Switzerland
Selected Issues and Statistical Appendix

The Swiss banking system is characterized by a two-tier structure. The first tier is composed of the two large banks and some smaller banks focused on private banking, all of which have a significant international presence. These banks represent, so to speak, the “international face” of the Swiss banks. They are mostly joint-stock companies or privately owned (unlimited personal liability). The second tier is composed of a varied group of banks, mostly focused on domestic, or even regional, business.

Abstract

The Swiss banking system is characterized by a two-tier structure. The first tier is composed of the two large banks and some smaller banks focused on private banking, all of which have a significant international presence. These banks represent, so to speak, the “international face” of the Swiss banks. They are mostly joint-stock companies or privately owned (unlimited personal liability). The second tier is composed of a varied group of banks, mostly focused on domestic, or even regional, business.

I. Swiss Banking at the Start of the Twenty-First Century: Challenges and Opportunities1

A. Introduction

1. Swiss banking has a long gilt-edged tradition. Benefiting from Switzerland’s geographic position in the heart of Europe, Swiss bankers have, through the centuries, acquired a solid position in the areas of asset management, private banking, and merchant banking. Swiss banks are well known for their professionalism, discretion, and reliability, and have—through their acquisition of U.S. and U.K. banks—successfully entered onto the global stage in competition for major investment banking deals. The big banks are among the most solid in the world and a number of smaller “blue-blooded” banks have established a strong reputation as top-quality private bankers.

2. Recent years, however, have not been without troubles for the Swiss banks. On the international front, much-publicized losses in derivative operations, a billion-dollar settlement in a class action suit concerning their conduct during World War II, and, recently, the withdrawal of a banking license for a subsidiary in Japan have somewhat tainted the Swiss banks’ traditional image of conservatism and sobriety. On the domestic front, a collapse of the property market and a prolonged recession in the early 1990s necessitated the rescue of a number of smaller regional and cantonal banks and led to a weakening of the balance sheets of the larger banks.

3. This chapter examines the challenges and opportunities facing Swiss banking at the start of the twenty-first century, and poses two key questions. First, how well are the Swiss banks prepared to deal with the international trends toward increased scale and cross-border integration, for example, in the context of the ongoing European integration? Second, to what extent are there internal and external pressures for the removal of the privileges of the cantonal banks, and what are their implications?

4. It is argued that the two large international Swiss banks are quite well placed to deal with the international trends toward increased scale and cross-border integration: in particular, they compare favorably with their European counterparts as the Swiss banks have a stronger strategic foothold than their counterparts in the international investment banking arena. Rather, the main challenge to the Swiss banks is likely to arise in the domestic banking markets; public ownership and public guarantees of the cantonal banks have created a rigid structure that is likely to come under increased pressure from both international and domestic forces.

5. The chapter is divided into three main sections. The main structure of the Swiss banking system is outlined in the first section. (See Box I-1 for an overview of the regulatory authority.) In the second section the international competitive position of Swiss banks is discussed, including an analysis of Swiss banks’ future prospects in investment banking and asset management. The pressures for change in domestic banking sector are discussed in the final section.

B. Main Structure of the Swiss Banking System

6. The Swiss banking system is characterized by a two-tier structure. The first tier is composed of the two large banks and some smaller banks focused on private banking, all of which have a significant international presence. These banks represent, so to speak, the “international face” of the Swiss banks. They are mostly joint-stock companies or privately owned (unlimited personal liability). The second tier is composed of a varied group of banks, mostly focused on domestic, or even regional, business. The most important of these are the cantonal banks, which are majority-owned by the cantons2 and have, in most cases, a special legal status.

Table I-1

Switzerland: Structure of Bank and Finance Company Assets, 1997 1/

article image
Source: Swiss National Bank (Les banques suisses, 1997).

Includes branches of foreign banks.

Regulation and Supervision

This box provides an overview of the legal framework and prudential regulation, relevant for banks and other financial intermediaries providing banking services.

The legal framework for all Swiss banks is provided by the Bank Act of 1934, and its later revisions. This Act is supplemented by the Federal Council’s ordinance on banks and saving banks, stipulating in detail the supervisory responsibilities of the Banking Commission and the prudential regulations. The banks are also subject to the civil code regarding, for example, contracts and property.

Swiss capital adequacy rules stipulate that total capital has to exceed 8 percent of risk-weighted assets; core capital should at least amount to 4 percent of risk-weighted assets. Off-balance sheet positions are incorporated by the use of credit equivalent values; additional capital to cover market risk is allocated according to risk classes or, in the case of the larger banks, estimated by the use of internal risk models. Although similar to the Basel Committee’s standard, the Swiss capital requirements differs from this standard in several respects: (i) the Swiss capital requirements are based on unconsolidated balance sheets; and (ii) the risk-weights are generally higher than in the Basel Committee’s guidelines. Only the two large banks are subject to the Basel Committee’s capital standard on a consolidated basis (as modified to take account of market risk). The banks are also subject to liquidity requirements and concentration of risk limits.

Although formally a part of the Ministry of Finance, the Federal Banking Commission (FBC) enjoys significant operational autonomy. The president and the members of the Banking Commission are nominated by the Federal Council for a period of four years and it raises a significant share of its own funding through fees on the supervised financial institutions. The FBC has the power to initiate an administrative procedure and call witnesses; a banking license can, however, only be withdrawn in the case of material evidence of a breach of the conditions for banking licenses as stipulated in the Federal Council’s ordinance. The FBC also licenses auditors and requests them to monitor the banks; it has the discretion to call interim audits at any time.

Within the framework of the Banking Act, the Swiss Bankers Association issues professional rules and guidelines. In addition, a number of self-regulatory agreements have been completed, of which a “Depositor Protection Agreement” (a deposit insurance scheme) and the “Due Diligence Convention” (complementing the Money Laundering Act) are the most important. The Depositor Protection Agreement guarantees the prompt withdrawal of up to SwF 30,000 for saving, salary and pension accounts (excluding inter-bank deposits), investment accounts, and bank-issued medium term notes (the Banking Act provides for a privileged reimbursement of the same amount) in the event of a compulsory liquidation but is limited to SwF 1 million in the case of each individual bank.

In the most recent amendment to the Banking Act—effective October 1, 1999—the obligation for the cantons to provide a guarantee to the cantonal banks was abolished. From October 1, 1999, the supervisory authority of the FBC was extended to cover the cantonal banks, and the capital adequacy will apply equally to all the banks, except for the cantonal banks with full cantonal guarantee. For these banks, a 12.5 percent discount (amounting to about one percentage point of risk-weighted assets) applies to the capital adequacy requirement.

Insurance and fund management companies, and securities dealers are supervised by separate supervisory authorities (Insurance Supervision Act, Investment Fund Act, and Stock Exchange Act). Other financial intermediaries, such as independent asset managers and trustees, are not covered, however, by these special laws and are only supervised by the Money Laundering Control Authority for the purpose of monitoring the observance of the Money Laundering Act (effective 1998). This law requires all financial intermediaries to report any suspicious transaction.

