Swiss Banks and Secrecy

For a small country, Switzerland punches above its weight in banking. This has largely been attributed to bank secrecy rules that make Swiss banks particularly useful to some. Over the past century, the country’s banking sector has been associated with secrecy, accused of facilitating tax evasion and other crimes. While a professional standard in banking for centuries, strict confidentiality became a requirement enshrined in Swiss criminal law in the 1930s. Bank secrecy has been threatened, largely by frustrated foreign governments, ever since then.

Swiss Banks

The development of a large financial sector in Switzerland cannot be attributed to its domestic market alone. Switzerland, a country slightly smaller than even the Netherlands by area, had in 1900, a population of just 3.3 million. However, Swiss banks were not reliant on their own domestic talent and market size. They had always had an international focus. Geneva was the first major banking center in Switzerland and had close associations with France after many French bankers settled there in the 18th century. Meanwhile, Basel and Zurich were German facing; when the bank Credit Suisse was founded in Zurich in 1856, half of its capital came from Germany.

Switzerland has of course become famous for its bank secrecy rules but this was a 20th century creation. Swiss bankers had already bound themselves to a code of confidentiality not unusual among other professions, from law to medicine. In the 1930s though, this unwritten code became formalized in a bank secrecy law that is perhaps the most widely known and distinguishing feature of Swiss banking today.

Tax Haven and Safe Haven

Tax evasion is, unsurprisingly, tied to the origins of bank secrecy in Switzerland. In the early 20th century, many European countries began to more heavily tax their wealthy populations and this encouraged capital flight to lower tax jurisdictions. For example, France greatly increased its inheritance tax in 1901 leading Swiss banks to advertise to French customers looking to hide money abroad. To avoid retaliatory measures by the French government, a Swiss Minister for the Economy asked the banks to tone down their advertising pitch.

However, it was after the First World War that this flow of tax evading capital into Switzerland became most torrential. The cost of war and the subsequent reconstruction led to higher taxes in many countries. Higher tax rates in turn caused the wealthy, especially in France, to look for places to leave money abroad. By the 1930s, one billion French francs were said to have eluded tax authorities, and this amount was likely an underestimate.

The theoretical maximum income tax rate reached 90% in France and 60% in Britain after the war. In Switzerland, tax rates were also high on large incomes but methods for avoiding tax were more readily available; in practice, public revenues as a percentage of GDP tended to be lower in Switzerland than in most countries in Europe. The large increase in public revenue needs that were otherwise widespread, left Switzerland relatively untouched. Public expenditures as a percent of GDP were just 14.77% in Switzerland in 1920, as compared to 25.91% in France and 28.37% in Britain. In Switzerland, taxes were also collected at the cantonal, rather than federal, level of government and cantons were keen on competing for foreign money by being rather lenient on tax collection.

The inflow of tax evading foreign wealth into Switzerland reshaped the banking landscape in Europe. Before the First World War, Swiss banks were very small compared to their French or German counterparts but that was changing. The cumulative balance sheet of the major Swiss banks grew from just 26% of that of their French counterparts in 1913 to 73% in 1929, giving Switzerland the largest bank deposit base per capita of any country in the world. Unable to find sufficient local uses for this capital, much of it would be reinvested abroad by the banks, making Switzerland into something of a railway turntable in European finance.

In addition to the ease of avoiding taxes, depositors were drawn to Switzerland by the country’s policy of neutrality, political stability, lack of currency exchange controls, and its laissez-faire conservative government. Preservation of purchasing power was of increased importance with the post-war monetary instability. By the eve of the Second World War, the French franc had retained just one-ninth of its 1913 value, while the value of the German mark had completely evaporated by the mid-1920s. In 1925 and 1926 in particular, French investors moved money to Switzerland or elsewhere in response to devaluations of the French franc.

Governments did not readily accept this capital flight. France and Germany each attempted to combat tax evasion during the interwar years. One new German law required that citizens declare all foreign currency assets to the Reichsbank, which could demand these assets be sold and converted into marks. German authorities also conducted bank espionage campaigns in Switzerland that attempted to obtain information on the German clients of Swiss banks, in some cases by bribing local bankers. In 1932, French authorities raided the Paris office of one Swiss bank, the Basler Handelsbank, which was revealed to be aiding French clients evade taxation. This bank’s French assets were frozen and two of its managers imprisoned; some of these actions were taken against other Swiss banks as well.

