would depend on the nature and scale of the institution’s operations and the ‘risks inherent in those operations’.Footnote ¹¹³ The Banking Supervision Division of the BoE further outlined the definition of capital adequacy based on its initial working paper from 1980. In a paper on subordinated loan capital, the BSD further specified the requirements of subordinated debt to be part of ‘other financial resources’.Footnote ¹¹⁴ The risk-weighting approach for credit risks on the asset side, developed in 1980, was expanded in a paper in 1986.Footnote ¹¹⁵ Other types of risks, such as operational and foreign exchange risks, were also discussed and formed part of the BoE’s assessment. Based on an individual analysis of each bank, the BSD defined a minimum capital ratio, termed the ‘trigger ratio’, and a goal for the capital requirement, referred to as the ‘target ratio’.Footnote ¹¹⁶ However, little was known publicly about the exact process that led to setting the individual ratios.

When the BCBS issued its first common framework for the assessment of capital adequacy in 1988, the BSD issued a paper on how the international framework could be implemented in the United Kingdom.Footnote ¹¹⁷ The BSD noted that the international convergence would not change much for UK banks.Footnote ¹¹⁸

The United Kingdom transferred to a Basel-compliant framework by the end of 1989. One of the key differences was that it also took off-balance-sheet items into account. However, the general approach towards the regulation of capital did not change. Capital requirements in the form of ‘triggers’ and ‘target risk assets ratios’ were still set based on individual evaluations of banks and continued to be confidential. The BoE noted that British banks would already meet the 8% capital requirement, and that it would not revise the individual ‘triggers’ or ‘target ratios’.Footnote ¹¹⁹

The introduction of Basel I in the United Kingdom marked the end of the process. Capital in banking had been almost irrelevant from the 1920s to the 1960s, until the secondary banking crisis at the beginning of the 1970s revived discussions about capital adequacy and initiated a series of papers by the BoE on the topic. Risk-based approaches to solvency found increasingly more attention in supervisory practice after 1975. Basel I and its application in 1988 represented only a gradual evolution that built on the already existing domestic framework for capital regulation. As such, this is not surprising. The United Kingdom took part in the discussions at the European and international levels and certainly influenced these discussions. The inclusion of subordinated debt as part of the Tier 2 capital under Basel I, for example, was clearly in the interests of the United Kingdom. At the same time, the international approach towards solvency certainly influenced domestic evolution as well (e.g. the treatment of provisions).

Despite all the regulatory changes, approaches on the supervisory side did not change to any great extent. The BoE remained independent in setting individual minimum capital ratios for banks, and there was never a legally prescribed capital ratio.

5.3.1 Banking Legislation in the 1930s

Swiss banking legislation consisted of three layers. The banking regulation introduced in 1934/5 was based on the Banking Act and the Banking Ordinance.Footnote ¹³² The former was passed by the government in November 1934 and became effective in March 1935.Footnote ¹³³ The latter – the Banking Ordinance – outlined the application of the Banking Act and was introduced in 1935.Footnote ¹³⁴ A third level was introduced in 1936: the Circulars issued by the FBC outlined its position on certain questions over the application of the law. The Circulars were not legally binding but gained soft law character over time. In the Circulars, the commission described how it applied banking legislation in supervisory practice.Footnote ¹³⁵

The responsibilities for each layer of the banking legislation were and still are different. New laws and amendments have to be passed by the Swiss parliament. In contrast to the Banking Act, the Ordinance requires only the approval of the Federal Council.Footnote ¹³⁶ The Circulars are in the power of the FBC. The three-layer system – Banking Act, Ordinance, and Circulars – remains the same today.Footnote ¹³⁷

The Banking Act was the first comprehensive banking regulation on the national level in Switzerland. The newly introduced legal framework also regulated capital requirements.Footnote ¹³⁸ Article 4 of the Banking Act stated:

The Banking Ordinance (Art. 10) further expanded upon Article 4 of the Banking Act. Regulatory capital was defined as paid-up capital, 50% of non-paid-up capital (liability), guarantees from municipalities, disclosed reserves, and retained profits (or losses).Footnote ¹⁴⁰

In Article 12, the Banking Ordinance set two different minimum capital requirements, depending on the type of bank and the structure of its assets. Cantonal banks and cooperative banks with the unlimited liability of their members were required to hold a capital equivalent to at least 5% of the liabilities. All other banks had to hold a minimum of 5% of the liabilities that were invested in assets covered by domestic real securities (i.e. mortgages) and government securities.Footnote ¹⁴¹

The Banking Act also stipulated liquidity requirements.Footnote ¹⁴² There were two types of liquidity ratios: one that included only cash and reserves at the SNB, and one that considered a broader range of liquid assets.Footnote ¹⁴³ The liquidity ratios were measured as a percentage of short-term liabilities.