7. For the purpose of official statistics, Swiss banks are often divided into six groups. Tier one, as defined above, is roughly equal to the first (two large banks) and the last of these groups (other banks):

  • Two large banks, UBS AG and Credit Suisse AG, dominate the Swiss banking scene. Taken together, these two banks hold about 56 percent of total assets of the Swiss banking system, and 39 percent of domestic assets (Table I-1). The two large banks are joint stock companies and owned by a diversified group of domestic and international investors. Both banks are a part of a broader holding company structure, UBS Group and Credit Suisse Group, incorporating a broad range of financial services: retail banking (parent banks), investment banking (Warburg Dillon Read and Credit Suisse First Boston or, in short, “CSFB”), asset management (UBS Brinson and CSFB), private banking (parent banks), and, in the case of Credit Suisse, insurance (Winterthur). UBS Group was created in June 1998, as a result of a merger between Union Bank of Switzerland and Swiss Bank Corporation (SBC). At end-1998, UBS Group and Credit Suisse Group were ranked as the eight and fourteenth largest groups in the world (on the basis of capitalization).3

  • Cantonal banks constitute a significant force in their “home canton.” Although their share of total assets is only 13 percent, their share of domestic assets amounts to about 26 percent. Their importance is particularly large in the mortgage market with a share of some 36 percent of outstanding mortgages. Out of the 24 cantonal banks operating at the end of 1998, 19 were fully owned by the cantons and their liabilities were fully guaranteed by their respective cantons. The five remaining cantonal banks were organized as limited liability companies, with the cantons as majority owners and limited cantonal guarantees. In general, cantonal banks limit their business to their “home canton,” although, recently, some cantonal banks have expanded their activity to other cantons or foreign markets.

  • Regional and saving banks constitute a more heterogeneous group of banks. Although most of the banks are joint stock banks, a number of the smaller saving banks are foundations, cooperatives, or have a special legal status. These banks are generally small and operate independently, although their interests are collectively represented. Despite considerable consolidation that was due to heavy losses from a massive collapse in property prices in the early 1990s, 117 regional and saving banks were still operating in 1998 (down from 210 in 1989) with a median capital of only SwF 13 million (average: SwF 30 million). At end-1998, their combined share of total assets was 3½ percent (7 percent of domestic assets).

  • Raiffeisen banks are credit cooperatives, located primarily in rural areas. These banks serve their local members, principally offering mortgages and small loans. By the end of 1998, all of the 722 Raiffeisen banks had been integrated into one umbrella organization. Large interbank transactions are performed by a special bank collectively owned by the Raiffeisen banks: Zentralbank des Schweizer Verbandes der Raiffeisenbanks. The share of the Raiffeisen banks in total domestic assets has increased gradually over the last 20 years, reaching about 7 percent in 1998.

  • Foreign banks focus mainly on a foreign client base. While the share of total assets totaled 7 percent in 1998, the share of domestic assets was only 4 percent. If foreign subsidiaries are included, the share was 6 percent of domestic assets.

  • And finally, “other banks.” This heterogeneous group includes prominent banks such as Julius Baer, Bank Leu, and Pictet & Co, mainly focused on private banking, smaller commercial banks, stockbrokers, and banks such as the Coop and Migros banks, which are owned by the cooperative retail chains with the same names.

8. It should be noted that this is not an exhaustive list of institutions providing banking services. The dividing line between banks and insurance companies has become increasingly difficult to define. Not only are Swiss banks entering insurance markets, for example Credit Suisse’s acquisition of Wintherhur, but Swiss insurance companies also are engaging in what traditionally has been called “banking.” First and foremost, the value of assets under management by Swiss insurance companies equals about the size of banks’ balance sheets. Second, the two large re-insurance companies have increasingly entered the project finance market, drawing on their expertise in insuring large risks.4 The Swiss insurance companies are among the largest in the world and may challenge banks in high-risk markets such as large-scale project finance.

C. The Global Challenge: How Well are Swiss Banks Prepared?

9. Since the early 1990s, a wave of banking mergers and acquisitions has been flowing across European and North America markets. Banking giants are being created: average core capital of the ten largest U.S. and European banks increased from USS 14 billion in 1995 to USS 25 billion in 1999. Many of the mergers has been driven by the desire to gain domestic share. But cross-border mergers are also on the rise, and are likely to spread in the coming years—particularly in Europe. Despite several mergers, the ranking of the two large Swiss banks among European and North American banks have fallen gradually, from among the seven largest in 1990 to among the 14 largest in 1999.

10. Does this mean that only size will matter in the coming years and that banks from smaller countries, such as Switzerland, will have the “choice” only between being acquired or being closed? Probably not. First, the trend toward increased size is not in itself sufficient evidence for the benefits of size. Both academic researchers and market analysts5 agree that size alone is not the deciding factor in the success of financial institutions, The question of what is the optimal size of a bank is essentially unresolved. Also, the creation of “common infrastructure” (such as the Swiss Interbank Clearing and the Swiss Stock Exchange) has enabled the Swiss banks to reap some economies of scale without the need to merge (See Box I-2). Second, the merger wave may partly be a defensive move to counter narrowing margins by attempting to gain local market dominance. Given that the market for banking services is likely to become increasingly global, such a strategy is likely to falter, though; the advent of electronic banking and the Internet has reduced the natural barriers to entry in both retail banking (reduced need for branches) and investment banking (distribution channels can be created on the Internet).

11. Finally, the large Swiss banks were among the earliest to enter the global arena, blending Swiss banking tradition with U.S./U.K. investment banking expertise. In this respect, the Swiss banks compare well with their European counterparts, which for the most part remain focused on their home markets. Although it is difficult to foretell the future, the survivors in the increasingly global banking markets are likely to be banks with: (i) a strong position in a broad range of financial services, including investment banking; (ii) an ability to take advantage of new technologies; and (iii) a sound risk management system. It is argued below that the two large Swiss banks score fairly well along these dimensions. In addition, smaller private banks have a strong franchise in private banking and are likely to be able to survive or even prosper far out in the future. Even a further erosion of the banking secrecy is unlikely to affect these institutions to any considerable degree.

Strategic position in international investment banking

12. Although “economies of size” will probably play a small role in determining the winners of tomorrow’s battles in the financial markets, the use of “economies of scope” is almost certainty to play an important role. Often called “synergies,” economies of scope are important in investment banking because the success of one business segment to a large extent depends on the bank’s capabilities in the other business segments. For example, an advisor on mergers and acquisitions needs the capability to raise large amounts of funds through the capital markets (bonds or equities) and to have a large distribution network for placing securities. In addition, clients often needs a broad set of investment banking services and would tend to use the same investment bank, even when there is no particular “synergy” between the different market segments.

Common Financial Infrastructure

This box details the creation of various systems and institutions that provide clearing, settlement, and trading platforms mainly as a joint service to banks domiciled in Switzerland. This “common financial infrastructure” includes the creation of a highly efficient interbank clearing system, a unique system for real-time settlement of repurchase agreements (providing for short term collateralized lending), and an indirect link to TARGET, the euro real-time gross settlement system.

As one of the first in continental Europe, a continuous real-time gross settlement system, the Swiss Interbank Clearing (SIC),1 was introduced in 1987. Initiated by the Swiss National Bank (SNB), the system is managed under contract by a private company (Telekurs SIC AG) and collectively owned by the Swiss banks. The system is supervised by the SNB. At its start in 1987, the SIC resulted in a surprisingly sharp reduction in the demand for base money (cash and central bank liabilities),2 and, with a daily average of some ½ million transaction,3 is one of the most actively used gross settlement systems in the world.

In response to the introduction of the euro, the euro-SIC, essentially a parallel clearing and settlement system in euro, was created on January 4, 1999 to enable Swiss banks to supply competitive transactions services in euro. The euro-SIC, operating in Frankfurt, is indirectly connected to TARGET through the Swiss Euro Clearing Bank (SECB), a collectively owned subsidiary of the Swiss banks.

Repo SWX, an international on-line trading, clearing, and settlement system for repurchase agreements (repos) was introduced in November 1999. The system provides an efficient platform for collateralized short-term lending and is useful for the conduct of SNB’s open market operations. Repo SWX is world’s first electronic repo platform with integrated clearing and settlement.

In 1998, the Swiss Option and Financial Futures Exchange (SOFFEX) merged with the German Future and Option Exchange (DTB) to create Eurex, a fully integrated transnational electronic trading platform for financial derivatives

1 The SIC was introduced one year ahead of the German gross interbank clearing system (EIL-ZB), but after the systems in the United States (1913), the United Kingdom(1984), and Sweden(1986)2 See, for example, Hviding (1999), p. 25.3 See Bank for International Settlements (1997).

