12  For suggestions on improving resolution options for systemically relevant financial institutions, cf. also “The Squam Lake Report: Fixing the Financial System”, Princeton University Press, May 2010. 6  BIS central bankers’ speeches  they also restore creditors’ incentives to monitor risk. Cocos can therefore be viewed as partial substitutes for unusable or impractical bankruptcy procedures, as they ensure that one major class of stakeholders – which would otherwise be outside the risk calculus loop – is now interested in monitoring the bank’s risk attitude and contributing to containing the prorisk bias of the other stakeholders. The Swiss solution Resolving the TBTF issue is a first order of priority. It is of utmost importance for Switzerland, given the relative size of the two big banks in relation to economic output.13 The recent history of developments has helped us to understand that our two big banks are not only too big to fail, but that circumstances could arise under which they would be too big to be rescued as well. The solution chosen by the Swiss authorities to address this important problem is fully in the spirit of the above conceptual discussion. It relies on higher capital requirements and a capital surcharge proportional to the systemic externality with a substantial part of the extra capital taking the form of Cocos. It also imposes organisational measures fulfilling the objective of allowing for a “partial” bankruptcy and thus reducing the size of the TBTF externality.
In addition to the fact that individual shareholders are often small and scattered, they only have limited ways of exerting pressure on management, short of disposing of their share. Importantly, the reality of limited liability seriously biases shareholders’ perspective on risk. While shareholders benefit from the upside of risk-taking, they are not symmetrically penalised on the  3  The focus here is placed on a typical banking institution, but other financial institutions might be similarly affected. BIS central bankers’ speeches  3  downside. This asymmetry is particularly acute in the case of highly levered institutions. For these institutions, the return on equity in good times is high, say above 20%. The trade-off between high returns if the risky gamble pays off, and zero, if it does not, is particularly lopsided. Both limited liability and the natural highly leveraged nature of banking thus come with a natural propensity for socially excessive risk-taking on the part of banks’ owners. In this sense, shareholders cannot be relied upon to impose on managers the socially optimal level of risktaking.4 Managers What about the bank’s managers? Here theory tells us that, apart from reputation and other soft considerations, the behaviour of managers will crucially depend on the link between their remuneration and the firm’s performance. What is at issue here is less the level of managerial remuneration. More important is the relationship between the remuneration and the medium to long-run performance of the bank.