The roots of the Banking Act of 1934 reach back to a first legislative draft developed between 1914 and 1916. After a series of bank defaults from 1910 to 1914, the Federal Council commissioned Julius Landmann, Professor of Economics at the University of Basel, to develop a draft for the regulation of banking.Footnote ¹⁴⁴ Landmann suggested a discretion-based framework for Switzerland’s bank regulation. Given that Swiss banks followed various activities, ad-hoc judgements would ensure that different business models were considered. Moreover, Landmann claimed that a governmental authority would usually be too late to intervene in a rule-based system, proposing flexible regulation without detailed rules. Specific capital and liquidity ratios should result from the ‘practice of regulation’.Footnote ¹⁴⁵

Landmann’s discretion-based approach and a substantial part of his first draft served as a blueprint for the Banking Act of 1934. The pressure of the Great Depression and two big banks on the brink of default finally led to the introduction of a national banking law.Footnote ¹⁴⁶ When the Banking Act was submitted to the parliament, the Federal Council emphasised the discretion-based approach taken in the regulation of banking. For the regulation of capital, that meant that it was ‘difficult or even impossible’ to stipulate a universally valid ratio between capital and liabilities for all banks. The Banking Act should provide guidelines only. Nevertheless, specific minimum capital ratios were set in the Banking Ordinance, according to the Federal Council, considering the ‘nature of the different institutes’.Footnote ¹⁴⁷

The main goals of the new banking regulation were to increase security for creditors, ensure the supply of capital for the economy, and improve the degree of information available to the SNB to enhance transparency.Footnote ¹⁴⁸ The role of capital was seen as being an absorber of losses to safeguard depositors.Footnote ¹⁴⁹ The liquidity requirements were viewed as being equally as important as capital adequacy for the stability of banks. Both measures were usually mentioned together and perceived as an instrument for the protection of depositors. The statement by the Federal Council in 1934 is fairly representative of the time: ‘It is not sufficient for the deposits to be secured in principle [by capital and reserves]; they must also be able to be withdrawn within the specified time limits.’Footnote ¹⁵⁰

The Federal Department for Finance and Customs was charged with developing the Banking Act and Ordinance.Footnote ¹⁵¹ In an internal report, the department analysed the capital structure of the Swiss banks in February 1934.Footnote ¹⁵² The authors remarked that there was a strong relationship between the level of capital and the share of mortgages: savings and Raiffeisen banks held the lowest capital and had the comparatively highest shares of mortgages on the asset side. The group of cantonal banks, also mainly focused on the mortgage business, held only slightly more capital than the other two bank groups. The authors of the report believed that banks with a predominant mortgage business have lower risks than the big banks. The Federal Department for Finance and Customs also discussed the liability of the banks’ owners. Most cantonal banks at the time had government guarantees, and Raiffeisen banks were cooperative banks with unlimited joint guarantees of their members. The department therefore proposed that the mortgage share and the form of the liability should be considered if capital requirements were introduced.Footnote ¹⁵³ Both recommendations found their way into the banking legislation.

The experts developing the law believed that using a bank’s mortgage share and liability situation to determine adequate capital was only the second-best option. They thought that capital should depend on the risks of each bank and that the risks could be ‘found in the assets’.Footnote ¹⁵⁴ However, they concluded that ‘it is impossible to find a measure for the risks on the asset side; it is not like reading the temperature on a thermometer’.Footnote ¹⁵⁵ Nevertheless, one could argue that the final legislation already provided a simple risk-weighted approach; it was just that there were only two risk categories: mortgages and government securities on the one hand, and all other assets on the other hand. Instead of a risk-weighting of assets, two different minimum capital ratios were applied to the two classes.

When discussing various possible capital ratios, the group of experts of the Federal Department for Finance and Customs debated the idea that capital requirements should balance the interests of creditors and shareholders. For creditors, the experts emphasised the role of capital as a buffer against losses. Regarding shareholders and banks, it was argued that excessive capital ratios could lead to more risk-taking by banks since they would be pressured to provide sufficiently high returns to their shareholders.Footnote ¹⁵⁶

The considerations for an appropriate liquidity requirement were almost identical to those on capital adequacy. The group of experts argued that banks with a high share of mortgages bore a lower risk. Thus, they should be allowed to have lower liquidity ratios. Furthermore, the experts noted that bigger banks, measured by total assets, should hold more liquid assets as they were systemically more relevant ‘to maintain the ability to pay’.Footnote ¹⁵⁷

Apart from this argument on the systemic stability of the financial market, another issue became apparent in the context of liquidity: in contrast to capital adequacy, liquidity was perceived as relevant for monetary policy. Liquidity ratios were not actively used to influence the individual business policies of banks, such as domestic lending policies, accepting foreign capital, or investing abroad.Footnote ¹⁵⁸ The relevance of liquidity ratios for monetary policies, however, was recognised. One of the central concerns of the Banking Act was to increase the transparency of the banking market for the SNB. The commercial banks had to submit monthly or quarterly balance sheets (depending on their size) that allowed the SNB to assess their liquidity.