13. A ranking in key investment banking markets provides some clues to a bank’s ability to benefit from economies of scope. As can be seen from Table I-2, the two Swiss-owned investment banks, Warburg Dillon Read (owned by UBS) and CSFB (owned by Credit Suisse), have an excellent position in most of the market segments (with the exception of loan syndication). Their average rank in these markets is clearly higher than for other European banks. In particular, CSFB ranks among the five largest in three market segments: mergers and acquisitions, bonds, and equities.

Table I-2.

Switzerland: Investment Banking “League Tables,” 1998 and 1999

(Ranked by market share)

article image
Source: International Finance Review, Thomson Financial Securities Data.

Merger and Acquisition advisors; January to September, 1999.

Bookrunners; January 1 to September 18, 1999.

Arrangers, 1998.

14. Particularly striking is the strong position of the Swiss investment banking arms of the Swiss financial groups as advisors in mergers and acquisitions, a high-margin business segment. In the league of world advisors, CSFB is the only European bank among the six largest. Its share of the international merger and acquisition market (in terms of the value of the deals) is about 20 percent, compared with 30-35 percent for each of three other world leaders: Goldman Sachs, Morgan Stanley Dean Witter, and Merrill Lynch.6 The position of Warburg Dillon Read is apparently less solid, but its overall ranking in this market segment is comparable to European giants such as Deutsche Bank and Banque Nationale de Paris (BNP).

15. Related to economies of scope are the benefits from the global presence. In investment banking, global presence is important because of the need to tap markets with surplus savings and supply these resources to markets with need for finance. In addition, a successful advisor in cross-border mergers must have local knowledge of different cultures and expertise in varying jurisdictions. In terms of global presence, the two large Swiss banks are also well positioned relative to the other European banks. For one, the share of revenue with a non-European origin is large (53 percent for CSFB and 34 percent for Warburg Dillion Read). In particular, CSFB has a strong position in the United States (44 percent of its 1998 revenue came for the Americas) and is consequently often referred to as a “U.S.-Swiss bank.” In addition, Swiss banks have significant foreign assets: at end-1998, the outstanding amount of foreign assets amounted to 56 percent of total assets. This amount excludes fiduciary assets, which are off-balance sheet.

Ability to benefit from new technologies

16. Advances in computer technology are changing the nature of banking quite dramatically. Most obviously, retail banking has been fundamentally changed as a result of the ATMs, which are rapidly replacing bank branches as distributors of cash and receivers of payments. Internet banking takes this development even further, rendering branches virtually obsolete for nearly all banking functions. Furthermore, extensions of loans are also becoming increasingly automated: information technologies are used increasingly to assess the creditworthiness of potential borrowers, and can form the basis for the issuance of asset-backed securities.

17. To fully benefit from these new technologies, banks will probably have to undertake substantial restructuring, In the first round, the number of branches and bank clerks would need to be reduced (Table I-3). New bank employment may be achieved as a result of the increased demand for new banking services, but there is no guarantee that the previously employed could easily be reemployed in the new jobs. Formal or informal restrictions on the banks’ ability to “hire and fire” would thus limit the cost-savings that could be achieved from investment in labor saving information technology.

Table I-3.

Switzerland: Number of Branches per 1000 Inhabitants

article image
Source: OECD (Bank Profitability).

18. In this regard, the two large Swiss banks compare quite well to their continental European competitors. First, the Swiss labor market is considered among the more flexible in Europe.7 Second, the relatively low level of unemployment makes layoffs more politically acceptable than, for example, in the neighboring countries which have double digit unemployment rates. Thus, mergers are less often subject to “no firing” conditions, as is often the case in other European countries. Third, as a result of the two large banks’ global operations, a significant number of their staff members work abroad, often in financial centers with highly liberal labor laws.

19. Comparing the UBS and SBC merger with similar mergers in other European countries is instructive. In the case of the merger between UBS and SBC—effective June 1998—the total Group headcount was reduced by 13 percent (from end-1997 to end-1998) and total personnel costs fell by 15 percent. Most of the staff reductions were abroad, This reduction of headcount appears to exceed those of other recent large European mergers. In two other large European mergers,8 staffing changes in the year following the merger varied from a decrease of some 10 percent, in the case of the merger between Banco Central Hispano, and Banco Santander, to a four percent increase, in the merger between Bank Austria and Creditanstalt. In the cross-border merger between Fortis and Generale Bank, the average staffing level was up some two and a half percent (year-on-year) four months after the merger was completed.9

20. In the same vein, international data on banks’ cost efficiency suggests that the Swiss banks’ are relatively “cost conscious.” A common measure of banks’ cost-efficiency is provided by cost-income ratios, as measured by the banks’ operational costs as a ratio of net interest income and net noninterest revenue. With an average cost-income ratio of about 50 percent, the two large Swiss banks—"parent banks," i.e., excluding investment banking—compare well with large commercial banks in other developed OECD countries (Figures I-1 and I-2). Consolidated group figures have much higher cost-income ratios, probably reflecting the inclusion of low margin investment banking and insurance services. Figure 1-1 attempts to adjust the cost-income ratio for the share of non-interest revenue in total revenue by a simple cross-country regression on a selection of commercial banks; seen in this light, the consolidated group figures also compare relatively well with other banks.10

Figure I-1.
Figure I-1.

Switzerland: Cost Efficiency and Profitability, 1979-1998

Citation: IMF Staff Country Reports 2000, 043; 10.5089/9781451957297.002.A001

Source: OECD Bank Profitability.1/ Regression line is based on a sample of aggregate data from OECD countries (as reported in OECD Bank Profitability) but excludes Swiss banks.
Figure I-2.
Figure I-2.

Switzerland; Net Interest Margin and Cost-income Ratio, 1979-98

Citation: IMF Staff Country Reports 2000, 043; 10.5089/9781451957297.002.A001

Source: Swiss National Bank.

21. All in all, this should suggest that the two large Swiss banks’ earnings should be relatively comfortable. As can be seen from Figure 1-1, Panel 2 showing net income before loan loss provisions, this does indeed seem to be the case. It also appears that the profitability of the two large Swiss banks has improved somewhat over the last decade. Return on equity (ROE)—measured as earning before taxes and extraordinary items as a percentage of book value of capital and reserves—averaged about 20 percent during the 1990s despite a prolonged recession. This is also an improvement relative to the late 1980s and are at par with the ROE reported for US commercial banks and higher than in the large German banks (Figure 1-1 and I-3).

Figure I-3.
Figure I-3.

Switzerland: Bank Profitability, 1979-98

Citation: IMF Staff Country Reports 2000, 043; 10.5089/9781451957297.002.A001

Source: Swiss National Bank.

22. It is, however, an open question whether the relatively high earnings comes at the cost of relatively high risk taking. The large losses in the early 1990s (Figure I-3, Panel 2) underlines the need to adjust the return on equity (excluding loan loss provisions) for risk. Unfortunately, there is no foolproof method of calculating such a risk-adjustment and it can be debated whether the volatility of earnings is an appropriate risk measure.

Quality of risk management

23. The large losses in emerging markets and on derivative positions highlight the need for strong risk management in Swiss banking. Owing to their increased focus on investment banking and related financial services, the earnings of the two large Swiss banks have become increasingly volatile over the last few years, despite the use of sophisticated risk management models. Notably, both UBS Group and Credit Suisse Group experienced significant losses as a result of the emerging market crisis: in 1998, combined losses in the wake of the Russian crisis amounted to $2.5 billion, or about 6 percent of combined shareholder equity (of which 28 percent relate to Long Terra Capital Management, a U.S.-based hedge fund).

