## _cr07187

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---

### Executive summary — financial system overview
- The Swiss financial system is large, well developed, and plays an important role in the Swiss economy and internationally.
- The two large Swiss banks dominate the domestic market and are important intermediaries in global financial markets.
- The Swiss insurance and reinsurance industry comprises a few players that are significant internationally.
- Other institutions operate mainly domestically and are not systemically important.
- The dualistic nature of the system implies significant differences in the risk profile and counterparty exposure across segments.

### Executive summary — strengths, vulnerabilities, and downside risks
- Current macroeconomic and financial environment:
  - Financial soundness indicators are strong and market indicators are positive.
  - Economic activity rebounded since 2004; GDP growth was 2.7 percent in 2006.
  - Inflation remains low and policy interest rates at 2.25 percent are low by historical comparison.
  - Fiscal accounts recorded surplus in 2006.
  - The Swiss franc has weakened against the euro.
  - Swiss equity markets have outperformed most international equity markets and volatility remains low.
  - House price increases have been moderate with no signs of overheating.
  - Corporate sector: bankruptcy rate well below peak in early 1990s; companies’ debt ratios at their lowest levels in fifteen years.
- Main downside risks (external and domestic):
  - Large trading portfolios of the two large banks are potentially exposed to market downturns and significant increases in volatility (including from a disorderly unwinding of global imbalances affecting U.S. exchange and interest rates, and a potentially severe drop in global equity markets).
  - Hard landing of housing markets in the U.S. and other key industrial countries could compound risks via direct exposures and feedback to real activity.
  - Domestic slowdown would most likely originate from external influences.
  - Domestic risk: increasing share of fixed-rate mortgages to households could raise interest rate risk in the domestically-oriented banking system if hedging is relaxed.
  - Carry-trade risks: abrupt adjustment in the Swiss franc exchange rate would manifest mainly in counterparty and credit risks.

### Executive summary — banking sector resilience
- Banking sector resilience:
  - Top-down stress tests of the banking sector and bottom-up stress tests of the two large banks confirm resiliency to the most relevant macroeconomic stress events.
  - Financial soundness indicators for the banking sector are strong.
  - Profitability has been on an upward trend across all bank segments.
  - Return-on-assets was broadly similar across bank segments; return-on-equity was about 25 percent for the large banks and around 7 percent for other groups.
  - Asset quality, as measured by non-performing loans (NPLs), is high by historical standards; overall credit risk in domestic loan portfolios—principally mortgages—appears low.

### Executive summary — insurance and pension vulnerabilities
- Insurance sector:
  - SST field tests suggest market risks in some Swiss insurance entities need attention.
  - A moderate drop in interest rates and a fall in share prices and property values could cause distress for some insurers.
- Pension sector:
  - Pension funds are recovering from earlier under-funding; stress tests indicate funding levels are not yet adequate.

### Executive summary — mitigation, supervisory progress, and policy concerns
- Regulatory and supervisory progress:
  - Switzerland has upgraded regulatory and supervisory arrangements and strengthened cooperation and information exchange with foreign regulators.
  - Tripartite supervisory arrangement between SFBC, FRBNY, and FSA for the two large banks is a model of cooperation.
- Need for strong, independent regulator:
  - Draft FINMA Act intended to create unified regulator; concern that some provisions may give excessive weight to industry costs and limit FINMA’s capacity.
- Banking supervision priorities:
  - Liquidity supervision is a key area to be addressed, especially for the two large banking groups.
  - SFBC oversight of external auditors needs strengthening.
  - SFBC should increase resources and expertise.
  - Review in depth capital adequacy of the two large banks and pillar II capital requirements in Basel II context; Pillar II should reflect institution-specific and systemic risks.
- Insurance supervision priorities:
  - SST implementation requires FOPI to have adequate resources for supervision of large, internationally diversified insurers.
- Pension sector reforms:
  - Upgrade fragmented supervision; strengthen regional consolidation or consider centralized approach.
  - Improve pension regulations on risk-based funding requirements and governance.
- Crisis management:
  - Authorities have progressed in lender-of-last-resort and crisis management arrangements, but cross-border solvency and liquidity failures in global banks require international cooperation.

### Priority policy recommendations (preserved structure and timeframes)
1. Strengthen the regulatory and supervisory framework
   - a. Ensure proposed unified financial markets authority is provided with sufficient independence:
     - Review draft FINMA Act to avoid provisions that might limit FINMA’s operational independence and prudential powers.
     - Provide FINMA with the powers to impose civil money penalties.
     - Timeframe: Short-term
   - b. Strengthen resources and expertise of supervisors:
     - Increase SFBC staff resources and expertise.
     - Provide FOPI with adequate resources for implementation of new solvency regime.
     - Timeframe: Medium-term

2. Enhance supervision of the two large banks
   - a. Review in depth capital adequacy as part of Basel II implementation; Pillar II capital requirements to be assessed annually per bank.
     - Timeframe: Short-term
   - b. Strengthen supervision of liquidity risks including contingency funding plans and cross-border funding disruptions.
     - Timeframe: Short-term
   - c. Conduct focused audits to evaluate risk management vis-à-vis hedge funds.
     - Timeframe: Short-term
   - d. Improve oversight of external auditors.
     - Timeframe: Medium-term

3. Address vulnerabilities in the (re)insurance sector
   - Conduct focused inspections of high risk insurers; if needed require increase in capital/reserves or reduction in risk exposures.
     - Timeframe: Short-term
   - Continue to reduce intra-group balances.
     - Timeframe: Medium-term

4. Upgrade pension sector supervisory and regulatory frameworks
   - Timeframe: Medium-term
   - Establish a centralized supervisory body; adopt a risk-based standard solvency test after agreement on coverage margins; enhance governance, investment structure, and risk management standards.

5. Consider measures to ensure cantonal banks operate according to market-based incentives
   - Timeframe: Medium-term
   - Strengthen governance; consider overriding goal of profit maximization and fiscal allocation of part of profits to social functions.

### The soundness of the two large banks — market indicators and ratings
- Market indicators:
  - Yield spreads on bonds and prices of credit default swaps moved in line with peers.
  - Credit ratings stable or improving.
  - Distance-to-default indicators fell significantly around mid-2006 reflecting market turbulence, but remain well above 2002–2003 lows.
- Capital adequacy, risk weights, leverage:
  - Capital adequacy ratios (CARs) are ample by current regulatory standards with high risk-weighted CARs under Basel I.
  - Leverage ratios (equity to assets) are relatively low by international comparison.
  - Quantitative impact studies for Basel II indicate Basel I ratios underestimate asset risk for the two large Swiss banks.
  - Note: CARs reported are based on SFBC-specific risk weights that tend to be stricter than Basel I; CARs reported in figures are larger than elsewhere. Footnote: CARs would be lower if Basel II methodology was used.

### Stress testing and scenario analysis — top-down and bottom-up
- Approaches:
  - Top-down (SNB): whole banking sector.
  - Bottom-up: UBS and Credit Suisse using internal models.
- Top-down results:
  - International (global) scenario had most significant effect; wiped out sector profits but negligible effect on capitalization since sector suffered only minor losses.
  - Sensitivity analysis for market risk indicates adequate hedging against a parallel interest-rate shock.
- Bottom-up results:
  - Stress events have a significant effect on excess capital, but two banks remain above regulatory minimum.
  - After-stress CARs of the two banks would be lower if Basel II methodology was used.
- Box 1 systemic risks (high-level highlights preserved):
  - Large involvement in derivatives and equity markets, low transaction margins, growth in volumes causing rapid balance-sheet expansion.
  - Trades in OTC derivatives with major counterparties being hedge funds.
  - Operational/back-office capacity concerns (e.g., “Fed 14” initiative).
  - Market-liquidity disruptions in crowded markets can create contagion risk, force holdings, cause larger regulatory capital needs, and compress earnings.
  - Consideration of additional capital charge for large banks to reflect risks not covered in Pillar I and systemic importance; SFBC supervisory buffer: regulatory capital plus 20 percent is a trigger for action (below 120 percent of regulatory capital → closer supervision).

### Liquidity resilience
- Liquidity stress tests indicate the two banks are highly liquid.
- Combined stress scenario of asset illiquidity and liability withdrawals conducted on a consolidated basis indicated resilience.
- Tests do not account for possible ring-fencing by host regulators or correlations between liquidity and default/contagion risk in systemic events.

### Domestically-oriented banks — efficiency and medium-term profitability
- Productivity increased steadily since 2002; large banks more efficient than others; productivity gap increased between 1995 and 2005.
- Cantonal, Raiffeisen, and regional banks could exploit further cost efficiencies; consolidation could yield efficiency gains.
- Medium-term profitability pressures due to population aging and expected slowdown could induce consolidation, unlikely to threaten systemic stability if gradual.

