The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

By Liam Proud

LONDON, March 27 (Reuters Breakingviews) - When UBS UBSG.S Chair Colm Kelleher was negotiating the weekend rescue of Credit Suisse in March 2023, the arcane regulatory question known as “equity double leverage” probably could not have been further from his mind. Two years on, it’s effectively the only topic that matters for the future of the $107 billion Zurich-based lender. Swiss lawmakers could tweak the rules to whack UBS by increasing the capital it’s required to hold by roughly a third. To reduce the blow to shareholders, Kelleher would have to radically reshape the group.

The technical question at stake stems from the legal structure of European megabanks, which have a series of subsidiaries sitting below a so-called parent bank. The Russian doll-like edifice is designed so that the divisions at the bottom of the chain, like UBS’s Swiss unit or its U.S. business, are distinct and broadly self-sufficient entities, capable of continuing undisturbed if the wider group fails.

The failure of Credit Suisse revealed a problem with the way Switzerland implemented this design after the 2008 financial crisis. Regulators permitted the parent bank, which owns the subsidiaries, to fund 40% of its assets with debt. Given that the operating units also have borrowings, the result is so-called “double leverage”. One consequence is that serious losses at the subsidiaries can blow an even larger hole in the parent bank’s capital. That precarious structure made it harder for Credit Suisse to radically scale back or sell its loss-prone investment bank when it got into trouble, according to an official government account of the crisis. This limited the lender’s options to save itself as it sped towards disaster.

The painful memory is why many Swiss officials now favour requiring UBS to fund its foreign subsidiaries with 100% equity. That demand could require the lender to find up to $25 billion of extra capital, Finance Minister Karin Keller-Sutter has said. Adding that sum to the bank’s common equity Tier 1 capital as of December 31 would lift the figure to 19% of risk-weighted assets, according to Breakingviews calculations, far above a current management target of around 14%.

Such a hefty capital buffer would make UBS an outlier among global systemically important banks, which on average have CET1 ratios of 13%, Visible Alpha data shows. Kelleher and CEO Sergio Ermotti will no doubt argue that such high capital levels will harm UBS and therefore Switzerland’s competitiveness as a financial centre. UBS is proposing a raft of concessions including offering to cap the size of its investment bank to win political favour, Reuters reported on Wednesday, citing people familiar with the discussions.

Yet Swiss parliamentarians, who may take years to agree a final law after the government makes its proposal in June, could also argue that UBS poses unique risks to the alpine economy. The bank’s CET1 capital - a rough proxy for the cost of recapitalisation in a crisis - exceeds 7% of Swiss GDP. No other major lender surpasses 5%, according to Breakingviews calculations. In other words, taxpayers would benefit from an extra buffer to reduce the odds of having to underwrite a rescue, as they did in 2008 and 2023.

UBS shareholders, however, will expect Kelleher to do whatever he can to minimise the hit. Analysts expect the bank to end 2027 with $13 billion of net income and CET1 capital of $76 billion, implying a 17% return. If regulators add $25 billion of equity to the denominator, the return slips below 13%, according to Breakingviews calculations. That would end UBS’s hopes of closing the valuation gap with U.S. wealth management rival Morgan Stanley MS.N, whose shares trade on more than double the multiple of expected tangible book value.

Kelleher has options. The most extreme response, which Bloomberg reported the bank is examining, would be to move UBS’s headquarters to a country with a more favourable regulatory regime. It’s not hard to imagine U.S. President Donald Trump or UK finance minister Rachel Reeves rolling out the red carpet. UBS would be less of an outlier alongside megabanks like New York-based JPMorgan JPM.N or London-headquartered HSBC HSBA.L, 0005.HK. There’s a successful precedent: $46 billion Nordic lender Nordea Bank NDAFI.HE in 2018 hopped from Sweden to Finland, partly to avoid tougher rules.

The drawback is that UBS derives plenty of value from its Swiss nationality. Having a home base in the stable, neutral state is probably more important than ever given increasingly fractious geopolitics. UBS caters to a globally mobile and super-wealthy client base, some of whom might balk at the idea of entrusting their money to an institution under the direction of the U.S. or UK government. Some of them could leave if Kelleher decamped to New York or London.

A less extreme option would be for UBS to shrink its foreign subsidiaries, in turn reducing the capital required to back them. The largest of the units in question is UBS Americas, which in December had a $27 billion book value supporting an array of businesses from private wealth management to Wall Street dealmaking and trading. A rival like Goldman Sachs GS.N could in theory be interested in buying UBS’s army of financial advisers, though it would have to pay a huge price to persuade UBS to part with valuable deferred tax assets in the United States.

It would also make sense to devote less capital to trading and dealmaking. These activities are already among UBS’s least capital-efficient operations, judging from the investment banking unit’s subpar historic returns. Investors might even cheer such a move, since the relevance of M&A and trading to managing money for multimillionaires and billionaires has always been sketchy. Ermotti has successfully hacked away chunks of this business before – once after the financial crisis and again after absorbing Credit Suisse.

UBS executives will hope they can persuade Swiss lawmakers to reconsider. In 2023, the country’s politicians and regulators scrambled to arrange Credit Suisse’s shotgun marriage to its rival, in part because they feared that the failure of one of the country’s biggest banks would fatally wound its international reputation as a financial haven. It would make little sense for the same authorities to permanently hobble UBS’s ability to compete. Kelleher has ways to soften or swerve the Swiss capital blow.

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CONTEXT NEWS

UBS is offering to limit the size of its investment bank, among other possible concessions, in an attempt to head off tougher Swiss regulations, Reuters reported on March 26 citing people familiar with the discussions.

The group chaired by Colm Kelleher has floated ideas including capping its investment bank at 30% of the total business and increasing the group's capital by $5 billion, the report said.

The Swiss government will in June present proposals for UBS's future capital requirements, though lawmakers may not decide the final rules for years.

UBS is also examining moving its headquarters though it has no intention of leaving Switzerland, Reuters reported citing two sources.

(Editing by Peter Thal Larsen and Streisand Neto)

((For previous columns by the author, Reuters customers can click on PROUD/liam.proud@thomsonreuters.com))