The final introduction of a minimum capital ratio in the Banking Ordinance is somewhat surprising, given the liberal character of the legislation that was meant to be restricted to a ‘few general principles’.Footnote ¹⁵⁹ The banks themselves did not resist these capital requirements. During the consultation process, various interest groups submitted their suggestions for changes in the draft of the law. Credit Suisse’s general manager, Adolf Jöhr, was primarily concerned that private banks should not be excluded from capital requirements.Footnote ¹⁶⁰ The cantonal banks wanted to be excluded from being subjected to banking legislation altogether, claiming that the regulation of cantonal banks would undermine cantonal sovereignty.Footnote ¹⁶¹ And the Berne Audit Association, a self-regulatory body auditing its member banks, suggested a capital/deposits ratio of 10%, as its member banks already voluntarily adhered to this ratio.Footnote ¹⁶²

The use of capital ratios was already well accepted as a vital factor for the soundness of a bank before the introduction of banking legislation in the 1930s. There were already conventions among the banks with regard to capital adequacy for different groups of banks (e.g. that of the Berne Audit Association). Also, the bank group (e.g. cantonal banks, big banks) served as a proxy for the riskiness of a business model. To some extent, the capital requirements formalised conventions that already existed before. The introduction of a capital threshold was further facilitated by most banks fulfilling the requirements. Based on the year-end figures of 1932, the Federal Department of Finance and Customs had discussed potential capital/liability ratios of between 5% and 15%. The department’s analysis showed that most banks would have fulfilled these requirements.Footnote ¹⁶³ On a broader level, the big banks had little negotiating power once they accumulated significant losses in the 1930s.

5.3.2 The Evolution of Capital Regulation: 1934–91

Figure 5.4 visualises the evolution of capital regulation in Switzerland from 1934 to 1991. There are two key components of the regulation: capital requirements (required capital), and the definition of capital from a regulatory point of view (regulatory capital). In 1961, the Banking Ordinance and its capital requirements were revised for the first time. Changes were made on two levels. First, a lowered ratio for investments made in liquid assets was introduced, which reduced the required capital. For banks that were not cantonal or cooperative banks, that meant that were three risk classes on the asset side: liquid assets, assets invested in government securities or covered by mortgages, and all other assets. Second, the definition of the regulatory capital was broadened. The revised Banking Ordinance allowed any kind of ‘free reserves’ to be used as part of the capital. That included hidden reserves. The extent of this use could be set by the FBC.Footnote ¹⁶⁴

Figure 5.4

Capital regulation in Switzerland, 1934–95

The FBC allowed that up to 15% of the required capital could consist of hidden reserves. The ratio was increased to 25% in 1967. After 1972, hidden reserves could be used as part of the required capital without any restrictions at all. After 1981, banks could also use subordinated debt as part of their required capital (up to 10%; the ratio was further increased in 1988). Thus, the definition moved closer towards what came to be Tier 2 capital in Basel I in 1988. By 1981, the definition of regulatory capital in Swiss legislation was almost identical to that in the Basel Accord.

The revision of the Banking Ordinance of 1981 also brought the introduction of a risk-weighted approach. For the first time, capital was not measured against liabilities, but against assets. According to the FBC, the new approach allowed a better consideration of banks’ different business activities.Footnote ¹⁶⁵

Having presented capital regulation as introduced in 1934/5, and the changes it subsequently underwent up to 1991, the question remains as to whether or not banks actually met the statutory capital requirements. In order to assess this, one can divide the regulatory capital by the required capital. The percentage is the so-called capital coverage ratio.Footnote ¹⁶⁶ If the ratio is above 100%, a bank holds more capital than legally required. Until the revision of the Banking Ordinance in 1961, most balance sheet items relevant for calculating the capital coverage ratio were public. After 1961, the opacity of the banking market was significantly increased as hidden reserves could be used as well. In 1953, however, the SNB started to publish the capital coverage ratio for all bank groups in Switzerland.Footnote ¹⁶⁷ Based on a few assumptions, one can estimate the capital coverage ratio for the period 1935–53 (see footnote 168).

Figure 5.5 shows the capital coverage ratio from 1935 to 1991. The average of all Swiss banks together was above the minimum capital requirement of 100% for the entire period. However, the capital coverage of the group of big banks deteriorated rapidly after the end of the Second World War, and in the mid-1950s the big banks increasingly struggled to meet capital requirements. The capital coverage still reached 105.7% in 1957, but in 1958 it fell below the 100% capital requirement, to 95.5%, for the first time. The low point was reached with a capital coverage ratio of 84% in 1960, meaning that the banks lacked 16% of the required capital. The ratio recovered in the 1960s, only to drop below the minimum capital requirement in 1971 (93.0%). It was only in the 1980s that the big banks managed to improve their capital coverage to above the minimum threshold.