### Cantonal banks — ownership, governance, and capital treatment
- Public ownership and contingent public liability considerations for deposit guarantees.
- Recommendation to strengthen governance and reorient towards profit maximization, with profits distributed through fiscal channels for social functions.
- Planned phasing out of preferential capital treatment by 2011 is welcome.

### Insurance sector — SST field tests and intra-group exposures
- Historical stress: several major insurers experienced difficulties at cyclical low in early 2003; conditions improved since 2003.
- SST 2006 field test preliminary results:
  - A moderate fall in share and property values with somewhat lower interest rates could cause distress to:
    - five out of nine life insurers,
    - two of twelve non-life insurers,
    - two of nine health insurers in the 2006 SST field tests.
- Intra-group exposures (Table 2 — In percent; preserved values):
  - Direct Insurance: 2003 12.4, 2004 12.5, 2005 12.4
  - Life: 2003 5.3, 2004 4.8, 2005 5.1
  - Non-life: 2003 30.7, 2004 31.4, 2005 29.1
  - Reinsurance: 2003 22.5, 2004 18.9, 2005 17.4
  - Total (insurance and reinsurance): 2003 14.3, 2004 13.8, 2005 13.5
- Notes:
  - SST field test on legal entities basis; does not account for capital and risk transfer instruments within groups.
  - Current Swiss regulations do not include additional capital charge for high intra-group balances, though regulators typically apply additional capital charge above a threshold.

### Pensions — coverage ratios, stress-test scenarios, and key statistics
- Coverage status:
  - Pension funds largely recovered from underfunding but coverage adequacy remains an issue; sensitivity analysis shows vulnerabilities.
  - About 2,900 pension funds in Switzerland.
  - DC plans cover 77 percent of beneficiaries (85 percent of private-sector and 38 percent of public-sector employees) and account for about 85 percent of total number of occupational plans.
  - Tests applied to 246 DC schemes, 86 DB schemes, and 35 guaranteed public schemes.
- Applied Single Factor Stress — end-2005 coverage ratio (average) for all pension funds: 113 percent.
- Sensitivity analysis results (Table 3 — values preserved; entries represent coverage ratios or percent results by scenario and scheme type):
  - Scenario 1 ( - 50 bp interest rate, -25% equity price, 1 yr at 65 life expectancy shock, -5% on assets other risks):
    - DC Schemes: 114 114 106 112 108 98
    - DB Schemes: 113 110 105 110 108 89
    - Guaranteed public funds: 93 90 86 91 88 76
  - Scenario 2 ( - 50 bp interest rate, -45% equity price, 1 yr at 65 life expectancy shock, -5% on assets other risks):
    - DC Schemes: 114 114 99 112 108 91
    - DB Schemes: 113 110 98 110 108 85
    - Guaranteed public funds: 93 90 80 91 88 71
  - Scenario 3 ( -100 bp interest rate, -25% equity price, 1 yr at 65 life expectancy shock, -5% on assets other risks):
    - DC Schemes: 114 114 106 112 108 97
    - DB Schemes: 113 107 105 110 108 89
    - Guaranteed public funds: 93 88 86 91 88 74
- Additional pension notes:
  - Tests not based on a stochastic model; correlations not taken into account.
  - Around 111 pension funds still had underfunding of SwF 19 billion, of which around SwF 16 billion was attributed to 37 public pension funds guaranteed by the cantons.
  - Average coverage of these underfunded funds is about 83 percent with three funds below 50 percent.
  - Persistence of under-funding creates a de-facto pay-as-you-go feature in the second pillar.
  - “Other risks” stress rate applied to all assets to capture exchange rate, real estate, and credit spreads risk.

### Cross-sectoral regulatory and supervisory issues — FINMA, cooperation, and legal concerns
- Draft FINMA Act:
  - Draft submitted to Parliament to create strong unified independent regulator; in a small country a single regulator can pool expertise.
  - Some provisions need clarification:
    - Article 7’s four regulatory principles could give industry representatives excessive leverage and lead to regulatory forbearance.
    - Certain provisions could inhibit FINMA independence: federal oversight of strategy and policy issues applicable to the financial center; remuneration scale of FINMA employees; approval of oversight tax to fund FINMA.
  - Recommendation: revise Article 7 to ensure balance between private costs and public benefits.
  - To bolster independence, FINMA should be given powers to impose civil money penalties; current draft leaves power to Ministry of Finance.
- Cooperation and information exchange:
  - Switzerland actively promotes cooperation with foreign regulators.
  - Tripartite arrangement with U.S. and U.K. regulators on supervision of two large banking groups is a model.
  - New insurance law empowers regulator to exchange information and conclude MoUs; FOPI executed a MoU with some 28 members of EU/EEA recognizing equivalence of Swiss insurance regulatory regime.

### Restrictions on cross-border exchange of confidential client information (securities)
- 2005 amendment to Securities and Exchange Act eased restrictions on cross-border exchange for enforcement of securities regulations.
- Sharing remains subject to prior client notification and consent.
- Peremptory clause: clients have a 10-day period to challenge transmission by administrative court appeal.
- Information required for enforcement may be retransmitted by foreign supervisor to other authorities without specific SFBC approval.
- Relevant information may be publicly disclosed if required by foreign regulator legislation to enable use in foreign court cases.

### Banking supervision — progress and remaining gaps
- SFBC achievements:
  - Implemented most areas of the “Recommended Action Plan—Basel Core Principles” from 2001 FSAP; nearly doubled staff.
  - Noteworthy improvements: continuous supervision for large banking groups; more risk-based approach; strengthened policies in auditing, AML/CFT, Basel II, and consolidated supervision.
- Remaining concerns:
  - SFBC’s budgetary independence remains a concern.
  - Need to strengthen supervision of bank-specific liquidity risks; update Banking Ordinance to align with Basel Committee guidance.
  - SFBC to develop contingency funding plan analysis, liquidity-incremental default risk relationships, and stress testing for cross-border funding disruptions.
  - SFBC to develop advanced supervisory techniques and ensure necessary resources and expertise.

### Hedge funds and auditors — supervisory attention
- SFBC monitors exposures of the two large banks to hedge funds and conducts detailed annual reviews.
- Recommended actions:
  - Conduct focused audits of banks’ risk management vis-à-vis hedge funds.
  - Improve oversight of external auditors: involve different international experts and audit firms in special examinations; consider periodic rotation of audit firms (not just audit partners); more on-site discovery work for large banks.

### Basel II implementation
- Most banks to adopt simpler standardized approaches; two large Swiss banks will adopt more advanced approaches.
- Pillar II capital requirements for the two large banks need evaluation; implementation expected over next 2–3 years.

### Insurance supervision — ISL, SST, and recommendations
- ISL (effective January 2006) reoriented regulation to group supervision, governance, risk management, market conduct; FOPI empowered to exchange information and conclude MoUs.
- SST introduced January 2006; mandatory for large insurers as pillar 2 requirement.
- Reinsurers and small insurers expected to perform SST by 2008; full implementation planned for 2010.
- Recommendations:
  - Focus inspections on high-risk insurers identified by 2006 SST; require capital/reserve increases or risk reductions if needed.
  - Continue dialogue with reinsurers to prepare for SST and group models.
  - Review FOPI staff resources to retain experienced personnel and develop regulatory capacity.
  - Consider additional regulatory reporting for off-site surveillance and risk-focused on-site examinations.
  - Regulatory equivalence with EU will require FOPI to undertake lead/co-supervisor functions for cross-border supervision.

### Securities regulation — legislative changes and gaps
- 2005 amendment eased cross-border client information sharing.
- Collective Investment Schemes Act (January 2007) imposed licensing requirement on managers of Swiss collective investment schemes; managers of foreign collective investment schemes may apply for SFBC license.
- Draft FINMA Act aims to align securities regulation with IOSCO and strengthen independence, staffing, and enforcement powers.
- Rules on unfair trading practices under revision; prior recommendation for higher SFBC involvement in supervision of securities exchanges remains unaddressed.