24. The importance of risk management is also highlighted by the banks’ earlier experience with large losses in the domestic market. Following a boom in the late 1980s, interest rates were increased sharply in late 1988 and 1989, triggering a prolonged recession and a sharp fall in housing prices. The combined effect of (i) a sharply inverted yield curve, (ii) collapsing real estate prices, and (iii) increasing insolvencies resulted in sharply worsening loan portfolios.11 Even though the losses affected virtually all Swiss banks, smaller regional banks and the cantonal banks were particularly hard hit, as they had mainly domestic loans.12

25. Although most Swiss banks are well capitalized 13 (Figure I-4), maintaining a high level of risk management is of key importance. The two large Swiss banks are clearly aware of the importance of risk management and have implemented sophisticated internal risk-management systems (described in some detail in the annual reports). Clearly, no risk management system is foolproof; cracks can emerge in an apparently perfect system, arising typically from the lack of central control or a sharp breakdown of established price relationships. Owing to the multicultural identity of the two large Swiss banks, they may be particularly exposed to coordination problems. Nevertheless, the highly diversified business portfolio and the resources spent on risk management suggest that the two large Swiss banks should be able to strengthen their reputation as prudent bankers.

Figure I-4.
Figure I-4.

Switzerland: Structure of Lending and Capital Reserves, 1979-98

Citation: IMF Staff Country Reports 2000, 043; 10.5089/9781451957297.002.A001

Source: Swiss National Bank.1/ Paid in capital and accumulated reserves as defined in SNB’s “Les banques suisses”. Excludes hybrid capital instruments accepted in the Basle Committee’s (BC) capital ratio. In addition, the denominator includes all assets while the BC’s capital ratios are based on risk-weighted assets.

26. Smaller banks are also well advised to focus on risk management. The regionally specialized banks (cantonal banks, regional banks, and savings banks) are heavily exposed to regional or domestic shocks. Thus, some wider diversification of their portfolio appears warranted. This could result from encouraging cross-regional or, even better, cross-border mergers. Moreover, some cantonal banks have increasingly been entering into new business lines, such as investment banking. Thus, the type of risk may have become more complex, requiring increasingly sophisticated risk management techniques.

27. The quality of banking supervision is in many respects a “common good” for Swiss banks.14 Vigilant banking supervisors not only protect taxpayers against large losses, but also provide a service for the private bankers. In particular, the supervisors gain insight into a number of different institutions and can determine common problems, that could potentially arise from unsustainable macroeconomic developments. Thus, an outside assessment should be helpful in maintaining the quality of risk management in smaller Swiss banks, with insufficient resources to build up sophisticated risk management units.

28. Although formally a part of the Federal Finance Administrations, the Federal Banking Commission (FBC) has been given considerable operationally independent from the political authorities (Box I-1) and the Implementing Directive provides clear guidelines on minimum prudential standards. The operational independence of the has been recently enhanced by the introduction of increased budgetary flexibility enabling the FBC to offer more competitive salaries to financial market specialists. Furthermore, the recent amendment to the Banking Act (Box I-1) has improved international cooperation by facilitating on-site inspection by foreign supervisors in branches or subsidiaries of foreign banks located in Switzerland.

29. Experience with the insolvency of one small bank has, however, revealed that roles played by the courts and the FBC during a financial crisis in an individual bank are not sufficiently clear; thus, the option of merging technically insolvent institutions with larger and more solid institutions has been used instead of liquidation in most cases.15 The use of consolidation as the only effective “exit” for insolvent institutions, may potentially delay the resolution of a crisis or could give rise to an undesirable increase in concentration (to the extent that the large banks may see a positive value in taking over the insolvent bank as it could enhance the large banks’ market dominance).

The future of Swiss asset management

30. Swiss banks and asset managers occupy one of the leading positions in the world market for asset management services. UBS Group Economic Research estimates that, at end-1997, the total amount of assets under management was approximately $2.3 trillion (about 10 times Switzerland’s GDP), of which a majority was for private clients (Table I-4).

Table I-4.

Switzerland: Assets Managed by Swiss Banks, End-1997

(In billions of dollars)

article image
Source: Blattner, Gratzl, and Kaufmann (1996).

31. Although there is no doubt that the strong position in asset management is partly a result of the high Swiss savings rate,16 the Swiss position is particularly strong in the market for “offshore” private asset management—the market for the management of private portfolios owned by foreign residents. It has been estimated17 that about SI,600 billion, or about 30 percent of “offshore” private wealth, is deposited in Swiss banks, making Switzerland the world’s leading location for the management of private wealth owned by foreign residents (exceeding by far the United Kingdom with about 15 percent, the second largest destination for “off-shore” wealth).18

32. Despite the Swiss private banks traditionally strong position in the management of wealth of established families, the Swiss private banks can be expected to benefit from the prospective increase in the transfer of wealth created during the post-war period. Particularly in neighboring Germany and Austria, a large number of post-war business founders will retire in the coming 5-10 years.19 As a result of its geographic location, its local knowledge (including languages), and its outstanding reputation, Swiss banks should be well placed to participate in the management of this wealth.

33. Their relatively small scale may, however, not allow the Swiss private banks to offer highly sophisticate information technology, most likely to be most demanded by young wealthy entrepreneurs. As the average costs of large scale investment in some information technology is likely to be negatively related to size, the relative burden of such investment would be larger for smaller banks. Thus, the smaller private banks may respond by merging or cooperating in the creation of common information technology infrastructures.

34. What role does Switzerland’s strict banking secrecy laws20 play in explaining its strong position in the private banking market? The answer is probably: “Some, but not as much as is often believed.” Particularly in the case of the private banks, the main attraction is the development of long-standing relationships with high-wealth individuals and the acquired reputation for professionalism, discretion, and reliability. Whether this relationship is protected by a strict banking secrecy law is probably of less importance than the banks’ acquired reputation, as long as a fundamental protection against arbitrary expropriation is maintained. The rapid growth in assets managed by Swiss private banks in recent years21 suggests that the recent measures to clamp down on “money laundering” have not slowed down the inflow of foreign funds into Swiss private banks, although these measures clearly modify the strictest interpretation of “banking secrecy.” Rather, the introduction of clear legal procedures against money laundering may have helped to maintain or even improve the international reputation of the Swiss private banks.

35. Similar arguments may apply to the case of tax evasion. Although Swiss banks undoubtedly benefit from some tax motivated investments, the core motivation for having the money managed in Switzerland is probably still related to the professional reputation of Swiss private banks. Thus, the effects on Swiss private banks earnings from an introduction of, for example, a wider application of the withholding tax (to include, for example, returns on fiduciary assets) may only be limited.

36. A couple of additional points may shed some light on the role of banking secrecy in the Swiss private banking. First, the Swiss banks built up their strong position in private banking before the introduction of the strict banking secrecy laws in 1934, motivated by the need to protect deposits flowing in from Germany. Second, some other European countries have similar banking secrecy laws, notably Luxembourg and Austria, but a far smaller share of the market for “offshore” private wealth. Thus, the strict banking secrecy law is probably only a secondary factor behind, the success of the Swiss private banks.