Figure 5.5

Capital coverage ratio (regulatory capital vs. required capital), all banks and big banks in Switzerland, 1935–91Footnote ¹⁶⁸

5.3.3 The Influence of Banks on the Evolution of Banking Regulation

The number of non-compliant banks did not change significantly over time. What changed, however, was the relevance of the banks concerned. In 1959, the FBC granted eleven approvals to Raiffeisen banks, savings banks, and one cantonal bank. Besides these banks, the Union Bank of Switzerland and the Swiss Bank Corporation (SBC) also failed to meet capital requirements.Footnote ¹⁶⁹ At the beginning of the 1960s, Credit Suisse also failed to meet capital requirements.Footnote ¹⁷⁰ This gap in the capital requirements meant that the three most significant financial institutions in Switzerland lacked capital from a regulatory point of view. The three banks represented about a fourth of Switzerland’s banking market (measured by total assets).Footnote ¹⁷¹

Such a situation triggers a reaction from a banking supervisor. Theoretically, a non-compliant bank may be forced to terminate its business and be liquidated or sold. Alternatively, the bank may continue its business by (1) issuing new shares, (2) restructuring (e.g. reducing the total of assets), (3) being granted an exceptional approval for not complying with the regulatory standards, or (4) the regulation is changed altogether and the capital requirements are lowered. In the Swiss case, apart from divesting and reducing the balance sheet sizes, all these alternative options were used.

The Swiss banks frequently sold new shares to their shareholders. The Union Bank of Switzerland increased its paid-up capital in 1959, 1961, 1962, and 1965. Within seven years, the paid-up capital had doubled. Credit Suisse issued fresh capital in 1961, 1963, and 1965. The SBC raised its nominal capital in 1961, 1963, and 1966. The FBC also frequently granted exceptional approvals for non-compliant banks based on the Banking Act (Art. 23, 3d). In the long run, however, the capital requirements were further eased through lower capital requirements and broader definitions of capital, as shown in Section 5.3.2. Naturally, non-compliant banks have a distinct interest in their regulatory framework. What was the role of the banks in the regulatory changes which took place from the 1960s to the 1980s?

The regulatory changes outlined herein were made upon requests from banks. Besides the big banks, the Swiss Bankers Association (SBA), as a representative body for banking interests, lobbied for the continuous development of banking legislation. The SBA had been established in 1912. One of its goals was to coordinate and promote banking interests domestically and abroad. Since then, it had become one of Switzerland’s most influential business interests associations. The SBA also had well-established connections at the political and administrative levels. Members of the SBA were frequently present in extra-parliamentary commissions.Footnote ¹⁷² There were also links between the SBA and the SNB: several board members of the SBA were also members of the SNB’s ‘bank council’, while some were even members of the SNB’s ‘governing board’.Footnote ¹⁷³

The first requests to lower the capital requirements were brought to the FBC by the Swiss Bank Corporation in 1955 and 1956. A second attempt was made in 1957 by the group of the big banks together with the SBA. The banks and the SBA suggested that hidden reserves should be counted as part of the regulatory capital and that the required ratio for liquid assets should be lowered.Footnote ¹⁷⁴

The banks used a range of arguments to convince the FBC to broaden the definition of capital. The general directors of the big banks argued that their business activities had changed strongly in the last couple of years: large-scale industrial investments had become less relevant, their foreign exposure had become more diversified, and, overall, they were developing more towards deposit banks. Furthermore, they argued that liquid assets especially were mostly risk free, and regulation should take this into account. Overall, the proposed changes would, according to the bank managers, not affect the protection of creditors, and the lower risk would justify lower capital requirements.Footnote ¹⁷⁵ The general director of Credit Suisse argued that ‘the solid tradition, with which the banks are run, leads to safety buffers that would allow a more liberal regulation’.Footnote ¹⁷⁶

The banks also argued that the high growth rates of the balance sheet totals caused by foreign capital inflows in the previous years might not be sustainable. Thus, balance sheets might contract again, leaving banks overcapitalised.Footnote ¹⁷⁷ Finally, comparisons to foreign competitors were also often used. The general director of the Union Bank of Switzerland, for example, highlighted that ‘the high share capitals of the Swiss banks have proven their worth but are also their most expensive source of capital. Besides, the Swiss dividend rates for bank shares are far below the foreign dividend.’Footnote ¹⁷⁸

During the 1930s and 1940s, the position of the FBC had been that the capital requirements were generally too low. The FBC even proposed to the Federal Council that the Banking Ordinance should be revised, and minimum capital, as well as liquidity requirements, increased.Footnote ¹⁷⁹ The tightening of the requirements failed because ‘no agreement with the interested banking groups could be reached’, according to the FBC’s former Head of the Secretariat.Footnote ¹⁸⁰

The view of the FBC changed in the 1950s. Considering the proposals made by the Swiss Bankers Association and the big banks, the FBC drafted a revised Ordinance and submitted it for consultation to the SNB in 1958 and the SBA in 1959.Footnote ¹⁸¹ The proposed legislation was then discussed in a conference between the FBC, the SNB, the SBA, and representatives of the big banks in December 1959.