### Hedge funds — statistics and statutory restrictions (Box 2 key figures)
- Switzerland: second largest market of funds of hedge funds (FoHF) worldwide after United States.
- Close to 256 registered and supervised hedge funds in Switzerland approved for public distribution (up from 39 in 2001) with total assets around US$9.4 billion in 2005 (compared to US$273.8 billion invested in all regulated Swiss funds).
- Almost all registered funds structured as FoHF; bulk of hedge-fund assets in Switzerland are in off-shore hedge funds not registered in Switzerland, available only to qualified investors.
- Estimates indicate more than 150 hedge funds and FoHF offered by Swiss financial companies domiciled abroad, with asset volume of about US$200 billion, against an estimated US$1.4 trillion worldwide.
- Statutory restrictions for registered hedge funds and FoHF:
  - 6:1 limit on leverage.
  - 30 percent limit on a fund’s assets invested in target funds managed by the same manager.
- Licensing and supervision emphasize professional quality of management, qualitative assessment, risk management systems, reporting lines, and internal risk controls.
- Registered hedge funds subject to stricter audit regime during first two years after inception.
- Transparency: prospectuses with SFBC-approved special risk-warning clause; target funds shown in annual and semi-annual reports; investors have redemption rights at least four times per year.
- Statutory restrictions: short sales or investments in another FoHF are not allowed.

### Pensions — fragmentation, funding, governance, and example
- Supervisory fragmentation:
  - Supervision divided between FOSI and cantons → fragmented and uneven supervision.
  - Authorities considering creation of High Supervisory Board to issue uniform regulations while leaving cantons responsible for supervision; regional consolidation or centralized approach recommended.
- Funding and valuation:
  - Current valuation reserve requirements not risk-based and may overestimate coverage.
  - Pension liabilities valued using discount rate that may not reflect market interest rate corresponding to liability duration, potentially underestimating liabilities.
  - Recommendation: determine funding levels by a market- and risk-based standard solvency test after agreement on minimum coverage margins; strengthen procedures for under-funding.
  - Discount rate used for valuing liabilities should be market-based.
- Empirical example:
  - Publica calculations: valuation reserve of around 29 percent for defined benefit pension liabilities if valuations of both assets and liabilities were risk-based; implies shortfall of current reserves by SwF 6.3 billion.
  - Many funds still use a technical discount rate of 4 percent despite recommendation to use a lower rate.
- Investment restrictions:
  - Repeal only after proper risk-based approach and supervisory capacity in place; current restrictions likely advantageous given weaknesses.
- Governance:
  - Governance regulations strengthened but further legally binding code of conduct and standards on investment structure and risk management are needed.

### Safety nets and crisis management
- Depositor protection:
  - 2004 revisions made deposit protection mandatory; improved protection for small depositors and reduced repayment delay possibility.
  - Coverage includes domestic and foreign currency deposits of all banks operating in Switzerland; compatible with EU requirements.
- Crisis management and LOLR:
  - 2006 Banking Law amendments provide SFBC legal powers to intervene in problem banks (temporary management, forced merger).
  - New National Bank Act (effective May 1, 2004) allows SNB flexibility on accepted collateral for emergency liquidity; liquidity assistance must be fully collateralized.
  - SNB emergency liquidity support conditions: bank must be systemically relevant and solvent.
- Operationalization and cross-border issues:
  - Operational frameworks advanced; SNB and SFBC discussing procedures, personnel, contacts, and information needs for crisis conditions.
  - Information framework developed to enable informed views of bank solvency under crisis.
  - Discussions with foreign authorities on cross-border liquidity crisis management advanced and should include likely host authorities’ responses (e.g., ring-fencing).
  - Solvency and liquidity failures in important global banks could pose significant risks, highlighting need for pre-arranged cooperation with foreign supervisors and central banks.

### Appendix 1 — implementation status of 2001 FSAP recommendations (highlights)
- Banking supervision:
  - Reduction in reliance on external auditors and formal quality assurance: Implemented.
  - Increase frequency of special audits and on-site visits: Implemented.
  - Exception allowing non-bank employer-sponsored deposit taking entities to remain: Not implemented.
  - Safeguarding SFBC budgetary independence: Partially implemented (draft FINMA Act provides improvements but not final).
  - SFBC authority for consolidated supervision: Partially implemented (amendments in January 2006).
  - Authority to impose financial penalties and public sanctions: Not implemented (draft FINMA Act does not give FINMA powers to impose monetary penalties).
  - Elimination of 12.5 percent capital reduction for cantonal banks: Partially implemented (staggered voluntary reduction with full elimination by 2011).
  - Improving supervision of bank-specific liquidity: Not implemented (action pending).
  - Integration of banking and insurance supervision and pension responsibility: Partially implemented (Draft FINMA Law under discussion; pension supervision not included).
- Crisis management and safety nets:
  - Modernizing LOLR and crisis management: Implemented (SNB Act revisions; 2006 Banking Law amendments; deposit protection mandatory).
- Insurance supervision:
  - New law on insurance aligned with EU: Implemented (effective February 2006).
- Securities:
  - Legal basis for information sharing with foreign supervisors: Implemented.
  - Inclusion of unregulated independent asset managers and investment advisors under SFBC: Implemented with minor exceptions.
- Pensions:
  - Mandatory rates of return and payout ratios revision: Not implemented (reforms under discussion).

### Appendix 3 — banking sector stress tests (methodology, scenarios, selected numerical projections, and results)
- Methodology (exercises based on financial information as of end-June 2006):
  - Two complementary approaches: Top-down (SNB) using macroeconomic and bank variables (annual data 1987–2005); Bottom-up (UBS and Credit Suisse) using internal models.
  - Key stress parameter: single-factor interest rate shock of increase in interest rates of 200 basis points.
  - Banks reported credit risk severities: 1-in-10 year event (90th percentile) and 1-in-25 year event (96th percentile).
  - Market risk in macro scenarios modeled for the first year only; market shocks for 2007 treated as instantaneous.
- Macroeconomic scenarios (selected projection datapoints preserved exactly):
  - Switzerland, Baseline Projections: Real GDP growth 2006 3.00 2007 2.00 2008 1.70 2009 1.80.
  - Switzerland, Global Scenario Projections: Real GDP growth 2006 3.00 2007 0.50 2008 0.10 2009 1.90.
  - Switzerland, Domestic Scenario Projections: Real GDP growth 2007 -2.0 2008 -0.4 2009 2.0.
  - Interest rate single-factor shock analyzed: increase in interest rates of 200 basis points.
- Bottom-up market risk shocks (preserved verbatim examples):
  - Interest Rates (examples): parallel shift short: 60 bp; long: 60 bp; negative tilt short: 100 bp to long: 0 bp; positive tilt long: 100 bp; decreases and volatility increases specified (Short +24% to +55%; to long +8% to 20%).
  - Increase in corporate bond spreads: Bank 1: 10-20 bp for AAA; +30 bp for AA1 to +400 bp for Caa. Bank 2: AAA 25 bp to BBB +80 bp; BB -5% to NR -20%.
  - Equity Price: Across the board drop in equity prices -30 percent; volatility increases short +8% to +14%; long +1.5% to +7%.
  - Exchange rate shocks: examples include euro/SwF stable 10%; depreciation euro/SwF 10%; volatility increases short +3% to +4%; long +1% to +2%.
- Liquidity stress-test assumptions (from Table 10 — preserved values):
  - Going concern scenario — Expected outflow (percent) within one week/one month: Money market paper issued 10; Due to banks 1/ 10; Due to customers 1/ 5; Bonds issued 0.
  - Asset illiquidity — Haircut as percent of book/market value: Cash and due from banks 20; Unencumbered collateral: fixed income 2/ 10; Unencumbered collateral: equities 30; Loans 2/ 100.
  - Deposit withdrawals — Expected outflow (percent): Money market paper issued 100; Due to banks 1/ 40; Due to customers 3/ 10; Bonds issued 100.
  - Notes: 1/ Includes all demand deposits and time deposits maturing within the period. 2/ Unencumbered collateral defined as net unencumbered marketable securities position. 3/ Includes all demand and time deposits, not only those maturing within the period.
- Top-down results (summary and selected numeric results from Table 11 — effects in percent of excess capital preserved):
  - Overall: stress tests indicate Swiss banking sector resilient to a variety of macroeconomic shocks; global scenario had most significant effect.
  - Selected table excerpts (2007–2009; Baseline and scenario effects on excess capital):
    - 2007, Baseline: +29.5
      - Global Scenario combined shock: -3.3 -32.8pp (second column shows decrease (-) or increase (+) in percentage points relative to baseline).
      - Domestic Scenario combined shock: +15.6 -13.9pp
    - 2008, Baseline: +28.1
      - Global Scenario combined shock: +23.7 -4.4pp
      - Domestic Scenario combined shock: +23.9 -4.1pp
    - 2009, Baseline: +27.1
      - Global Scenario combined shock: +23.5 -3.6pp
      - Domestic Scenario combined shock: +25.5 -1.6pp
  - Note: positive number indicates expected positive profits after shock; combined shocks might result in losses although separate shocks might not.
- Bottom-up highlights:
  - Market risk modeled for first year only; market shocks for 2007 applied as instantaneous shocks and tests ignored portfolio rebalancing.
  - Credit risk shocks applied to PDs and LGDs by portfolio segment using internal datasets; global scenario calibrated to 2001 observed defaults for some portfolios.
  - Liquidity stress tests considered timeframes within one week and within one month and three scenarios: asset illiquidity; deposit withdrawals; combination; evaluated against going-concern steady balance sheet.