D. Pressures for Change in the Domestic Banking Sector

37. The previous sections reviewed the extent to which Swiss banks are likely to face increased international competition. This review has mainly focused on the more internationally oriented banks, in particular the two large Swiss banks and the smaller banks specializing in private banking. The domestic banking sector is, however, more important for the efficiency of the domestic economic system. Although the two large banks are also large players in the domestic markets, the domestic banking sector is also heavily influenced by state-controlled banks (the cantonal banks) and, to a lesser extent, mutual or cooperative banks (saving and Raiffeisen banks).22

38. The present section focuses on the challenges facing the Swiss banks on their “home turf.” It is argued that rigidities created in particular by the significant influence of state-owned and state-guaranteed banks are likely to be challenged in a more or less orderly process. Compared with privately-owned banks, the state-owned cantonal banks (i.e., owned by the cantons) benefit from a double advantage: first, the cantonal banks have access to “cheap equity” from the canton; second, cantonal liability guarantees have the effect of reducing the their funding costs. Thanks to these advantages the cantonal banks can underbid the joint-stock banks unless the latter have a special expertise in the business segment, or are sufficiently large to compensate for the special advantage given to the cantonal banks, Although the cantonal banks are generally required to provide for “local needs” (in rather vague terms), the effect of the privileges enjoyed by the cantonal banks is likely to raise the barriers to entry, thereby bolstering the market power of the incumbents. In effect, the regional market is highly concentrated: most cantons are dominated by the two large banks and one or, at most, two cantonal banks,23 While the two large private banks dominate the market for small and medium-size business credit, the market share of the cantonal banks is particularly high in mortgage lending and in lending to government institutions (Table I-6). 24

Table I-5.

Switzerland: International Comparison of Ownership Structures in Banking, 1998

(Percent of total assets)

article image
Sources: National central banks, European Commission, Building Societies Association, and staff estimates.

1997; includes branches of foreign banks (source: European Commission).

The assets of Bank Austria are included proportionally to the public sector share of the votes.

The specialist Caisse des Dépôts et des Consignations is not included (assets of about 3 percent of all banks). Similarly, the 10 percent public stake in Credit Lyonnais is excluded.

Landesbanken (owned by the Länder), saving banks (owned by the municipalities), and state-owned mortgage companies (estimated asset share; 2 percent).

Table I-6.

Switzerland: Developments in Domestic Market Shares1/

article image
Source: Swiss National Bank.

Excludes private banks, finance companies, and branches of foreign banks.

39. There are also additional barriers to entry affecting foreign banks. According to the Banking Act, the establishment of a foreign subsidiary or a branch of a foreign banks is restricted; and a majority of the management has to be Swiss.25 As a joint result of this provision and the entry barriers mentioned above, foreign banks (foreign-owned subsidiaries and branches) play a relatively minor, albeit growing, role in Switzerland. Despite the substantial international activity of Swiss banks, the proportion of total assets of foreign banks in Switzerland is much smaller than, for example, in France and the United Kingdom. The foreign banks concentrate mainly on asset management, investment banking, and wholesale banking, all highly international market segments; their market share in the domestic market is only around 6 percent.

40. Pressure for change may arise from several sources. The first and foremost source arises from the distortions created by state-ownership and state-guarantee, which are likely to meet political opposition from groups that would benefit from a change. As noted in the statement by the Competition Commission on the amendment of the Banking Act,26 taxpayers in general have suffered in several instances from the state-guarantee of the cantonal banks.27 The combination of state-guarantee and lower capital requirements is a particularly “explosive” constellation; the value of taxpayers’ implicit liability increases if the amount of capital is reduced.28 Also, state-ownership risks being used for the purpose of directed lending, a practice accentuated by the special legal status of the banks and the lack of clear profit targets. This lack of a clear commercial objective is bound to favor certain groups at the expense of others, in ways which may be not conform to accepted “social justice.”

41. The second source is the lack of incentives for innovation arising from state-ownership, potentially creating over time a “technology gap.” In particular, in such a highly complex sector such as banking, private ownership has proven superior to state-ownership, unless the objective is a “public good” (e.g., development aid). Lower profit aspirations arising from the state-ownership combined with a lack of competitive pressures, makes it less urgent for the managers to take advantage of new technologies than in the case of joint-stock banks (where, e.g., the owners can align the incentives of the managers with the owners interest through the award of stock options). Moreover, state-ownership is apt to impose stronger constraints on the ability to reduce staff in order to benefit from technological progress. In effect, staffing levels in the cantonal banks and the number of branches have hardly changed over the last four years while, at the same time, the two large banks have been significantly reducing their staff levels and pruned their branch networks (Figure I-5).

Figure I-5.
Figure I-5.

Switzerland: Resource Use in Banking, 1986-98

Citation: IMF Staff Country Reports 2000, 043; 10.5089/9781451957297.002.A001

Source: Swiss National Bank.

42. A third related source of change comes from the relentless progress of technology which can be expected to nibble away on the artificially high barriers to entry. The advent of internet and direct banking is likely to reduce the obstacles facing foreign banks when they want to sell banking services in Switzerland as none or only a few physical branches may exist.29

43. The incumbent banks can respond to these pressures in several ways. One approach may be to consolidate, thus increasing the degree of market concentration (i.e., maintaining market power, if any) and reducing costs. Several indicators suggest that, to some extent, such a process of consolidation has already taken place during the 1990s. Besides the highly publicized merger between UBS and SBC, there are other signs of increased concentration: the combined share of the cantonal banks and the two large banks has been gradually increasing in the 1990s (Table I-6). The collapse in the real estate market in the early 1990s reinforced the squeezing out of the smaller regional and saving banks by the cantonal banks and the two large banks. Although most banks were severely affected by the sharp fall in collateral values resulting from the collapse in the real estate market in the early 1990s, the cantonal banks drew on public guarantees and public ownership, and the two large banks drew on more diversified revenues to withstand the losses. The regional and savings banks suffered, by contrast, from small size and geographical limitations.

44. Another approach may be to take on more risks in the hope of generating higher earnings; an approach often taken by banks in countries which have experienced significant financial market liberalization.30 In the case of the cantonal banks, state-ownership and state-guarantees would make such increased risk-taking virtually costless. The increased share of foreign lending in total credit (from 4 percent in 1990 to 6½ percent in 1998) is an indication that such a risk-shift may indeed be talcing place. Similarly, the two large banks have undoubtedly switched to increased risk-taking as can be seen from an even stronger increase in the foreign-credit share and large losses; this strategy may be, however, motivated by the tougher competition in the international banking markets than an attempt to compensate for tighter margins in the domestic credit market.

E. Conclusions

45. Driven by a mixture of technological change, global consolidation, political pressures, and the advent of the euro, the Swiss banks are undergoing significant structural change. The changes are likely to be positive: increased competition and a reduction of direct state involvement in the financial sector is likely to increase the degree of liquidity, flexibility, and efficiency in the domestic financial markets. The process of change is, however, not without dangers as banks could try to compensate the narrowing margins by entering into potentially more lucrative but also increasingly risky areas of business. Although there are as yet no decisive signs that such a risk-shift is indeed taking place, the continued extension of state guarantees to cantonal banks, which are subject to more lenient capital requirement, provides perverse incentives in this respect.

46. The role of the smaller regional and savings banks is uncertain. On the one hand, their market share has been significantly curtailed during the 1990s and they appear to be increasingly crushed by the two large banks and the dominant cantonal bank (in the relevant canton). On the other hand, the lack of state protection or a parent bank with deep pockets has taught some of these banks to survive on their own. As a result, their branch network has been significantly trimmed, their cost-income ratio has declined, and their profitability has increased significantly. Overall, in spite of the international drive for consolidation and the apparent increasing economies of scale, it is likely that there will be some place for smaller banks with local focus. It is an open question, however, whether these banks will arise from the cantonal banks, the remaining regional and savings banks, the Raiffeisen banks, or completely new banks.

47. The two large banks have recently gone through a difficult period. Although it is hard to foretell the future, it has been argued above, however, that these banks seem relatively well placed to face the increased global competition, at least when compared to other European banks. In the highly volatile “high seas” of international finance, efficient risk management is likely to be at the core of the success or failure of these banks. The low rate of return on their domestic operation is also a problem, as they may subsidize their domestic business in order to keep their Swiss links. Attempts to use their domestic market power to increase their rate of return are also likely to fail as it would only increase the incentives for market entry.

