Can Switzerland still be trusted?

Two weeks ago, the world saw a run on a major Swiss bank. Intent on restoring trust in one of the premier wealth managers of the planet, the Swiss government engineered a forced takeover of Credit Suisse – and in the process might have destroyed trust in Switzerland as a whole, undermining the basis of the gigantic wealth management business of all Swiss banks.

What is the problem? According to well various press articles, the Swiss government panicked when Credit Suisse – that actually sported amongst the best capital and liquidity ratios of any major bank in the world – encountered massive outflows that at least in part had been triggered by factually wrong press articles and a baseless comparison of Credit Suisse (tightly regulated based on the sophisticated Basel capital accord) with lightly regulated regional US banks whose managers seem to have skipped banking risk management 101. And even though Credit Suisse received a CHF 5 billion offer from Saudi investors (not requiring any impairment of the bank's AT1 bonds), the Swiss government insisted on merging Credit Suisse with its archrival UBS in spite of several important arguments against the merger. When both UBS and Credit Suisse barked at the deal, it seems that somebody came up with a mischievous strategy for sweetening the deal with a CHF 16 bn windfall profit in the form of the complete write-off of all AT1 bonds.

This doesn't make any sense at all in the context of a liquidity shortage – cancelling the bonds is a balance sheet transfer from loss-absorbing liabilities to equally loss-absorbing equity, so in effect there is not a single Franc more of loss capacity to absorb future losses to protect depositors, hence depositors could not care less about the measure. In fact, unlike AT1 bonds, equity could be distributed to shareholders, so if anything, in the future depositors may be worse off.

There was sufficient uncertainty about the legality of the maneuver that the Swiss government changed the law over the weekend to sanction it. FINMA, the Swiss regulator, assured that there was extraordinary government support justifying the action at the same time when the Swiss Finance Minister insisted that this was no bailout but a commercial transaction – somebody clearly wanted to eat her pie and keep it, too. And whatever many years from now the final judicial verdict will be – the market reaction made it clear that nobody had expected that a "convertible" bond rather than being converted into equity would arbitrarily be wiped out, that a loss absorption instrument would be triggered in the absence of actual losses, and that an instrument where the terms mention the possibility of a write-off in the context of "all equity being written off" could be wiped out at the same time when ordinary shares change hands at CHF 0.76 a piece.

We therefore don't know yet if we should consider this episode expropriation by a sovereign, fraud by a corporate, or rather "only" misleading advertisement at the time of origination of the AT1 bonds – but we know that a financial market where any such thing can happen on such a scale cannot be trusted.

The problem is that governments and other stakeholders in financial markets constantly face conflicts of interest, and if a government once has decided to throw a particular group of investors under the bus in order to advance domestic political goals – such as preventing Credit Suisse from being sold to overseas investors –, they might do so again any time.

And there are many scenarios international wealth management investors must worry about. For example, when there is a run on the Swiss currency, Switzerland might be tempted of following the script of more rogue countries such as Argentina and severely restrict access to foreign currency for overseas wealth management customers – or even mandatorily convert hard currencies such as USD or EUR into CHF, maybe at ridiculously inflated official exchange rates.

Or if the newly emerged UBS-Credit Suisse juggernaut ever was to seriously get into trouble (e.g., because of a cyber attack), the government would be tempted to prioritise Swiss citizens over overseas investors, e.g., when it comes to honouring its deposit insurance. And the wipe-out of the AT1 bonds suggests that the Swiss government is prepared to do so at ease.

It is no wonder that Switzerland now has been called a "financial banana republic" – and global investors start reassessing what share of their total wealth they can entrust Swiss institutions at a maximum. This is obviously the exact opposite of the intention that drove the Swiss government to take extraordinary action and threatens all Swiss wealth managers, not just Credit Suisse and UBS. Of course, a specific additional sword of Damocles now hangs over UBS, too – if after years of court proceedings the wipe-out of the bonds was to be found not just unlawful but actually an act of having misled investors at the time of origination, UBS may be forced not to reinstate the written off bonds but potentially even pay out cash compensation to the tune of CHF 16 bn – or more if it needs to undo its own AT1 bond issuance as well. It would not be the first time a bank needs to pay billions in compensation because it has misled investors about a product.

The drama around Credit Suisse won't make Switzerland a pariah, and its banks will continue to offer sophisticated products and professional (albeit expensive) service to wealth management clients. The problem for Switzerland is, however, that the huge size of its wealth management industry actually is a handicap if it comes to risk management and trust in its institutions. For depositors and investors to have an average level of trust in, say, deposit insurance, such a small country with such a huge volume deposited in its valleys must make an extraordinary effort to keep the industry safe and support it in times of turbulence.

Switzerland's exceptionalism was based on its ability to instill an unquestionable level of trust in this being the case. Credit Suisse's journey through a valley of tears in the past couple of years has shown, however, that Swiss corporate culture and regulators were not failsafe – and that the Swiss government not only was reluctant to bail out a bank once more (following the rescue of UBS during the Global Financial Crisis) but that it even did not shy away from legally questionable maneuvers in order to protect domestic political interests.

In order to undo the damage, Switzerland probably still has a rapidly disappearing window of opportunity to take back the wipe-out of the AT1 bonds, declaring that this act had not withstood a more thorough assessment of the legality of an action taken in an extremely rushed situation under great stress and duress.

Unfortunately countries have a habit of stubbornly sticking to a course once taken as this is a quintessentially human trait; just think of Brexit. Will Switzerland have the humility and wisdom to do better??