*Source: Executive Summary, Switzerland FSAP Update (November 9–20, 2006) — _cr07187 - Executive Summary_*

### Executive Summary ......................................................................................................

### Executive Summary

### Financial system overview
- The Swiss financial system is large, well developed, and plays an important role in the Swiss economy and internationally.
- The two large Swiss banks dominate the domestic market and are important intermediaries in global financial markets.
- The Swiss insurance and reinsurance industry also comprises a few players that are significant internationally.
- Other institutions operate mainly domestically and are not systemically important.
- The dualistic nature of the system implies significant differences in the risk profile and counterparty exposure across segments.

### Financial system strengths and vulnerabilities
- The current macroeconomic and financial sector environment is favorable.
  - Financial soundness indicators are strong and market indicators are positive.
  - Economic activity rebounded since 2004 and GDP growth was 2.7 percent in 2006.
  - Inflation remains low and policy interest rates at 2.25 percent are low by historical comparison.
  - The fiscal accounts recorded surplus in 2006.
  - The Swiss franc has weakened against the euro.
  - Swiss equity markets have outperformed most international equity markets and volatility remains low.
  - House price increases have been moderate with no signs of overheating in the real estate market.
  - The corporate sector appears healthy; the bankruptcy rate is well below its peak in the early 1990s, and companies’ debt ratios are at their lowest levels in fifteen years.
- Main downside risks are external:
  - Large trading portfolios of the two large banks are potentially exposed to market downturns and significant increases in volatility, including from a disorderly unwinding of global imbalances affecting U.S. exchange and interest rates, and a potentially severe drop in global equity markets.
  - A hard landing of housing markets in the U.S. and other key industrial countries could compound risks via direct exposures and feedback to real economic activity.
  - A domestic slowdown would most likely originate from external influences.
  - Domestic risk: increasing share of fixed-rate mortgages to households could raise interest rate risk in the domestically-oriented banking system if hedging is relaxed.
  - Risks from the use of the Swiss franc in carry trades would be manifested mainly in counterparty and credit risks from any abrupt adjustment in the Swiss franc exchange rate.
- Banking sector resilience:
  - The Swiss banking sector appears resilient to shocks.
  - Top-down stress tests of the banking sector and bottom-up stress tests of the two large banks confirm resiliency to the most relevant macroeconomic stress events.
  - Current financial soundness indicators for the banking sector are strong (see Appendix 2, Tables 5 and 6).
  - Profitability has been on an upward trend across all bank segments.
  - Return-on-assets was broadly similar across bank segments; return-on-equity was about 25 percent for the large banks and around 7 percent for other groups.
  - Asset quality, as measured by non-performing loans (NPLs), is high by historical standards; overall credit risk in domestic loan portfolios—principally mortgages—appears low.
- Insurance and pension sector vulnerabilities:
  - Data from the direct insurance field tests of the Swiss Solvency Test (SST) suggest market risks in some Swiss insurance entities need attention.
  - A moderate drop in interest rates and a fall in share prices and property values could cause distress for some Swiss insurers.
  - Pension funds are recovering from earlier under-funding; stress tests indicate funding levels are not yet adequate.

### Mitigation of risks in the financial system
- Regulatory and supervisory progress:
  - Switzerland has been actively upgrading its regulatory and supervisory arrangements and strengthening cooperation and information exchange with foreign regulators.
  - It has addressed most of the recommendations in the earlier FSAP report (see Appendix 1).
  - The tripartite supervisory arrangement between the Swiss Federal Banking Commission (SFBC), the Federal Reserve Bank of New York (FRBNY), and the U.K. Financial Services Authority (FSA) covering the two large banking groups is a model of supervisory cooperation.
- Need for a strong, independent regulator:
  - Effective supervision of the major Swiss financial institutions requires a strong, independent regulator.
  - The draft Federal Authority for Financial Market Oversight (FINMA) Act is intended to achieve this.
  - Concern: provisions in the draft act intended to balance public benefits with industry costs may go too far in giving weight to the latter, which would limit FINMA’s capacity to be an effective regulator.
- Banking supervision priorities:
  - While the SFBC has made impressive progress, liquidity supervision remains a key area to be addressed—especially critical for the two large banking groups.
  - SFBC’s oversight of external auditors needs strengthening.
  - SFBC should continue to increase its resources and expertise.
  - The SFBC should review in depth the capital adequacy of the two large banks and pillar II capital requirements in the context of Basel II implementation.
    - Pillar II capital requirements should reflect both institution-specific and systemic risks.
    - Given the complex nature and systemic importance of the two institutions, careful evaluation of complex models and risk exposures is needed.
- Insurance supervision priorities:
  - Reforms since 2003 have updated insurance regulation and supervision; the new SST is at the forefront of risk-based liability measurement.
  - The updated framework has a very high level of observance with the Insurance Core Principles (ICPs), but the reform process is not yet complete.
  - For successful implementation and effective supervision of the large, internationally diversified insurance industry, the supervisor must have adequate resources.
- Pension sector reforms needed:
  - Authorities need to upgrade pension sector supervision, which is fragmented and uneven.
  - The regional consolidation proposal for cantonal supervisors should be strengthened; a centralized approach should be considered to provide economies of scale and uniform supervision and enforcement.
  - Pension regulations should be improved, particularly regarding risk-based funding requirements and governance regulations.
- Crisis management:
  - Authorities have made significant progress in developing lender of last resort and crisis management arrangements and are at the forefront of countries in operationalizing this framework.
  - However, solvency and liquidity failures in important global banks could pose significant risks, requiring cooperation with supervisors and central banks in other jurisdictions.

### Priority policy recommendations (Table 1)
1. Strengthen the regulatory and supervisory framework:
   - Implementation Timeframe: Short-term / Medium-term (as specified below)
   - a. Ensure that the proposed unified financial markets authority is provided with sufficient independence:
     - Review the provisions of the draft FINMA Act to avoid provisions that might limit FINMA’s operational independence and prudential powers.
     - Provide FINMA with the powers to impose civil money penalties.
     - Timeframe: Short-term
   - b. Strengthen the resources and expertise of the supervisors:
     - Continue to increase the SFBC’s staff resources and expertise given the global nature of the two large banks and the systemic risks they pose.
     - Provide the Federal Office of Private Insurance (FOPI) with adequate resources especially for the implementation of the new solvency regime.
     - Timeframe: Medium-term

2. Enhance the supervision of the two large banks:
   - Timeframe: Short-term / Medium-term (as specified below)
   - a. Review in depth the capital adequacy of the two large banks as part of Basel II implementation:
     - Pillar II capital requirements should be considered. These need to be thoroughly assessed and reviewed on an annual basis for each bank to reflect the institution-specific risk profile and supervisory/regulatory concerns.
     - The SFBC should continue to gain expertise and engagement by performing more on-site discovery work itself.
     - Timeframe: Short-term
   - b. Strengthen supervision of the two large banks’ liquidity risks to include advanced analysis of potential risks such as contingency funding plans, disruptions in cross-border funding, and incremental default risk.
     - Timeframe: Short-term
   - c. Conduct focused audits to evaluate the two banks’ risk management vis-à-vis hedge funds.
     - Timeframe: Short-term
   - d. Further improve oversight of bank external auditors.
     - Timeframe: Medium-term

3. Address vulnerabilities in the (re)insurance sector:
   - Timeframe: Short-term / Medium-term (as specified below)
   - • Conduct focused inspections of high risk insurers. If needed, require an increase in capital and reserves or a reduction in risk exposures.
     - Timeframe: Short-term
   - • Continue to work closely with the (re)insurers concerned to bring down intra-group balances, which are relatively high.
     - Timeframe: Medium-term

4. Upgrade the pension sector’s supervisory and regulatory frameworks:
   - Timeframe: Medium-term
   - • Upgrade the proposed supervisory framework by establishing a centralized body with supervisory responsibility.
   - • Strengthen funding requirements by adopting a risk-based standard solvency test after an agreement on adequate coverage margins, and enhance the procedures in the case of under-funding.
   - • Enhance standards on governance, structure of investments, and risk management.

5. Consider measures to ensure that cantonal banks operate according to market-based incentives:
   - Timeframe: Medium-term
   - • The governance structures of cantonal banks could be strengthened. The cantonal banks could be given the overriding goal of profit maximization while dedicating part of their profits through the fiscal process to achieve their social function.