48. As regards asset management, the Swiss private banks are likely to maintain their strong position relatively unaffected by the international pressures to relax the strict Swiss banking secrecy laws. Despite recent measures to combat money laundering, the value of assets under management by Swiss private banks has been increasing rapidly. As long as the core elements of banking secrecy are maintained, the negative impact from the introduction of additional measures against money laundering and gross tax evasion would probably be limited. It may even be argued that such measures are essential to maintain the Swiss banks’ international reputation.

  • Bank for International Settlements, 1997, Real-Time Gross Settlement Systems, Basel.

  • Berger, A. N. and D. B. Humphrey, 1991, “The Dominance of Inefficiencies over Scale and Product Mix Economies in Banking,” Journal of Monetary Economics, No. 28, pp. 117-148.

    • Search Google Scholar
    • Export Citation
  • Berger, A. N. and D. B. Humphrey, 1997, “Efficiency of Financial Institutions: International Survey and Directions for Future Research,” European Journal of Operational Research, No. 98, pp. 175-212.

    • Search Google Scholar
    • Export Citation
  • Bikkerr, Jacob A., 1999, “Efficiency in the European Banking Industry: an Exploratory Analysis to Rank Countries,” De Nederlandsche Bank Staff Reports, No. 42.

    • Search Google Scholar
    • Export Citation
  • Blattner, Niklaus, Benedikt Gratzl, and Tilo Kaufmann, 1996, Das Vermӧgensverwaltungsgeschӓft der Banken in der Schweiz, Haupt, Berne.

    • Search Google Scholar
    • Export Citation
  • Christensen, Benedicte V., 1996, “Switzerland’s Role as an International Financial Center,” IMF Occasional Paper No. 45.

  • Danthine, Jean-Pierre, Francesco Giavazzi, Xavier Vives, Ernst-Ludwig von Thadden, 1999, “The Future of European Banking,” Monitoring European Integration 9, Centre for Economic Policy Research.

    • Search Google Scholar
    • Export Citation
  • The Economist, 1999, Financial Mergers: Complex Equations, June 5, p. 69.

  • Edey, Malcolm and Ketil Hviding, “An Assessment of Financial Reform in OECD Countries,” OECD Economic Studies, No. 25, 1995.

  • Engstrӧm-Bondy, Béatrice and Claire Makin, 1992, Swiss Banking in the 1990s, International Finance Review Books.

  • Hviding, Ketil (1999), “Switzerland’s Monetary Policy Framework,” Switzerland: Selected Issues and Statistical Appendix, SM/99/31.

    • Search Google Scholar
    • Export Citation
  • IBCA, 1990, “The Swiss Banking Industry: Prudential Regulations,” IBCA Country Report.

  • IBCA, 1994, The Swiss Banking System, IBCA Country Report.

  • Kaufmann, Hans, 1996, Swiss Banks on the Way to Global Leadership, Bank Julius Baer.

  • KPMG (1999), Banking and Finance in Switzerland.

  • Merton, Robert C., “An Analytic Derivation of the Cost of Deposit Insurance Loan Guarantees, Journal of Banking and Finance, June 1977, pp. 3-11.

    • Search Google Scholar
    • Export Citation
  • Molyneux, Philip, Yener Altunabas, and Edward Gardener, 1996, Efficiency in European Banking, John Wiley & Sons, New York.

    • Export Citation
  • Neven, Damien and Thomas Von Ungern-Stemberg, 1998, “The Competitive Impact of the UBS-SBC Merger,” Université de Lausanne Cahiers de Recherches Economiques, April, pp. 20.

    • Search Google Scholar
    • Export Citation
  • OECD (1987), “Switzerland,” Economic Surveys.

  • OECD (1999), “Switzerland,” Economic Surveys.

  • Pictet & Cie, 1999, Swiss Banks: Focus on Private Banking, research report.

  • Rime, Bertand, 1999, “Mesure du degré de concurrence dans le système bancaire suisse à l’ aide du modèle de Panzar et Rosse,” Swiss Journal of Economics and Statistics, Vol. 135 (1), pp. 21-40.

    • Search Google Scholar
    • Export Citation
  • Rime, Betrand and Dominik Egli, 1999, “The UBS-SBC merger and Competition in the Swiss Retail Banking Sector,” mimeo, Swiss National Bank.

    • Search Google Scholar
    • Export Citation
  • Sandler, Todd and John Tschirhart (1997), “Club Theory: Thirty Years Later,” Public Choice, December, pp. 335-55.

  • Schiitz, Dirk, 1998, Der Fall der UBS, BILAN, Zurich.

  • International Monetary Fund, 1997, “Recent Developments in the Banking Sector,” Switzerland—Selected Issues and Statistical Appendix, SM/97/23.

    • Search Google Scholar
    • Export Citation
  • Staub, Markus, 1998, “The Term Structure of Interest Rates and the Swiss Regional Bank Crisis: Empirical Evidence and its Limits,” Swiss Journal of Economics and Statistics, Vol. 134 (4,2), pp. 655-684.

    • Search Google Scholar
    • Export Citation
  • Swiss Federal Administration, 1998, Background Information on some Aspects of the Swiss Financial Centre, mimeo.

  • Swiss Bankers Association (1999), The Swiss Banking Sector: Development, Structure and International Position.

1

Prepared by Ketil Hviding.

2

The Swiss federation is composed of 26 cantons and half cantons. The cantons benefit from a high degree of autonomy; the federal government has no authority over cantonal affairs unless explicitly authorized in the Swiss constitution.

3

The Banker, July 1999.

4

The Economist,“The New Financiers,” September 4, 1999, pp. 69-70.

5

See, for example, The Economist (1999), Berger (1991 and 1997), Molyneux, Altunabas, and Gardener (1996).

6

Refers to the total value of deals (market capitalization of the merged company) during January to June 1999. Market shares add up to more than 100 percent since one deal may involve several advisors. See “Sharks on the Loose” The Banker, August 1999.

7

See, for example, OECD Economic Survey on Switzerland, 1996. The OECD Job Study identifies the Swiss employment protection legislation as among the most liberal in the OECD area.

8

(1) Bank Austria and Creditanstalt, effective November 1997; and (2) Fortis (Netherlands) and Generale bank (Belgium), effective September 1998.

9

Banco Central Hispano and Banco Santander (both Spain), effective January 1999.

10

On the basis of production frontier estimates, Bikker (1999) finds that the Swiss banks are overall the third most efficient (in X-efficiency terms) among a group of nine European countries (Belgium, France, Germany, Italy, Luxembourg, Netherlands, Spain, the United Kingdom, and Switzerland), after Luxembourg banks (most efficient) and Belgian banks (second most efficient).

11

See, for example, Staub (1998).

12

See IMF (1997).

13

The consolidated capital adequacy ratio of the internationally active large banking groups was 14.8 percent in June 1999 (excluding international subsidiaries, the capital ratio of the Swiss banking system as a whole was 11.3 percent in December 1998).

14

Such“common good” has also been called a “club good” (see, e.g., Sandler and Tschirhart, 1997). In contrast to pure public goods, exclusion in consumption is possible; the “club goods” differs also from private goods, however, as their joint production is beneficial.

15

As in most other European countries, bank failures are virtually nonexistent in Switzerland. See, for example, Staub (1998).

16

In addition, a beneficial tax regime favors debt financed investment in insurance products (collateralized with real estate) thus making it relatively beneficial to roll over outstanding mortgage debt and to invest savings in insurance products or other financial assets. See OECD (1999).

17

The Banker (1998).

18

This comes in addition to assets held for institutional investors (e.g., pension funds) and Swiss nationals.

19

See Pictet & Co (1999).