The most crucial change in the draft of the Banking Ordinance was that the FBC would be responsible for setting the percentage of hidden reserves that could be used as regulatory capital. The question discussed in the meeting of the interest groups was where to set the limit on the use of hidden reserves. The SNB had opposed the extensive use of hidden reserves for regulatory purposes. The big banks wanted to use as many hidden reserves as possible. Interestingly, although hesitant at first, the FBC sided with the big banks. The representatives of the Commission argued that the big banks had struggled to fulfil capital requirements for some time and that if there was no change in regulation, the commission would have to continue granting exceptional approvals for non-compliance with the capital requirements. The meeting between the various interest groups in 1959 led to the compromise that 15% of the required capital could be composed of hidden reserves.Footnote ¹⁸²

According to the FBC, the 15% rule was meant to be a temporary exception to support some undercapitalised big banks. In the view of the FBC, this temporary solution would prevent even bigger capital issuances. The commission was aware that the need for further capital was mainly driven by the large inflows of foreign capital to the big banks.Footnote ¹⁸³ The effect of the regulatory change in 1961 on the capital coverage ratio was striking. Down at 84% in 1960, the ratio of the big banks grew to 108% in 1961 (see Figure 5.5). About half of this increase came from the use of hidden reserves. Archival material indicates that the big banks used at least CHF 104 m of hidden reserves for regulatory purposes in 1961.Footnote ¹⁸⁴ The rest of the change in the capital coverage ratio can be attributed to capital issuances by the big banks (CHF 95m) in the same year. From a regulatory point of view, the banks were suddenly substantially better capitalised.

The cycle of proposals from the banks to the supervisor leading to a compromise that eased capital regulation was repeated several times in later years. A first request to use more hidden reserves by the Union Bank of Switzerland in 1963 was declined.Footnote ¹⁸⁵ In 1967, however, the SBA asked for an increase of the hidden reserves allowed for regulatory purposes to 30%. The FBC confirmed a ‘benevolent’ consideration of the Bankers Association’s proposal and decided – as a compromise – on 25%.Footnote ¹⁸⁶

In 1971 and 1972, the Banking Act and the Banking Ordinance were revised.Footnote ¹⁸⁷ During the preparation of the Ordinance, a delegation of the SBA bypassed the FBC and talked directly to Switzerland’s Minister of Finance, Nello Celio. The FBC was disappointed to have been excluded from these discussions, even more so as the Minister of Finance made various concessions. At this point, the FBC was clearly against a further weakening of the capital requirements. The experts’ group of the FBC tasked with preparing a new Banking Ordinance suggested that a maximum of 80% of the regulatory capital could be hidden reserves. The Minister of Finance, however, decided to allow the unlimited use of hidden reserves.Footnote ¹⁸⁸

Publicly, the government argued that the revisions of the Banking Act and the Banking Ordinance in 1971 increased the liquidity and solvency requirements.Footnote ¹⁸⁹ Both changes were undertaken against the background of the internationalisation of the Swiss financial centre. The revised Banking Ordinance required a minimum capital of CHF 2 m for the foundation of a bank (this was what was meant by the ‘stricter’ capital requirements). The requirement targeted mainly new market entrants – many of them foreign institutions. Established banks in Switzerland, however, were not affected by this change.

The stricter liquidity requirements were the result of growing criticism of the large-scale foreign investments of the big banks. In the consultation process for the new Banking Act, the Social Democrat Party as well as the Workers Union had voiced their concerns that foreign investments – specifically referring to the Euromarkets – had increased the risks of the banks. The Federal Council shared this opinion, commenting that ‘the increasing shift of liquidity from the domestic to the foreign market cannot be denied and poses a number of risks’ and suggested that the liquidity requirements should be increased.Footnote ¹⁹⁰

In 1981, capital regulation in the Banking Ordinance was revised again.Footnote ¹⁹¹ For the first time, subordinated debt was allowed to be counted as part of the regulatory capital. The banks had been attempting to introduce such a change for several years.Footnote ¹⁹² It was also the first time that Switzerland moved to a capital adequacy model that exclusively focused on the asset risk.Footnote ¹⁹³ The assets were differentiated according to fifteen different categories, and each category was matched with a capital requirement ratio. The underlying idea was the same as in the Basel I framework that was introduced in Switzerland in 1991 and 1994.Footnote ¹⁹⁴ The application, however, was different. Basel I used risk-weights for each asset category and multiplied the risk-weighted assets with 8%. The Swiss approach in 1981 assigned a capital requirement ratio to each asset category (instead of a risk weight). Despite this, when the Basel I requirements were introduced into Swiss banking legislation ten years later, it did not bring fundamental changes. Subordinated debt, hidden reserves, and hybrid capital instruments could already be partially credited as Tier 2 capital. In addition, taking into account off-balance-sheet items was not an innovation, but rather a development of the existing framework.

Were all these regulatory changes relevant to the big banks? Figure 5.6 shows the structure of the regulatory capital used by the big banks from 1970 to 1995. There is no data available for the period before 1970. In the first half of the 1970s, the hidden reserves were even bigger than the paid-up capital. By 1974, for example, the hidden reserves held by the big banks were CHF 2.2bn, while the paid-up capital was CHF 1.9bn. Thus, the inclusion of hidden reserves as part of the regulatory capital was fundamental. Similarly, the relevance of subordinated debt grew over time. By 1994, the paid-up share capital of the big banks was CHF 9.4bn; the subordinated debt was CHF 11.1bn. Finally, it is also important to note that the largest part of the regulatory capital was disclosed reserves, and not paid-up share capital.