*Source: Executive Summary, Switzerland FSAP Update (November 9–20, 2006) — _cr07187 - Executive Summary_*

### 9. The soundness of

### 9. The soundness of

### Soundness of the two large banks: market indicators and ratings
- Yield spreads on their bonds and prices of their credit default swaps have moved in line with their peers in other industrial countries.
- Credit ratings have been stable or improving.
- Distance-to-default indicators (DD) fell significantly around mid-2006 reflecting market turbulence, but remain well above their lows in 2002–2003.
- Peer group in text figures includes HSBC, Santander Central Hispano, Royal Bank of Scotland, BNP Paribas, ABN Amro, Deutsche Bank, Barclays, Société Générale, Citi Group, and Bank of America.

### Capital adequacy, risk weights, and leverage
- Capital adequacy ratios (CARs) of the two large Swiss banks are ample by current regulatory standards, with internationally comparable high risk-weighted CARs under Basel I.
- Leverage ratios (equity to assets) are relatively low by international comparison.
- Quantitative impact studies for Basel II indicate that the Basel I ratios underestimate asset risk for the two large Swiss banks.
- Note: The CARs reported for UBS and Credit Suisse elsewhere in this paper are based on SFBC-specific risk weights that tend to be stricter than Basel I; accordingly, the CARs reported in the figures for the two Swiss banks are larger than those quoted elsewhere in the report.
- Footnote: The CARs of the two banks would be lower if Basel II methodology was used.

### Stress testing and scenario analysis
- Top-down and bottom-up stress tests were conducted:
  - Top-down: whole banking sector, carried out by the SNB.
  - Bottom-up: carried out by the two large banks using their internal models.
- Top-down results:
  - The international scenario had the most significant effect on the banking sector.
  - The international scenario wiped out the sector’s profits but its effect on the sector’s capitalization level was negligible since the banking sector suffered only minor losses.
- Sensitivity analysis for market risk (given high share of fixed-rate mortgages) indicates adequate hedging against such a shock.
- Bottom-up results:
  - Stress events have a significant effect (large effect on excess capital), but the two banks remain above the regulatory minimum for capital.
  - After-stress CAR of the two banks would be lower if Basel II methodology was used to calculate the CARs.
- Box 1 notes additional risks not captured in stress tests, including major market disruptions and contagion risks.

### Liquidity resilience
- Liquidity stress tests indicate that the two banks are highly liquid.
- Combined stress scenario of asset illiquidity and liability withdrawals was conducted by the two large banks on a consolidated basis.
- Results indicate resilience to a liquidity shock.
- Tests do not take into account possible ring-fencing action by host regulators or correlations between liquidity and default or contagion risk due to systemic events.

### Domestically-oriented banks: efficiency and medium-term profitability challenges
- Study on efficiency (1995–2005 input-output mix) findings:
  - Bank productivity has increased steadily since 2002.
  - Large banks tend to be more efficient than other banks.
  - The productivity gap has increased between 1995 and 2005.
  - Evidence that cantonal, Raiffeisen, and regional banks could further exploit cost efficiencies; further consolidation could lead to efficiency gains in some sectors.
- Medium-term profitability pressures for domestic retail-oriented banks:
  - Under current benign macroeconomic environment, banks have been posting robust results, easing immediate pressure for cost-cutting.
  - Over the medium-term, competitive pressures are expected to resume due to expected slow-down in economic activity induced by population aging, which could increase pressures for mergers or exits.
  - Expected future consolidation pressures are unlikely to pose a threat to systemic financial stability if the process occurs over an extended period.

### Cantonal banks: public ownership and governance considerations
- Public policy consideration: public ownership and contingent public liability associated with their deposit guarantees.
- Recommendation to strengthen governance to improve productivity and ensure focus on profit maximization rather than public service mandate.
- Suggestion that banks could distribute profits to cantonal governments to fund budgetary social functions.
- The planned phasing out of preferential treatment in capital requirements by 2011 is welcome.
- Example governance reform: revise charters to exclude public service mandate and reconstitute bank boards (as noted in text).

### Box 1 — Systemic risks of the large banks
- Large involvement in derivatives and equity markets; they intermediate large volumes of transactions that remain on balance sheets for short periods.
- Low transaction margins and historically compressed spreads; growth in volumes has led to rapid balance sheet expansion.
- Trades conducted in over-the-counter derivatives with major counterparties being hedge funds.
- Operational/back office capacity concerns highlighted by the “Fed 14” initiative, particularly in credit derivatives markets.
- Systemic or institution-specific market-liquidity disruptions, especially in crowded markets, create contagion risk and could prevent banks from trading out of positions, forcing holdings with increasing volatility or liquidation in falling markets.
- In such circumstances, the asset class would require much higher levels of regulatory capital; banks could face trading losses and sharply compressed earnings.
- Consideration of an additional capital charge for the large banks:
  - Additional charge should reflect specific risks not adequately covered in Pillar I of Basel II and the systemic importance of the banks.
  - Pillar II capital requirements should be thoroughly evaluated and considered on an annual basis to reflect institution-specific risk profiles and supervisory concerns.
  - This would require the SFBC to intensify oversight, particularly in market risk, and provide flexibility in capital charges.
- Existing Swiss supervisory buffer:
  - A “threshold” of regulatory capital plus 20 percent is a trigger for supervisory action: if an institution’s capital falls below 120 percent of regulatory capital, it is placed under closer supervision by the SFBC.
  - This buffer is uniform across banks and does not take into account the specific risk profiles of the two large banks.
- Peer comparisons indicate highly-rated internationally active banks hold significantly larger buffers to maintain ratings, underlining that Basel capital requirements reflect minimum standards.

### Insurance sector: past stress and current vulnerabilities
- During the last cyclical market low in early 2003, several major Swiss insurers experienced financial difficulties; these problems seem to have been resolved, reflecting favorable financial conditions since 2003.
- SST direct insurance field test preliminary results (2006) suggest market-risk vulnerabilities:
  - A moderate fall in share and property values, with interest rates somewhat lower than prior cyclical lows, could cause distress to:
    - five out of nine life insurers,
    - two of twelve non-life insurers,
    - two of nine health insurers participating in the 2006 SST field tests.
  - This suggests need for focused inspection of high-risk insurers and potentially increased capital and reserves or reduction in risk exposures.
- Proportion of insurers’ intra-group assets is relatively high, increasing contagion risk within groups and potential liquidity and solvency issues if restrictions on free movement of assets are imposed.
- FOPI is working with (re)insurers to bring down intra-group balances.
- Table 2 (In percent) — Intra-group Loans and Investments as Share in Total Assets in the Insurance/Reinsurance Industry:
  - Direct Insurance: 2003 12.4, 2004 12.5, 2005 12.4
  - Life: 2003 5.3, 2004 4.8, 2005 5.1
  - Non-life: 2003 30.7, 2004 31.4, 2005 29.1
  - Reinsurance: 2003 22.5, 2004 18.9, 2005 17.4
  - Total (insurance and reinsurance): 2003 14.3, 2004 13.8, 2005 13.5
- Note: The SST field test was conducted on a legal entities basis and does not take account of capital and risk transfer instruments within a group.
- Note: Current Swiss regulations do not include an additional capital charge for high intra-group balances, though regulators typically subject such balances above a threshold to an additional capital charge.

### Pensions: coverage ratios and stress-test results
- Pension funds have largely recovered from underfunding but adequacy of current coverage ratios remains an issue; sensitivity analysis confirms vulnerabilities.
- Tests evaluate effects of market and mortality shocks on coverage ratios.
- Results indicate that even under a mild scenario (scenario 1) both defined benefit (DB) and defined contribution (DC) schemes would become underfunded, with milder effects for DC schemes.
- State-guaranteed pension funds have lower initial coverage ratios; after-stress coverage ratios would be the lowest, potentially putting pressure on local government finances.
- Coverage improvement is needed despite recent improvements.
- Table 3: Results of Sensitivity Analysis for Pension Funds’ Coverage Ratios (In percent, unless noted otherwise)
  - Applied Single Factor Stress — end-2005 coverage ratio (average) for all pension funds: 113 percent.
  - Scenario 1 ( - 50 bp interest rate, -25% equity price, 1 yr at 65 life expectancy shock, -5% on assets other risks):
    - DC Schemes: 114 114 106 112 108 98
    - DB Schemes: 113 110 105 110 108 89
    - Guaranteed public funds: 93 90 86 91 88 76
  - Scenario 2 ( - 50 bp interest rate, -45% equity price, 1 yr at 65 life expectancy shock, -5% on assets other risks):
    - DC Schemes: 114 114 99 112 108 91
    - DB Schemes: 113 110 98 110 108 85
    - Guaranteed public funds: 93 90 80 91 88 71
  - Scenario 3 ( -100 bp interest rate, -25% equity price, 1 yr at 65 life expectancy shock, -5% on assets other risks):
    - DC Schemes: 114 114 106 112 108 97
    - DB Schemes: 113 107 105 110 108 89
    - Guaranteed public funds: 93 88 86 91 88 74
- Notes and context:
  - There are about 2,900 pension funds in Switzerland.
  - DC plans cover 77 percent of beneficiaries (85 percent of private-sector and 38 percent of public-sector employees) and account for about 85 percent of the total number of occupational plans.
  - Tests were applied to 246 DC schemes, 86 DB schemes, and 35 guaranteed public schemes.
  - Tests were not based on a stochastic model; correlations between variables were not taken into account.
  - Around 111 pension funds still had underfunding of SwF 19 billion, of which around SwF 16 billion was attributed to 37 public pension funds guaranteed by the cantons.
  - The average coverage of these funds is about 83 percent with three funds below 50 percent.
  - The persistence of under-funding in this segment creates a de-facto pay-as-you-go system, an undesirable feature for the second pillar.
  - “Other risks” stress rate is applied to all assets to capture exchange rate, real estate, and credit spreads risk.