20

“Banking secrecy is defined as the discretion which the representatives and employees of a bank must guarantee in regard to information about the business affairs of their clients or third parties which comes to their knowledge during their profession. Authorized agents, auditors mandated by the supervisory authority and other persons involved in business with the bank are also obliged to maintain banking secrecy.” Banking secrecy is enshrined in the banking law (and the civil law). See Swiss Federal Administration (1998) and KPMG (1999).

21

On average, the assets of the three largest incorporated private banks (Julius Baer, Sarasin, and Vontobel) grew by an annual rate of close to 20 percent in 1998 and 1999.

22

See Table I-5 for an international comparison of ownership structures.

23

In the market for small and medium size business loans (above Sw F 100,000), Neven and Ungern-Sternberg (1998) reports that the two large banks and one cantonal bank have a combined marked share of 90 percent in almost all cantons. Furthermore, the Federal Competition Commission (FCC) judged the potential threat from new entrants to be small, reflecting the combined dominance of the two big banks and the cantonal banks. Subsequently, the FCC ordered the new UBS AG to sell 25 branch offices and to freeze the outstanding volume of smaller business loans until 2004, motivated by a concern to prevent the creation of an oligopolistic market structure. See Commission de la concurrence,“Rapport annuel 1998,” p.9.

24

Rime and Egli (1999) finds a positive relationship between market concentration and saving deposits rates in the large cantons; in the small cantons, by contrast, this relationship is negative suggesting that economies scale effects from increased concentration dominate the negative effect on competition.

25

“The Swiss Banking System,” Fitch lBCA Country Report, May 1994.

26

Stellungnahme der Wettbewerbskommission vom 5. Mai 1997 zum Bericht der Expertenkommission im Vernehmlassunsverfahren: Staatsgarantie as konstitutives Merkmal. Available at: www.wettbewerbskommission.ch.

27

The Competition Commission mentions four cantons: Appenzell, Ausserhoden, Bern, and Solothurn.

28

Merton (1977) shows that the value of a deposit guarantee increases with the amount of risk and decreases with the value of bank capital.

29

It has been reported that at least one prominent internet broker has recently been marketing its services successfully to Swiss residents, without having a branch in Switzerland. In addition to savings on rent the absence of a branch in Switzerland also exempted the broker from the need of a license from the Swiss authorities.

30

See, for example, Edey and Hviding (1995).

APPENDIX I A Stylized Model of Portfolio Allocation

88. This appendix elaborates the theoretical framework sketched in Section C of the main text.

Framework and assumptions

89. The economy of the stylized model is populated by a continuum of identical agents of measure 1. Agents maximize their expected lifetime utility subject to an intertemporal budget constraint. They derive (flow) utility from an index of traded goods and nontraded goods consumption flow. Nontraded consumption flow is assumed to be proportional to the current stock of assets invested in the nontraded goods sector. For simplicity, we assume that the constant of proportionality is one.58

90. In addition to deciding how much to consume, agents must also decide how to allocate their portfolio. There are four investment possibilities. First, assets can be kept in the form of capital in the domestic traded goods sector. Second, they can be invested in capital abroad in the traded goods sector. These two assets are assumed to earn a risky rate. In addition to risky investment, there are two possibilities to earn a riskless rate: to invest in the domestic nontraded sector, or to invest in riskless foreign bonds. While agents can costlessly adjust their portfolio between the first three assets, changing the amount held in nontraded sector capital is assumed to be costly.

91. Formally, the representative consumer solves thé following problem:

max<c,h,k,k*,ξ>E00(ln(Ct)eδtdt(1)

subject to:

Ct=(Ctθ1θ+htθ1θ)θθ1(2)
da==(πdt+σdω¯)k+(π*dt+σ*dω¯*)k*++ρdt(akk*hP)+(φdthP+hdP)cdtkhPξ(3)

92. According to (1) and (2), the traded and nontraded goods consumption flows c and h are combined into a flow consumption index C with a constant elasticity of substitution θ>1. Instantaneous utility is logarithmic in C. Expected lifetime utility is obtained as the expected discounted sum (with a time preference rate δ) of instantaneous utilities.

93. Equation (3) specifies the agent’s budget constraint, without the time indices for notational simplicity. Total assets a accumulate based on returns, portfolio allocation, consumption choices, and adjustment costs. The first two terms on the right hand side of (3) specify returns from assets invested in the domestic and foreign traded sector, respectively. During the interval dt, assets in these two forms (k and k*) yield random returns πdt+σdω and π*dt+σ*dω*, respectively, where and * are Wiener processes with mean zero, variance dt, and covariance ɳdt. The parameters π, π*, σ, σ* determine the mean and variance of returns. The third term specifies the safe return earned on foreign bonds. The amount of assets kept in this form is determined as total assets a, minus assets held in traded sector capital k+k*, minus assets held in nontraded sector capital hP, where P is the relative price of nontraded sector capital in terms of traded sector capital. (Whenever P increases, nontraded sector capital becomes more expensive in terms of traded sector capital, and the real exchange rate is said to appreciate.) The fourth term is the return on assets invested in nontraded sector capital, which has two components: depreciation (at the instantaneous rate φ), and capital gains or losses from relative price changes. The fifth term is consumption during the interval dt, while the last term specifies adjustment costs related to changing the amount of assets held in nontraded sector capital. If adjustment happens in an instant τ, the indicator variable ξ which is equal to zero when no adjustment occurs, takes the value 1. Adjustment costs will then be a share k of the stock of nontraded sector capital held at f, the instant immediately preceding adjustment. Because adjustment costs are not proportional to the size of the adjustment, discrete adjustments will be undertaken.59

The no-transaction-cost benchmark (k=0)

94. If we define the relative “shadow price” of nontraded sector capital as:60

Ps=P(φ+ρ)dP/dt(4)

and ignore transaction costs, the asset accumulation equation (3) can be rewritten as:

da==(πdt+σdω¯)k+(π*dt+σ*dω¯*)k*++ρdt(akk*)Pshdtcdt(3)

95. If there are no transaction costs, all decision variables are adjusted instantaneously, and the Bellman equation associated with (1)–(3) is:

δV(a,Ps)=max<c,h,k,k*>{ln(C)+VaE(da)dt+Vaa2E(da2)dt++  VPsE(dPs)dt+VPsPs2E(dPs2)dt+VaPsE(dPsda)da}(5)

96. If the relative price of traded and nontraded sector capital Ps is constant, the problem (1)-(3) eventually collapses to Merton’s model, with a known solution. When Ps is a parameter, the value function V(.) is time invariant and depends only on total assets a, so that the last three terms in (5) can be set to zero. Therefore, the following first-order conditions must be satisfied:

0=1CCcVa(6)
0=1CChVaPs(7)
0=Va(πρ)+Vaa(σ2k+σσ*ηk*)(8)
0 =Va (π*ρ) +Vaa (σ*2k* +σσ*ηk)(9)

97. Combining equations (5) and (6) and substituting C/c, andC/h yields the familiar formula linking the consumption mix to relative prices:

hc=Psθ(10)

That is, the ratio of nontraded to traded goods consumption is negatively related to the relative “shadow price” Ps of nontraded goods. Using the relation in equation (10), it is straightforward to show that (1)-(3) is equivalent to the standard portfolio allocation problem (Merton (1971)), and thus the value function is logarithmic in a. In this case, the first order conditions imply that consumption of traded and nontraded goods are proportional to total assets; and that the share of both domestic and foreign traded sector capital holdings in total assets is constant.61 Equations (11)-(14) below characterize the solution:

c=δ(1+Ps1θ)a(11)
hP=δPsθP(1+Ps1θ)a(12)
k=(σ2(1η2))1{(πρ)(π*ρ)σσ*η}a(13)
k*=(σ*2(1η2))1{(π*ρ)(πρ)σ*ση}a(14)

98. It can be easily verified that (i) traded goods consumption c is increasing in the shadow price of nontraded goods; and (ii) nontraded goods consumption h is decreasing in the shadow price of nontraded goods. Ceteris paribus, an increase in the shadow price of nontraded goods, or a (permanent) real appreciation will tilt consumption patterns toward the relatively cheaper traded good. From equation (12), this consumption pattern will be matched by a lower portfolio share of nontraded sector capital. As the portfolio shares of domestic and foreign traded sector capital remain unchanged, the lower portfolio share of nontraded sector capital is matched by a higher portfolio share of riskless foreign assets. As a result, countries where the shadow price of nontraded sector capital is higher, will have higher foreign assets to total assets ratios.