Banking Law

Obtaining a competitive advantage for its banking sector based on tax dodging was not the only desire leading to the implementation of a bank secrecy law. Another was an attempt to better regulate its banks after the worldwide banking crisis in 1931. Many Swiss banking firms had large operations in Germany which was particularly badly affected by the crisis. The government there froze the assets of the banks and new currency controls prevented transfers of money between the two countries. Before the crisis’s end, one Swiss bank went bankrupt and several others had to be rescued or reorganized. By the mid-1930s, there was an opportunity and desire to refashion Swiss banking regulations.

Bank secrecy and tighter regulation are not obviously compatible. However, criminal penalties for breaches of secrecy rules were included in the regulations as a compromise. The banks were wary of supervision that could result in information about clients being shared with governments either in Switzerland or abroad. Banks supported greater regulation on the condition it be mild, directed by an institution at arm’s length from the government, and accompanied by stronger bank secrecy protections. Bankers and others warned of a flight of depositor capital if banks’ client information could be compromised.

The result of the post crisis debate was the Banking Law of 1934. The legislation’s secrecy provisions made unpermitted disclosure of client information a criminal, and not just a civil, offence. Sharing client information was now punishable by imprisonment. By making breaches a criminal offence, the state was essentially committed to prosecuting those who leaked client information, even where the victim did not sue.

The provision was designed in part to reassure bank clients that foreign pressure would not dent the country’s commitment to bank secrecy; it was an act of defiance towards the bank espionage efforts of foreign governments and tax authorities. Banks worried that if even one among them succumbed to foreign pressure, such as that applied by the French on the Basler Handelsbank, and began to share client records, then confidence in all the banks would evaporate.

A popular account of the origins of the secrecy law was that it was intended to prevent Jewish depositors from being identified after the establishment of the Nazi regime in Germany. However, few historians seem to agree with the claim that this was truly a motivating factor. Indeed, compared to other provisions of the banking law, the secrecy rules were not the object of great public discourse of any kind. They appear to have been little debated and the exact language in the draft bill was revised hardly at all in a drafting process that took a year-and-a-half overall. In the end, even left-wing parties went along with enshrining such strong secrecy practices into law if it were the price of enacting some bank supervision measures as well. The Banking Law was approved by 119 votes to 1 in the lower house of the Swiss parliament and unanimously by its upper house and came into force in March 1935.

Post-War

The threat to Swiss banking secrecy reached its next apex immediately after the Second World War. During the war, Swiss banks had engaged in transactions with the German and Italian governments, extending financing to Nazi Germany and Mussolini’s Italy. It is hardly surprising therefore that their activities would be scrutinized when the war ended, threatening the future of bank secrecy.

The biggest diplomatic challenge to secrecy now came not from France, as it had during the interwar years, but from the United States. American authorities conditioned the removal of Swiss firms from sanctions lists, and the release of Swiss assets frozen in America, on the lifting of bank secrecy. The Americans wanted to ensure that monies due to German entities or officials wouldn’t fall in the hands of war criminals or finance the reconstitution of the Nazi Party. In the face of this challenge, the Swiss government stalled and eagerly supported the extension of new loans to Allied governments while attention was focused on larger issues. In time, Allied demands moderated and Swiss bank secrecy survived its first decades in existence.

Lesson

Switzerland’s success in banking has largely been attributed to secrecy. However, to leave it at that would be to give the Swiss too little credit. There were many factors allowing the country to develop a banking system so large relative to its population or commerce. It would be hard to believe that the country would have been so successful as it has been if, for example, it had a political or monetary situation as volatile as that of Germany, with or without bank secrecy. The country’s stable politics and currency, free markets, low taxes, and policy of neutrality all helped attract capital from nervous, and perhaps avaricious, investors abroad.

More from the Tontine Coffee-House

Swiss bankers were behind some of the earliest securitizations in history, schemes known as the ‘Thirty Maidens of Geneva’. Read about the monetary instability of neighboring Germany during the height of capital flight to Switzerland. Also, consider subscribing to this blog’s newsletter here.