### Cross-sectoral regulatory and supervisory issues: FINMA and cooperation
- Federal Authority for Financial Market Oversight:
  - Mission supports objective of draft FINMA Act to have a strong unified and independent financial sector regulator; draft FINMA Act submitted to Parliament.
  - In a relatively small country, a single regulator can pool expertise and budgetary resources for large, internationally active institutions.
  - Some provisions in the draft Act should be clarified or elaborated to support the objective.
- Concerns about draft FINMA Act provisions:
  - Article 7 sets out four regulatory principles intended to ensure proportionate regulatory effort, but some provisions could give industry representatives excessive leverage and lead to regulatory forbearance by FINMA.
  - Recommendation: revise provisions in Article 7 to ensure appropriate balance between private costs and public benefits of regulation.
  - Certain provisions could inhibit FINMA independence: federal oversight of (i) strategy and policy issues applicable to the financial center; (ii) remuneration scale of FINMA employees; and (iii) approval of the oversight tax to fund FINMA.
  - Authorities indicated intention of these provisions was to provide exchange of views and checks and balances, not to interfere with independence.
  - To bolster independence, FINMA should be given powers to impose civil money penalties; current draft introduces explicit sanctioning regime but does not provide FINMA legal powers to impose sanctions (power remains with Ministry of Finance, which investigates charges on recommendations by FINMA).
- Cooperation and information exchange:
  - Switzerland has actively promoted cooperation and information exchange with foreign regulators.
  - The tripartite arrangement with U.S. and U.K. regulators on supervision of the two large Swiss banking groups is a model for supervisory cooperation.
  - New insurance law empowers regulator to exchange information and conclude MoUs with domestic and foreign supervisory authorities.
  - In 2006, the FOPI executed a MoU with some 28 members of the EU and the European Economic Area recognizing equivalence of the Swiss insurance regulatory regime.

*Source: _cr07187 - 9. The soundness of*

### 26. Restrictions on cross-border exchange of confidential client information for the

### 26. Restrictions on cross-border exchange of confidential client information for the enforcement of securities regulations

### Cross-border exchange of confidential client information
- 2005 amendment to the Securities and Exchange Act eased restrictions on cross-border exchange of confidential client information for the enforcement of securities regulations.
- Sharing of confidential client information with foreign supervisors remains subject to prior client notification and consent.
- A peremptory clause gives clients a 10-day period to challenge the transmission of information by means of administrative court appeal.
- Information required for enforcement of regulations on stock exchanges, securities trading, or securities traders may be retransmitted by the foreign supervisor to other authorities, courts, or bodies without the specific approval of the SFBC.
- Relevant information may be publicly disclosed if required by the legislation of the foreign regulator to enable its use in court cases in foreign jurisdictions.

### Banking — supervisory progress and remaining gaps
Findings
- The SFBC has made impressive progress organizationally and in supervisory practices to strengthen Switzerland’s banking supervisory framework.
- The SFBC has addressed most areas in the “Recommended Action Plan—Basel Core Principles” from the 2001 FSAP, adding functional areas including risk management, on-site review, and external audit review.
- The SFBC has nearly doubled its staff to oversee an increasingly complex banking sector.
- Noteworthy improvements include continuous supervision for large banking groups and a more risk-based approach for the rest of the sector.
- Policies strengthened in auditing, AML/CFT, Basel II and consolidated supervision.

Remaining concerns and recommendations
- Two areas remain concerns: (i) the SFBC’s budgetary independence; and (ii) the need to address liquidity monitoring.
- Supervision of bank-specific liquidity risks needs strengthening; the SFBC Banking Ordinance approach should be updated to align with the Basel Committee’s paper on managing liquidity in banking organizations.
- Analysis should extend to contingency funding plans, relationships between liquidity and incremental default risk, and stress testing of resilience to disruptions in cross-border funding.
- The SFBC plans to monitor liquidity more closely and is working with the SNB to develop an enhanced liquidity supervision framework.
- Given systemic relevance of large banks, the SFBC should develop advanced supervisory techniques such as advanced early warning analysis and ensure necessary resources, expertise, and advanced skills.

Hedge funds and auditors
- Switzerland participates regularly in international initiatives on hedge funds; the SFBC works closely with the U.S. Federal Reserve and the U.K. FSA.
- The SFBC monitors exposures of the two large banks to hedge funds regularly and conducts a detailed annual review of their overall exposures.
- It is important for the SFBC to conduct focused audits of banks’ risk management vis-à-vis hedge funds.
- The SFBC has improved oversight of external bank auditors via a “dual” supervisory system with new quality assurance, but should:
  - Involve different international experts and audit firms in special examinations.
  - Consider periodic rotation of audit firms (not just audit partners).
  - Continue performing more on-site discovery work for the two large banks.

Basel II implementation
- The SFBC devoted significant attention to Basel II implementation.
- Most banks will be subject to either a Swiss or international version of the simpler, standardized approaches under Basel II; the two large Swiss banks will adopt the more advanced approaches.
- Pillar II capital requirements for the two large banks would need evaluation; this is expected to be implemented over the next 2–3 years.

### Insurance — regulatory reforms and implementation
Findings
- Reforms since 2003 improved regulation and supervision for the insurance industry in line with international best practice.
- The ISL, in effect January 2006, reoriented the regulatory focus to include group/conglomerate supervision, corporate governance, risk management and market conduct of insurance intermediaries.
- The ISL provides corrective and preventive regulatory measures and empowers the FOPI to exchange information with domestic and foreign regulators.
- Active consultation with industry contributed to practical, proportionate, and effective regulations.

SST and implementation timeline
- In January 2006 the FOPI introduced the SST, one of the most modern solvency regimes in the world.
- The SST is mandatory for large insurers as a pillar 2 requirement.
- Reinsurers and small insurers are expected to perform the SST by 2008.
- Full implementation of the SST by all insurers, reinsurers and insurer-led financial conglomerates is planned for 2010.
- The SST adopts the Solvency II framework comprising three pillars.

Recommendations
- FOPI should focus inspections to strengthen risk management practices among high risk insurers identified by the 2006 SST field test; require reduction in market risks or increase in capital/reserves if needed.
- FOPI should continue dialogue with reinsurers to prepare for SST and in formulating robust internal and group models.
- Review adequacy of FOPI’s staff resources to retain experienced personnel and rapidly develop regulatory capacity; effective SST implementation requires understanding company-specific internal models and strengthening direct supervision of (re)insurers.
- Consider additional regulatory reporting to facilitate off-site surveillance and risk-focused on-site examinations.
- Regulatory equivalence with the EU will require FOPI to undertake more lead supervisor/co-supervisor functions for cross-border supervision of insurance groups and conglomerates.

### Securities — legal changes and outstanding issues
Findings and changes
- Restrictions on cross-border sharing of confidential client information for securities regulation were eased by a 2005 legal amendment.
- Jurisdiction of the supervisor over secondary markets widened by imposing a licensing requirement on managers of Swiss collective investment schemes under the Collective Investment Schemes Act, which came into force in January 2007.
- Managers of foreign collective investment schemes may apply for SFBC license and voluntarily come under SFBC supervision.
- The new act strengthens regulation of hedge funds.

Regulatory development and gaps
- Draft FINMA Act aims to align securities regulation with IOSCO principles and strengthen budgetary independence, staffing, and enforcement powers of the supervisor.
- Rules on unfair trading practices are under revision to align Swiss market abuse regulations with other major financial markets.
- An earlier recommendation for higher SFBC involvement in supervision of securities exchanges remains unaddressed.

