Banking crises have repeatedly inflicted serious damage on the real economy. This column discusses a new proposal for a public liquidity backstop in Switzerland to support the orderly resolution of systemically important banks in times of crisis. While such a backstop can deliver substantial ex-post benefits, it could also encourage excessive leverage and risk ex-ante and thus act as a too-big-to-fail subsidy. A regulatory framework is needed to effectively address these incentive distortions. It should focus on ex-ante tools such as robust capital requirements, credible resolution planning, and prudent remuneration policies to restore market discipline.
Banks have long posed threats to financial stability, and banking crises have repeatedly inflicted serious damage on the real economy. Switzerland has not been immune. In the wake of the 2008 global crisis, it implemented extensive regulatory reforms and introduced a new resolution framework aimed at reducing both the likelihood and severity of future banking crises.
Nevertheless, in 2023 the country faced another major shock. Structural weaknesses at Credit Suisse – one of Switzerland’s oldest and most prominent banks – triggered a sharp loss of market confidence and massive liquidity outflows. The crisis culminated in the emergency takeover of Credit Suisse by UBS, the country’s leading bank, facilitated by a Public Liquidity Backstop (PLB) established under emergency legislation (Böni et al. 2023, Coelho et al. 2023).
In response, Switzerland is now considering a formal legal basis for a public liquidity backstop. The proposed framework is designed to support the orderly resolution of a systemically important bank (SIB) that has reached the point of non-viability – as determined by the market regulator – and lacks sufficient pledgeable collateral to access emergency liquidity from the Swiss National Bank (SNB). In such a crisis scenario, the federal government would act as a guarantor for potential losses on SNB loans to the systemically important bank, thereby shifting the default risk of last resort lending from the SNB to the government.
The proposal envisages that systemically important banks pay a risk-based annual fee to compensate for the potential provision of a government guarantee and to mitigate competitive distortions. This fee – the proposal envisions CHF 0.07–0.21 billion for all Swiss SIBs combined – would be charged regardless of whether the guarantee is ultimately activated. If the public liquidity backstop is triggered, the federal government and the SNB would receive compensation in the form of commitment fees, interest on the emergency loan, and risk premia.
A key open question concerns how such fees should be set and, more broadly, what additional safeguards or design features the public liquidity backstop framework should include to ensure proper incentives. In a recent paper, we examine this question (Monnet et al. 2025).
By reducing the risk of economic disruption following the failure of a systemically important bank, a public liquidity backstop delivers substantial ex-post benefits. However, the anticipation of such support can distort ex-ante incentives, encouraging shareholders and managers to take on excessive leverage and risk. In this way, a public liquidity backstop may inadvertently reinforce the too-big-to-fail (TBTF) problem and contribute to the buildup of future financial instability.
These incentive effects arise indirectly. Crisis support typically provides no direct benefit to shareholders or managers, who are often wiped out or dismissed once a bank reaches non-viability. Instead, the distortion operates through reduced external financing costs: too-big-to-fail status shields senior bondholders from losses, allowing them to lend at lower rates. The implicit subsidy for bondholders lowers bank funding costs and amplifies incentives to pursue privately profitable but socially inefficient investments.
To judge the incentive effects of a public liquidity backstop framework, ideally one would assess its contribution to the overall too-big-to-fail subsidy. However, isolating this contribution is empirically challenging. To estimate the broader too-big-to-fail subsidy, we conduct a quantitative analysis based on the industry-standard CreditGrades framework (Merton 1974, Finkelstein et al. 2002). Using publicly available data for 2022 and applying conservative assumptions about recovery rates and asset volatility, we estimate that UBS Group AG benefited from an annual senior debt subsidy of approximately $2.9 billion — somewhat below the range reported in comparable studies.
This finding underscores the need for a regulatory framework that effectively addresses the incentive distortions created by such subsidies. Any meaningful solution should adopt a holistic approach, targeting the combined consequences of too-big-to-fail status. Crucially, corrective measures should operate ex-ante – targeting the incentives of current management and shareholders – rather than relying on punitive conditions imposed during a crisis. Ex-post penalties risk undermining the resolution process (‘throwing out the baby with the bathwater’) and may lack political feasibility in the face of imminent failure. Importantly, and contrary to the approach outlined in the Swiss proposal, effective regulation must also be independent of a bank’s current financial performance, which reflects past decisions and random shocks rather than the decisions that regulation seeks to influence.
Several ex-ante tools are available to address the distortions caused by the implicit too-big-to-fail subsidy. One approach is to impose capital requirements, thereby enhancing resilience to shocks and reducing incentives for excessive risk-taking. Other measures include targeted taxes or structural reforms, such as breaking up complex banking groups. The overarching goal of these tools must be to mitigate moral hazard and correct competitive distortions stemming from the too-big-to-fail status.
A common concern is that regulation – particularly capital requirements – forces banks to rely on more expensive funding sources, potentially increasing the cost of credit. However, this concern often conflates private with social costs and benefits. Regulation aims to discourage precisely those investments that are socially harmful even though they remain privately profitable by externalising costs. Empirical evidence suggests that stricter capital requirements have little adverse effect on lending volumes, loan pricing, or bank profitability. By contrast, there is strong evidence that higher capital standards improve financial stability (e.g. Financial Stability Board 2020, De Nicoló et al. 2021).
Even if a public liquidity backstop is priced actuarially fairly and regulation effectively balances the social costs and benefits of a systemically important bank, the bank’s activities can still increase a country’s exposure to aggregate risk – particularly when those activities are large relative to the host economy. Should such a bank fail, the macroeconomic consequences of a failed resolution – such as reduced investment, output losses, and reputational damage – can be severe. To mitigate these risks, both the government and the private sector must build buffers, including physical capital and foreign reserves. The costs of these precautionary measures must be fully accounted for in any comprehensive evaluation of whether the benefits of hosting systemically important banks outweigh their associated risks.
To conclude, while banking crises remain a recurring threat and a public liquidity backstop can help contain immediate fallout, it ultimately risks reinforcing the too-big-to-fail status of systemically important banks. According to our estimates, the too-big-to-fail status of UBS Group AG is substantial. Without addressing the structural distortions created by the too-big-to-fail status, anticipated liquidity support risks encouraging the very behaviour whose consequences the public liquidity backstop seeks to mitigate. A forward-looking strategy – centred on ex-ante tools such as robust capital requirements, credible resolution planning, and prudent remuneration policies – is essential to restore market discipline. The impact of Switzerland’s new regulatory framework on financial stability, public finances, and efficiency will be significant.
Source : VOXeu