Figure 5.6

Structure of the regulatory capital, big banks, 1970–94Footnote ¹⁹⁵

The broadening of the capital definition was absolutely crucial for the growth of the big banks. Estimates show that the total assets of the big banks would have had to be about 15–35% smaller if the capital regulation was not changed. Thus, changing capital requirements was an important factor that allowed banks to grow at such a rapid pace.

Despite the lobbying of the big banks, the change in capital requirements in the 1960s and 1970s is rather surprising, given Switzerland’s macroeconomic context at the time. The SNB was constantly fighting foreign capital inflows during these decades. It took defensive measures to limit the inflow of capital from abroad – for example, by prohibiting investments and negative interest rates on the deposits of non-residents, as well as restricting borrowing abroad.Footnote ¹⁹⁶ The Swiss economist Edgar Salin termed the state of the economy a ‘Devisenbann-Wirtschaft’ (‘currency ban economy’).Footnote ¹⁹⁷ The assessment made of this period, which lasted until 1979, both by economists and officially by the SNB itself, is clear: the defensive measures by the SNB were largely ineffective.Footnote ¹⁹⁸

One measure that might have been effective, however, was stricter capital requirements for the big banks. It is likely that stricter capital requirements would have acted as a brake for the balance sheet growth of undercapitalised banks, which was driven substantially by foreign capital flows. In retrospect, there might be two reasons why stricter capital rules were not considered as a tool for monetary policy.

Firstly, the FBC and various political actors (the Federal Council, parliament) could change the regulatory environment for banks (Banking Act, Ordinance, Circulars). The SNB attended conferences that discussed regulatory revisions but could only make recommendations. The archival material suggests that the SBA and the big banks were much more closely involved in the regulatory process than the SNB. The FBC acted more as a mediator between the interests of the banks and the SNB than as an independent supervisory voice. Furthermore, the FBC was a weak supervisor until the revision of the Banking Act in 1971. Its enforcement mechanisms were – even in its own view – ‘not sufficient’.Footnote ¹⁹⁹ In cases of non-compliance with the Banking Act, the commission could make either a criminal complaint to the cantonal prosecution authorities or fine the bank. The handling of such complaints, however, would often take years and reach the statutes of limitations. The FBC also had little success with regulatory fines, as the maximum amount was too low (CHF 20,000).Footnote ²⁰⁰ The ultimate threat for a bank – withdrawal of its banking licence – was only possible after 1971.

Second, the SNB had to strike its own bargain with the big banks and the SBA. Many measures to reduce foreign capital inflows were based on gentlemen’s agreements – for example in 1950, 1955, 1960, 1962, 1975, and 1976 – negotiated through the SBA.Footnote ²⁰¹ The SNB depended on the cooperation of the banks for these measures. Overall, the regulatory changes in the 1960s and 1970s were clearly in the interest of the banks, and the banks took part in shaping their regulatory environment.

Publicly, the regulatory changes and the non-compliance of the major big banks with the capital requirements were noted, but did not trigger a public debate on the topic. The revision of the Banking Ordinance in 1961, which was a crucial technical change with a significant impact on the growth of the big banks, received little public attention. The Neue Zürcher Zeitung, for example, simply described the regulatory changes or the capital ratios of the banks, without further comments.Footnote ²⁰² The banks themselves were also silent about their struggle to meet capital requirements at their annual meetings.Footnote ²⁰³

The interest of banks in developing the regulatory environment certainly persisted in the 1980s. However, the changes mainly followed trends that were already apparent on an international level. Risk-weighted approaches to measuring capital adequacy were being discussed at the beginning of the 1970s at the European level and later in the BCBS. Switzerland took part in the negotiations in the BCBS. In this context, the introduction of the Swiss framework in 1981 is not surprising. Moreover, the use of subordinated debt for regulatory purposes came into fashion too.

5.4.1 Changes in Capital Adequacy Standards in the 1970s

The increased banking instability in the United States in the 1970s put pressure on the regulators and supervisors. In particular, the criticism towards the supervisors grew, and one of the key arguments was that banking supervisors had not been able to detect ‘problem banks’ early enough. Moreover, many policymakers identified a second deficiency in the varying measurement approaches and definitions of capital. The Federal bank supervisors concluded that more uniformity in banking supervision and also in the issue of bank adequacy was needed.Footnote ²²³ Aiming to reform bank supervision in the United States, the FDIC, the OCC, and the FED (together with the Federal Home Loan Bank Board and the National Credit Union Administration) established an interagency body, the Federal Financial Institutions Examination Council (FFIEC) in 1979. The purpose of the FFIEC was to promote uniform principles and standards in bank supervision, which also encompassed the measurement and definition of capital.Footnote ²²⁴

The OCC made the first attempts to strengthen capital requirements in 1980, suggesting stricter rules for the definition of capital.Footnote ²²⁵ The banking sector strongly opposed these suggestions, and the OCC eventually refrained from introducing narrower definitions for capital.Footnote ²²⁶ The work of the FFIEC was more successful than the OCC’s first attempt. It published a first draft proposal for a uniform definition of capital and capital requirements in June 1981.Footnote ²²⁷ By the end of 1981, responding to the call for uniformity, the Federal Reserve and the OCC issued common guidelines for defining capital and capital requirements. The FDIC adopted slightly different criteria, as the agencies disagreed on the definition of capital.Footnote ²²⁸