Box 2 — Hedge Fund statistics and rules (key figures preserved)
- Switzerland is the second largest market of funds of hedge funds (FoHF) worldwide after the United States.
- Close to 256 registered and supervised hedge funds in Switzerland approved for public distribution (up from 39 in 2001) with total assets around US$9.4 billion in 2005 (compared to US$273.8 billion invested in all regulated Swiss funds).
- Almost all registered funds are structured as FoHF; bulk of assets invested in hedge funds in Switzerland are in off-shore hedge funds not registered or regulated in Switzerland and available for distribution in Switzerland only to qualified investors.
- Estimates indicate more than 150 hedge funds and FoHF offered by Swiss financial companies domiciled abroad, with asset volume of about US$200 billion, against an estimated US$1.4 trillion worldwide.
- Statutory restrictions for registered hedge funds and FoHF include:
  - A 6:1 limit on leverage.
  - A 30 percent limit on a fund’s assets invested in target funds managed by the same manager.
- Licensing and supervision for hedge funds and FoHF registered in Switzerland emphasize professional quality of fund management, qualitative assessment of fund managers, risk management systems, reporting lines, and internal risk controls.
- Registered hedge funds are subject to a stricter audit regime during the first two years after inception (albeit not formally specified in regulations).
- Transparency requirements include prospectuses with SFBC-approved special risk-warning clause; target funds shown in annual and semi-annual reports; investors have right of redemption at least four times per year.
- Statutory restrictions: short sales or investments in another FoHF are not allowed.

### Pensions — fragmentation, funding, and governance
Supervisory structure and issues
- Supervision of pension funds is divided between FOSI and the cantons, resulting in fragmented and uneven supervision with significant differences in practices and inadequate supervision.
- Weaknesses are attributed to dispersion of supervision among many cantonal supervisory authorities with modest resources; neither FOSI nor cantonal offices have instruments for adequate supervision (FOSI is relatively better resourced).
- Authorities are considering creation of a High Supervisory Board to issue uniform regulations while leaving the cantons responsible for pension fund supervision; this would involve regional consolidation of cantonal supervisors.
- A centralized approach to supervision could consolidate human resources and financial knowledge and provide uniform supervision and enforcement.

Funding and valuation recommendations
- Current requirements for valuation reserves (i.e., surpluses above a 100 percent coverage ratio) are not risk-based and may overestimate coverage ratios and reserves adequacy.
- Pension liabilities are valued based on a discount rate that may not reflect a market interest rate corresponding to liability duration, potentially underestimating liabilities and leading to inappropriate contribution rates, conditional indexation of pensions, and benefits.
- Required funding levels should be determined by a market- and risk-based standard solvency test after agreement on desired minimum coverage margins; procedures and measures in case of under-funding should be strengthened.
- The discount rate used for valuing pension liabilities should be market-based.

Empirical example and investment restrictions
- Example: Publica calculations indicate it would need a valuation reserve of around 29 percent for defined benefit pension liabilities if valuations of both assets and liabilities were risk-based; this implies a shortfall of current reserves by SwF 6.3 billion.
- Many funds still use a technical discount rate of 4 percent despite recommendation by the Swiss organisation of actuaries to use a lower rate.
- Restrictions on investments should be repealed only after pension funds and supervisors develop and implement a proper risk-based approach with clear rules; given current weaknesses, restrictions probably have more advantages than disadvantages.

Governance
- Governance regulations have been strengthened but more needs to be done.
- A code of conduct based on high and legally binding governance standards needs to be introduced.
- Lack of standards covering structure of investments and risk management should be addressed.

### Safety nets and crisis management
Depositor protection
- Depositor protection scheme was improved via 2004 revisions to the Banking Act; the deposit protection scheme is now mandatory.
- Revisions improved protection for small depositors and reduced possibility of repayment delay for this segment.
- Coverage includes domestic and foreign currency deposits of all banks operating in Switzerland.
- Coverage is compatible with EU requirements.

Crisis management and lender-of-last-resort frameworks
- 2006 Banking Law amendments provide legal powers to the SFBC to intervene in problem banks, including imposing temporary management or forced merger.
- The new National Bank Act, effective May 1, 2004, allows the SNB flexibility to decide on the form of accepted collateral for emergency liquidity provision and requires liquidity assistance to be fully collateralized.
- The SNB has defined conditions for emergency liquidity support: the bank must be systemically relevant and solvent.

Operationalization and cross-border issues
- Authorities have advanced in operationalizing frameworks but face significant challenges similar to other major financial centers.
- Discussions between SNB and SFBC are underway on conditions, procedures, personnel, contacts, and specific bank information needed in crisis conditions.
- An information framework has been developed to enable informed views of bank solvency under crisis conditions.
- Discussions with foreign authorities on cross-border liquidity crisis management have advanced; these should include likely host authorities’ responses such as possible ring-fencing during crisis situations.
- Solvency and liquidity failures in important global banks could pose significant risks, underscoring need for cooperation with supervisors and central banks in other jurisdictions in advance of such events.

*Source: _cr07187 - 26. Restrictions on cross-border exchange of confidential client information for the*

### Appendix 1. Status of Implementation of the 2001 FSAP Recommendations

### Appendix 1. Status of Implementation of the 2001 FSAP Recommendations

### I. Banking Supervision
- Reduction in reliance on external auditors and implementation of a formal quality assurance program for external auditors: Implemented. "A formal quality assurance program for external auditors has been implemented. An on-site review unit was formed for the large banking groups."
- Increasing the frequency of special audits and on-site visits to banks in general: Implemented (see above on on-site review unit).
- Removal of the exception of the Banking Act that allows non-bank employer-sponsored deposit taking entities that are not licensed as financial institutions: Not implemented. "The Banking Act was amended but this exception was retained. The Federal Council and Parliament determined that the systemic risk emanating from the very few remaining instances was negligible. The BCP Methodology allows for such exceptions if negligible."
- Strengthening the legal powers of the SFBC to enable more effective supervision, including:
  - Safeguarding the budgetary independence of the SFBC: Partially implemented. "The draft FINMA Act provides for improvements in establishing the financial independence of the supervisors but could be further strengthened. As the Act is still in draft, the situation has not changed from 2001."
  - Providing the SFBC with the authority to conduct consolidated supervision: Partially implemented. "The amendments to the Banking Law, which came into effect in January 2006 provide for explicit powers for the SFBC to conduct consolidated supervision."
  - Note on scope: "The legal powers of the SFBC did not extend to bank holding companies. However, the SFBC established through the courts its right to carry out consolidated supervision of banking groups, including affiliates that are effectively supported by the bank."
- Providing the SFBC with the authority to impose financial penalties and public sanctions: Not implemented. "The draft FINMA Act does not give powers to FINMA to impose monetary penalties."
- Elimination of a 12.5 percent capital reduction for cantonal banks: Partially implemented. "The SFBC and the association of Cantonal banks agreed on a staggered voluntary reduction of this capital exemption starting after the implementation of Basel II in 2007 with full elimination by 2011."
- Improving the supervision of bank-specific liquidity by the SFBC: Not implemented. "The supervisory framework for bank-specific liquidity risks has not yet been improved, although action is pending."
- Integration of banking and insurance supervision and responsibility for pension funds: Partially implemented. "The Draft FINMA Law is being discussed by the Parliament. Supervision of pension funds was not included in FINMA."

### II. Crisis Management and Safety Nets
- Modernizing the LOLR and crisis management regime: Implemented. "The revised SNB Act no longer specifies acceptable collateral. The 2006 Banking Law amendments provide legal powers to the SFBC to intervene in problem banks, including imposing temporary management in a forced merger. The banking deposit protection scheme was made compulsory."

### III. Insurance Supervision
- Adoption of a new law on insurance to align rules with the European Union: Implemented. "Law has been adopted and came into effect in February 2006."

### IV. Securities
- Improving the legal basis for information sharing with foreign supervisors: Implemented. "The Securities Law was amended to strengthen the legal basis for information sharing."
- Inclusion of unregulated independent asset managers and investment advisors under the SFBC: Implemented with minor exceptions.
- Establishing contact with the U.S. Securities and Exchange Commission (SEC) and contacts with appropriate foreign insurance supervisors: Implemented.

### V. Pension Regulations and Supervision
- Mandatory rates of return and payout ratios on pension assets should be revised: Not implemented. "Reforms in this area are under discussion."