99. Equations (13) and (14) specify a relationship between holdings of risky assets and the level of total assets which is seemingly linear in a.62 However, the expected returns on domestic traded sector capital, n, may depend on the total stock of capital invested in this sector k, which in turn may destroy the linearity of the relationship. Kraay and Ventura (1999) show that this is not the case if decreasing returns to £ are not important relative to the investment riskσ. If this condition is met, the portfolio rules are indeed linear in a, implying that investors will allocate increments to their wealth—their savings—between various assets in the same proportions as their existing portfolio.63 As this is also true for the split between foreign and domestic assets, countries with higher nontraded shadow prices would—ceteris paribus—also tend to run larger current account surpluses.64

Transaction costs

100. If nonproportional transaction costs are present, consumers will in general find it optimal not to adjust h instantaneously. Instead, they will follow an S-s rule which keeps the portfolio share of nontraded sector capital within a band. In periods of inaction (“inside the band”), the ratio hP/a will only evolve as a result of stochastic shocks to a, as well as changes in hP due to physical depreciation (at the instantaneous rate ϕ). At the boundaries of the band, nontraded sector capital holdings will be adjusted in a lumpy fashion.

101. Intuitively, the portfolio share of the nontraded sector capital will tend to hit the boundaries after a series of positive (negative) shocks to wealth. If a increases due to favorable shocks, the portfolio share of nontraded sector capital erodes and eventually hits the lower bound. When this happens, the investor regroups her assets from financial to real assets. As a result, foreign assets decline. On the country level, after a long upswing (both in creditor and debtor countries), the joint observation of a domestic investment boom and a current account deficit is likely. The opposite argument holds for downward adjustment after a long downswing.

102. Although an explicit closed form solution to the problem (1)-(3) does not exist, Beaulieu (1993a) provides a solution method and shows that the optimal policy is indeed an S-s rule, and that the position and the width of the band depends on the model’s parameters. His simulation results indicate that the investor’s attitude toward risk varies depending on her nontraded sector capital holdings. In particular, she tends to be more risk averse when her nontraded sector capital holdings are close to the optimum, and less risk averse when they substantially deviate from the optimum. Since riskless financial assets are foreign, attitudes towards risk matter for international portfolio allocation and thus for the current account. However, this effect is likely to be of second order magnitude.

APPENDIX II Data

Sources

103. The sources of the data used in Sections D and E are the International Financial Statistics (international investment position, exchange rates, stock market indices); the WEO database (GDP, current account, investment, GDP deflator); the Perm World Tables and the OECD Main Economic Indicators (price level).

Sample

104. The sample includes 16 OECD economies, selected based upon data availability on international investment position. The three largest economies (Germany, Japan, and the US) were not considered in the sample. Thus, the sample includes the following countries and time periods:

article image

Definition of variables

Alternative definitions of the share of foreign assets in total assets

FDI-based measure, used in specification 1 in Tables II-4 to II-6

  • (FDI assets + net portfolio investment + net other investment)/

  • (domestic capital stock - FDI liabilities).

Measure corrected for stock market valuation effects, used in specification 2 in Tables II-4 toII-6

  • (revalued FDI assets + revalued portfolio equity assets + net non-equity portfolio assets + net other investment)/

  • (domestic capital stock-revalued FDI liabilities-revalued portfolio equity liabilities).

Raw measure, used in specification 3 in Tables II-4 to II-6

  • (FDI assets + portfolio equity assets + net non-equity portfolio assets + net other investment)/

  • (domestic capital stock-FDI liabilities-portfolio equity liabilities).

Other variables

Table II-2

Implicit rate of return on assets (t) = investment income credit (t) / asset stock (t-1).

Implicit rate of return on liabilities (t) = investment income debit (t) / liability stock (t-1).

Tables II-3 and II-4

CA = current account to GDP ratio.

CA f = savings rate x FDI based measure of share of foreign assets in total assets.

CA m - savings rate x share of foreign assets in total assets corrected for stock market valuation effects.

CA v = savings rate x share of foreign assets in total assets.

Table II-6

Term 1 = savings rate (t-1) x forecast value of share of foreign assets in total assets (t-1).

Term 2 = (forecast value of share of foreign assets in total assets (t) - forecast value of share of foreign assets in total assets (t-1)) x total assets to GDP ratio.

Term 3a = length of period (in years) with positive output gap if output gap is positive;(-l)*length of period (in years) with negative output gap if output gap is negative.

Term 3b = output gap.

Capital inflows = forecast value of capital inflows to GDP ratio.

STATISTICAL APPENDIX

Table A1.

Switzerland: Real GDP Developments

(Percentage changes at 1990 prices) 1/

article image
Source: Swiss Institute for Business Cycle Research, data tape.

For quarterly data, growth rates are with respect to the same quarter of the previous year, calculated from seasonally adjusted figures.

Contribution to growth of GDP.

Table A2.

Switzerland: Components of Nominal GDP

(In millions of Swiss francs, at current prices)

article image
Source: Swiss Institute for Business Cycle Research, data tape.
Table A3.

Switzerland: Components of Real GDP

(In millions of Swiss francs, at current prices)

article image
Source: Swiss Institute for Business Cycle Research, data tape.

Including statistical discrepancy.

Table A4.

Switzerland: Implicit Price Deflators

(Percent changes)

article image
Source: Swiss Institute for Business Cycle Research, data tape.
Table A5.

Switzerland: Household Disposable Income and Savings

(Percent change, unless otherwise indicated)

article image
Source: Swiss Institute for Business Cycle Research, data tape.
Table A6.

Switzerland: Labor Market

(In millions, unless otherwise indicated)

article image
Sources: Swiss Institute for Business Cycle Research, data tape; and Federal Statistical Office.
Table A7.

Switzerland: Prices, Wages and Productivity

(Percentage changes) 1/

article image
Sources: Swiss Institute for Business Cycle Research, data tape; and IMF, World Economic Outlook database.

For quarterly data, growth rates are with respect to the same quarter of the previous year.

Deflators for goods.

Table A8.

Switzerland: Federal Government Finances

(In billions of Swiss francs, unless otherwise indicated)

article image
Source: Federal Ministry of Finance.

Up to 1996 excluding railway loans.

Includes military procurement.

Includes loans to unemployment insurance fund.

Table A9.

Switzerland: Federal Government Tax Revenue

(In billions of Swiss francs, unless otherwise indicated)

article image
Source: Federal Ministry of Finance.

VAT was introduced at the beginning of 1995; in January 1999, the VAT rate was raised by 1 percentage point to 6.5 percent.

Table A10.

Switzerland: Federal Government Assets and Liabilities

(End-of-period; in billions of Swiss francs, unless otherwise indicated)

article image
Source: Federal Ministry of Finance, Staatsrechnung.

Amount by which liabilities exceed all other assets.

Largely deposits of federal pension fund (EVK) with the federal government.

Difference between gross financial debt and financial assets.

Table A11.

Switzerland: General Government Finances

article image
article image
Sources: Federal Finance Administration; and staff estimates and projections.

Excluding cash surplus of the civil servant pension fund; from 1997 onwards, including loans to the railways.

Excluding revenue from the partial privatization of Swisscom, amounting to Sw F 2.9 billion.