The FFIEC chose a middle-way between the two positions on using subordinated debt or not-for-capital requirements by defining two types of capital: primary capital consisted of common and preferred stock, surplus, undivided profits, mandatory convertible debt instruments, reserves for loan losses, and other capital reserves. The FFIEC defined other forms of capital, such as limited-life preferred stock and subordinated debt, as secondary capital.Footnote ²²⁹

The guidelines of the FED and the OCC largely followed the suggestions of the FFIEC and categorised banks according to three different groups: multinational, regional, and community banks. The guidelines also included numerical minimum capital ratios for the very first time. Regional banks (total assets $1bn to $15bn) had to reach a primary capital/assets ratio of 5% and a capital/assets ratio of 5.5%. Community banks (total assets <$1bn) were required to meet a 6% primary capital/ratio and a 6.5% capital/assets ratio. The FED and the OCC excluded multinational banks from minimum capital requirements, arguing that the complexity of their businesses would require individual analyses. Contemporaries contended that the exclusion was because these banks failed to meet the capital requirements.Footnote ²³⁰ This argument is underlined by the large banks’ capital/assets ratio (total assets above $5bn) in Figure 5.7, which was below the 5% threshold from 1972 to 1984. Both the FED and the OCC were well aware of the difficulties that large banks faced if they had to meet a 5% capital requirement in 1981 and might have opted for informal pressure on these banks instead.Footnote ²³¹ Multinational banks reacted and issued substantial amounts of primary capital after 1981.Footnote ²³²

The FDIC set a 5% minimum capital/assets ratio for all banks and a 6% minimum requirement for all state non-member banks. Several deviations from the concepts of the OCC and the FED emerged. The FDIC guidelines did not differentiate between bank sizes. Moreover, the FDIC adjusted both the capital and the assets by deducting losses and one-half of the doubtful assets. For capital, the FDIC used primary capital, disregarding secondary capital.Footnote ²³³

Thus, by 1981, the Federal bank supervisory agencies had introduced leverage ratios, and the capital requirements and definitions became – despite some remaining differences – more harmonised between 1979 and 1981. However, three issues remained unresolved.

Firstly, bank supervisors’ enforcement of capital requirements – and, respectively, their authority – was still limited. The guiding principles issued by the three federal agencies in 1981 formalised capital requirements, but they were based on guidelines and not on law. Before 1981, there was no direct legal authority to enforce capital requirements, and the OCC, the FED, and the FDIC had to rely on persuasion. Beyond moral suasion, this could mean declining branch or acquisition applications or invoking cease-and-desist orders.Footnote ²³⁴ However, even with the new guidelines in 1981, the legal reach of the agencies was limited. The FDIC, for example, communicated in its official policy statement that it would use its authority by withholding the ‘approval of applications of various types’ to impose capital requirements.Footnote ²³⁵ A case in point for the limited legal authority of the federal agencies was the case of the OCC v. the First National Bank of Bellaire (Texas), which became a catalyst for an extension of the legal authority of the three Federal agencies.Footnote ²³⁶

The OCC had issued a cease-and-desist order against Bellaire in May 1981, arguing that the bank was operating without adequate capital. Through the order, the OCC requested that the bank issued additional capital to reach a capital/assets ratio of 7% or higher. Bellaire challenged the ruling. In May 1983, the United States Court of Appeals, Fifth Circuit, decided in favour of Bellaire, stating a lack of substantial evidence by the OCC proving that the bank was ‘unsafe and unsound’.Footnote ²³⁷ The court decision undermined the mandate of the OCC, the FED, and the FDIC to set and enforce capital requirements for banks.

Secondly, the new capital ratios introduced in 1981 did not quantitively consider the riskiness of assets, even though all three federal agencies had declared already in the 1930s that asset quality was the most relevant determinant for the required amount of capital and developed capital ratios that to some degree considered asset risk. The FED had even applied its ABC formula for capital adequacy in banking supervision since the 1950s.

5.4.2 The Latin American Debt Crisis as a Driver of Capital Standards

Between 1982 and 1986, the regulation and supervision of bank adequacy was completely transformed. The driver for the change was no longer internal financial instability but increasing international financial instability, leading to further harmonisation of capital requirements in the United States.

The debt of Latin American countries has been growing steadily since the 1970s. External borrowing by Argentina, Brazil, Mexico, and Venezuela grew by multiples of 7 to 32 from 1970 to 1981.Footnote ²³⁸ Large US multinational banks were among the major lenders to what was referred to as the less developed countries (LDC). Data from the eight largest US banks indicates that their loan exposure to LDC countries grew from $32.5bn in 1977 to $53.7bn and peaked in 1985 at $58.5bn. Such volumes represented more than 10% of their total assets, or more than three times their capital and reserves (1981).Footnote ²³⁹

In 1982, the largest borrowers among the LDC countries – Mexico, Argentina, and Brazil – announced their inability to pay interest and repay their debt. Given the involvement of large US banks in LDC lending, these defaults had potentially severe effects on solvency. Moreover, it triggered the involvement of the US Congress.

