William Tell wake up, Switzerland has gone mad!

William Tell contemplating SNB's portfolio

On June 10th, Swiss voters will cast their votes on the Vollgeld referendum: "For crisis-safe money: Money creation by the National Bank only! (Sovereign Money Initiative)." 

What is it about?  The idea is to limit money creation to the central bank only. That would be the end of the fractional reserve banking system in Switzerland. This system has ruled the global financial system since the 17th century.  Fractional reserve banking allows that only a fraction of deposits held by banks are backed by central bank money.

The proponents of the referendum want to avoid another 2008 like bank bailout and argue that: " [...]under the 100% reserve system the central bank wouldn’t have complete control over the money supply, while it would under a sovereign money system. Further, under a 100% reserve system the possibility of a bank-run or the government having to rescue a bank is not completely eliminated, whereas it would be under a sovereign money system.”.  To control money creation the central can: "[...] to keep the amount of money in circulation stable or inject, the Swiss National Bank will need to re-introduce this money into the economy. It can do this in one of several ways: - by buying assets such as securities or foreign exchange reserves (as it can now) - by lending money directly to banks - by handing debt-free money directly to the government to be spent back into circulation or to reduce taxes or to be given directly to citizens.". These statements, coming from the vollgeld paper  have severe drawbacks, we will look at them later.

If this referendum were to succeed that would be a jump into the unknown. It would represent a complete change of Swiss banks business model and it would have massive consequences for the Swiss economy. Some figures will help put this in perspective: Swiss banks provide loans worth 2 times GDP; the financial sector is about 10% of GDP and employs 5% of the labor force.

Some will say it is not that easy to pass a referendum, the yes must get more than 50% of the votes at the national level plus win in a majority of the 26 Cantons. Moreover, a recent poll by gfs.bern shows No at 49%, Yes at 35% and Undecided at 16%, one out today from Tamedia shows No at 54%, Yes at 39%, Undecided at 7%.

It's not because something has a low chance of happening that it must be discarded completely especially given the consequences are so asymmetric.

The Swiss institutions (Confederation, SNB, Banks...) and most of the academics (a great paper from Philippe Bachetta can be found here) oppose the referendum initiative. I do share their arguments and will try to summarize them below.

The proposal would separate money and credit.  It will move away from the historical distribution of responsibilities between the SNB and the banking system.

The SNB will have to guarantee the supply of credit to the economy by the financial services providers. That would have to be done via securitized loans. The SNB will have to take credit risk and would have a more direct influence on lending. It creates a risk of political interference and a possible lack of competition in the banking sector. 

To be true credit risk is already present on SNB balance sheet via its 82 bios USD equity portfolio, but this is meant to be temporary, i.e. this is the Swiss version of a QE portfolio.

Sovereign money will limit liquidity and maturity transformation as banks cannot create deposits through lending. It will restrict supply of credit to households and small and medium size firms with no access to capital markets. The referendum initiative does not address the too big to fail issue as misjudgement and over lending can still exist. It does not address the shadow banking issue either.

SNB will switch back to monetary targeting, that's back to the future! Central banks all over the world moved away from it 20 years ago for good reasons.

Sovereign money would be created “debt-free” rather than through SNB money market operations (purchasing securities or granting secured loans). It's not clear how money supply would be reduced when needed to.  It creates a huge uncertainty for the Swiss economy.

One of the problem with the underlying idea of money targeting is that is there is no historical link between money creation and credit provision.

M1 and Total Credit per GDP

 (The Sovereign Money Initiative in Switzerland: An Assessment Philippe Bacchetta, June 2017)

The other problems lie in the implementation of the change. 

As banks will transfer their customer's sight deposits to the SNB, they end up with a financing gap. Sight deposits minus reserves represent 25% of credit and 15% of banks’ balance sheets. The Vollgeld paper sees it happening in 2 steps:

1- SNB lends its reserves to fill the financing gap.

2- Banks need to find alternate sources of financing. It can borrow money from the Swiss National Bank, it can borrow from other banks, it can incentivize customers to place their money in savings accounts, it can issue shares or bonds.

It is not guaranteed that the new sources of funding will be more stable than the old client sight deposits. We could see an increase in savings deposits or Euro sight deposits which are not part of sovereign money.  It could lead to an increase in Euros transactions in Switzerland! We could see a switch to short term funding which is more volatile. 

Given sovereign money is a safe asset outside the banking sector, it will not take much for these funding sources to leave banks in time of crisis. Thus, the risk of bank runs is not reduced at all.

Let's now have a look at the economic impact.

As stated by Phillippe Bacchetta, the impact in the current state of negative rates would be very low. But... If normal positive rates were to come back, the impact can be up to -0.8%/annually.  This cost would be borne out by households and banks, it should be seen as a lower-bound, as other costs (implementation, regulation costs etc) are most difficult to assess.

What would be the market implications? According to Beat Siegenthaler at UBS, the CHF could appreciate as this would be seen as a road to tighter credit and restrictive monetary policy. The SNB might also argue it is not anymore allowed to intervene in the FX market. I'm not so sure about this outcome, I guess bank stocks would be hurt pretty badly as their profitability will be curtailed and the high uncertainty surrounding their replacement funding. Given this is an idiosyncratic issue, and the fact the SNB argument is contradicted by the Vollgeld paper I have a hard time to see CHF rally. 

As the Philippe Bacchetta puts it “It is to be hoped that all these costs and potential risks will be all well understood by Swiss voters.” 

There are numerous examples in recent history of why a very technical project should not be put to referendum, people will mostly vote to voice their concerns and fears rather than making an educated choice on the question asked. 

There is a snowball chance in hell that people will dig deep enough to get a thorough understanding of this technical issue. 

The current wave of populism makes me very nervous as to the outcome of this referendum. I hope the Swiss are immune to it.

MacroDiver