*Source: Appendix 1. Status of Implementation of the 2001 FSAP Recommendations (IMF staff report excerpt).*

### Appendix 3. Banking Sector Stress Tests

### Appendix 3. Banking Sector Stress Tests

### Methodology
- Objective: assess resilience of the Swiss banking sector to credit, market, and liquidity risks using shocks, models, and instruments described herein. Exercises based on financial information as of end-June 2006.
- Two complementary approaches:
  - Top-down (SNB): SNB stress testing model using macroeconomic and individual bank variables to capture effects on provisions, net interest income, and income from commissions, fees and trading. Model predominantly uses domestic macroeconomic data; data for banking system based on consolidated accounting information for individual institutions; annual data covering 1987–2005.
  - Bottom-up (banks): UBS and Credit Suisse applied their internal models, including the two macroeconomic scenarios, liquidity stress tests, and sensitivity analyses for market and credit risks. Tests assumed: no portfolio rebalancing by banks in response to the stress event; losses occur immediately; valuation effects translate to net losses.
- Key stress parameters and treatment:
  - Single-factor interest rate shock analyzed: increase in interest rates of 200 basis points.
  - Credit risk mapping: macroeconomic scenarios mapped into banks’ specific parameters (PDs and LGDs) using bank-specific methodologies and internal datasets.
  - Banks reported two severities for credit risk: a 1-in-10 year event (90th percentile confidence level) and a 1-in-25 year event (96th percentile confidence level).
  - Market risk in macro scenarios modeled for the first year only; market shocks for 2007 treated as instantaneous.

### Macroeconomic scenarios
- Two principal scenarios (extreme but plausible):
  - Global scenario: disorderly unwinding of global imbalances based on Fund’s General Equilibrium Model over a three-year horizon, featuring a sudden and permanent nominal depreciation of the U.S. dollar in effective terms, severe effect on global equity prices and U.S. growth, significant effect on Euro-area and Swiss growth; short-term rates tightened significantly in the U.S.; short-term rates in Euro area and Switzerland not expected to be affected.
  - Domestic scenario: effective nominal appreciation of the SwF bringing about a severe slowdown in Swiss real GDP growth (Real GDP projected to shrink 2 percent in the domestic scenario compared to mild growth of 0.5 percent in the global scenario), drop in the Swiss Market Index, and a relaxation of short-term interest rates.
- Selected projection datapoints (levels preserved as in source):
  - Switzerland, Baseline Projections: Real GDP growth 2006 3.00 2007 2.00 2008 1.70 2009 1.80.
  - Switzerland, Global Scenario Projections: Real GDP growth 2006 3.00 2007 0.50 2008 0.10 2009 1.90.
  - Switzerland, Domestic Scenario Projections: Real GDP growth 2007 -2.0 2008 -0.4 2009 2.0.
  - Interest rate single-factor shock analyzed: increase in interest rates of 200 basis points.

### Bottom-up stress tests (banks)
- Mapping and calibration:
  - Global scenario credit conditions mirrored changes in credit conditions in 2001 (for calibration).
  - Shocks applied to relevant portfolio segments: (i) investment bank “take and hold” portfolios; (ii) investment bank temporary exposure; (iii) wealth management Lombard lending (collateralized international lending); and (iv) private equity.
  - Domestic scenario calibrated as a severe recession for Switzerland, impacting Swiss enterprises, private equity in Switzerland, and mortgage spillovers.
- Market risk shocks used in sensitivity analyses (preserved verbatim from Table 9):
  - Interest Rates (applied to main exposures): Interest rate increase; parallel shift short: 60 bp; long: 60 bp; Interest rate increase; negative tilt short: 100 bp to long: 0 bp; Interest rate increase; positive tilt short: 0 bp; medium 15-40 bp; long: 100 bp; Interest rate decrease; parallel shift short: -60 bp; long; -60 bp; Interest rate decrease; negative tilt short: 0 bp; medium -15 to -40 bp; long: -100 bp; Interest rate decrease; positive tilt short: -100 bp; long: 0 bp; Increase in volatility of short-term interest rates Short +24% to +55%; to long +8% to 20%.
  - Increase in corporate bond spreads: Bank 1: 10-20 bp for AAA; +30 bp for AA1 to +400 bp for Caa. Bank 2: AAA 25 bp to BBB +80 bp; BB -5% to NR -20%.
  - Equity Price: Across the board drop in equity prices -30 percent; Increase in the volatility of market indexes short +8% to +14% percent; to long +1.5% to +7% percent.
  - Exchange rate shocks (examples): Appreciation of U.S. dollar/euro; euro/SwF stable 10%; 0%; Depreciation of U.S. dollar/euro; depreciation of euro/SwF 10%; 10%; Increase in the volatility U.S. dollar/euro short +3% to +4%; to long +1% to +2%.
- Liquidity stress-test assumptions (from Table 10):
  - Going concern scenario — Liabilities on demand and due within one week/one month: Expected outflow (percent): Money market paper issued 10; Due to banks 1/ 10; Due to customers 1/ 5; Bonds issued 0.
  - Asset illiquidity scenario — Assets on demand and due within one week/one month: Haircut as percent of book/market value: Cash and due from banks 20; Unencumbered collateral: fixed income 2/ 10; Unencumbered collateral: equities 30; Loans 2/ 100.
  - Deposit withdrawals scenario — Liabilities on demand and due within one week/one month: Expected outflow (percent): Money market paper issued 100; Due to banks 1/ 40; Due to customers 3/ 10; Bonds issued 100.
  - Notes: 1/ Includes all demand deposits and time deposits maturing within the period. 2/ unencumbered collateral is defined as the net unencumbered marketable securities position. 3/ Includes all demand and time deposits, not only those maturing within the period.

### Results — Top-down and Bottom-up
- Top-down (SNB) overview:
  - Overall finding: stress tests indicate the Swiss banking sector is resilient to a variety of macroeconomic shocks.
  - The international (global) scenario had the most significant effect on the banking sector (reflecting impact and large weight of the two large banks).
  - The international scenario wiped out the sector’s profits but had negligible effect on the sector’s capitalization level because the sector suffered only minor losses.
  - A 200 basis points increase in interest rates: analysis indicates banks continue to be resilient to such a shock.
- Top-down estimated effects on bank profits (Table 11; results in percent of excess capital, preserved):
  - 2007, Baseline: +29.5
    - Global Scenario: GDP growth shock +16.4 -13.1pp; Interest rate shock +31.0 +1.5pp; Exchange rate shock +20.9 -8.6pp; Equity price shock +19.4 -10.1pp; Combined shock -3.3 -32.8pp.
    - Domestic Scenario: GDP growth shock +17.8 -11.7pp; Interest rate shock +32.0 +2.5pp; Exchange rate shock +25.8 -3.7pp; Equity price shock +28.4 -1.1pp; Combined shock +15.6 -13.9pp.
  - 2008, Baseline: +28.1
    - Global Scenario: GDP growth shock +18.2 -9.9pp; Interest rate shock +32.3 +4.2pp; Exchange rate shock +29.0 +0.9pp; Equity price shock +28.1 +0.0pp; Combined shock +23.7 -4.4pp.
    - Domestic Scenario: GDP growth shock +22.1 -6.0pp; Interest rate shock +29.2 +1.1pp; Exchange rate shock +28.6 +0.5pp; Equity price shock +28.1 +0.0pp; Combined shock +23.9 -4.1pp.
  - 2009, Baseline: +27.1
    - Global Scenario: GDP growth shock +21.0 -6.1pp; Interest rate shock +29.6 +2.5pp; Exchange rate shock +27.0 -0.1pp; Equity price shock +27.1 +0.0pp; Combined shock +23.5 -3.6pp.
    - Domestic Scenario: GDP growth shock +25.9 -1.2pp; Interest rate shock +27.0 -0.1pp; Exchange rate shock +26.8 -0.3pp; Equity price shock +27.1 +0.0pp; Combined shock +25.5 -1.6pp.
  - Note: a positive number indicates expected positive profits after the shock; second column shows decrease (-) or increase (+) in percentage points relative to baseline. When shocks applied together, combined shocks might result in losses although separate shocks might not.
- Bottom-up (large banks) highlights:
  - Market risk modeled for first year only; market shocks for 2007 applied as instantaneous shocks (conservative: ignored portfolio rebalancing and risk mitigation over time).
  - Credit risk shocks applied to PDs and LGDs by portfolio segment using internal datasets; global scenario calibrated to 2001 observed defaults for some portfolios.
  - Liquidity stress tests considered two timeframes (within one week and within one month) and three scenarios: (i) asset illiquidity; (ii) deposit withdrawals; and (iii) combination of both, evaluated against a going concern steady balance sheet.

*Source: Appendix 3. Banking Sector Stress Tests (content as provided).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07187.pdf_