The International Monetary Fund (IMF) aimed to substantially increase its resources, including the share of the United States. Such an increase, in turn, required the approval of the US Congress. The new situation changed the balance of power between the legislature, supervisors, and banks. Banks depended on the IMF’s support for the LDC countries to avoid severe losses, threatening their own survival. The IMF required additional resources from the United States, which was subject to approval by the US Congress. Moreover, the perception in the hearings of the respective committees on banking in the Senate and the House of Representatives was that banks’ capital resources should be strengthened. To a lesser degree, US banks’ competitive position in capitalisation was a topic too.Footnote ²⁴⁰

The FED and the OCC reacted to the debate on capital requirements by amending their 1981 guidelines. The multinational banks, previously excluded from capital requirements, had to meet a 5% primary capital/assets ratio.Footnote ²⁴¹ Reinicke emphasises that twelve of the seventeen multinational banks had reached the 5% threshold by then.Footnote ²⁴²

In November 1983, Congress passed the International Lending Supervision Act (ILSA). Section 908 of ILSA dealt specifically with capital adequacy and had implications on two levels. Domestically, ILSA gave the Federal banking agencies – for the first time – the legal authority to impose statutory capital requirements. On an international level, the chairman of the Federal Reserve, Paul Volcker, received a mandate to ‘encourage governments, central banks, and regulatory authorities of other major banking countries to work toward maintaining and, where appropriate, strengthening the capital bases of banking institutions involved in international lending’.Footnote ²⁴³

During 1984 and 1985, the three federal bank supervisory agencies worked on new, uniform capital requirements. They agreed on a minimum primary capital/assets ratio of 5.5% and a 6% total capital (primary and secondary)/assets ratio for all federally supervised banks.Footnote ²⁴⁴ Another outcome of interagency cooperation was the increased emphasis on certain aspects that should determine capital adequacy: The agencies expressed their concern that capital/assets ratios exclude considerations on risk in the balance sheet and risk exposure resulting from off-balance-sheet items. The FED noted that the multinational banks had substantial off-balance sheet risks in the range of 5–15% of total assets.Footnote ²⁴⁵ Moreover, the FED noted a shift from low-risk, highly liquid assets to assets with higher risk exposure. Altogether, this meant that the overall risk exposure of large banks likely increased. Capital/assets ratios could not capture such changes and incentivised additional risk-taking by banks. Furthermore, the increasing capital/assets ratios of large banks during the first half of the 1980s even provided an impression of improved financial stability, which was not the case. The solution to these problems was a risk-based capital requirement.Footnote ²⁴⁶

The FED, the OCC, and the FDIC published a series of proposals for risk-based capital ratios between 1986 and 1988. The proposals largely followed the Federal Reserve’s ABC formula, placing assets into different risk categories, leading to the ‘weighted risk asset and off-balance sheet total’ as the denominator.Footnote ²⁴⁷ Dividing the primary capital by the risk-weighted assets resulted in the ‘risk-based capital ratio’. From 1986 onwards, the proposals for capital adequacy rules also started to integrate elements from discussions on the international level. As a first step, the agencies started integrating the agreement between the federal agencies of the United States and the BoE into their proposals for capital adequacy guidelines in 1987.Footnote ²⁴⁸ Once the Basel Committee on Banking Regulations and Supervisory Practices reached an agreement in the summer of 1988, the agencies published the final rules incorporating the Basel agreement in January and March 1989, with transition periods until the end of 1992.Footnote ²⁴⁹

Methodologically, the risk-weighted assets approach followed the ABC formula developed by the FED in the 1950s. However, there were differences in the classification of assets and the weights assigned to these risk classes, as well as the treatment of off-balance sheet assets. Beyond that, the Basel I approach multiplied the risk-weighted assets by 8% (respectively, lower percentages in the transition period), which led to the required capital. The definition of capital under Basel I also consisted of two capital tiers, as it was already the approach taken by the United States Federal Agencies. A key difference was the treatment of loan-loss reserves. The federal agencies had previously counted loan-loss reserves as primary capital. Basel I defined such reserves as Tier 2 capital.

The new capital requirements introduced in 1989 supplemented but did not replace risk-unweighted capital thresholds in the United States. The FDIC and the FED did not replace the requirement of 6% total capital/assets. The OCC, however, aimed to introduce a substantially lower total capital/assets requirement of 3%. The three agencies agreed on a compromise of 3% for banks in the best rating category. All other banks had to maintain additional capital between 1% and 2%, resulting in a capital/assets ratio of at least 4–5% for most banks.Footnote ²⁵⁰

The use of unweighted-capital requirements was further strengthened by the Federal Deposit Insurance Improvement Act (FDICIA) in 1991. After more than a decade of increased banking instability in the United States, the FDICIA introduced ‘prompt corrective action’ (PCA), which aimed to detect undercapitalised banks early and to force such banks to strengthen their capital. Numerical capital requirements were used as triggers that initiated severe supervisory actions. The 5% total capital/assets ratio thus became a de facto threshold.