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ZURICH (Reuters) - The Swiss National Bank (SNB) urged Credit Suisse CSGN.VX to improve its capital by halting dividends or issuing shares to raise cash to shield it from the risk of an escalation of the euro zone banking crisis.
"For Credit Suisse, given the low starting point and the risks in the environment, it is essential that it already substantially expand its loss-absorbing capital base during the current year," the SNB wrote in its annual financial stability report, which focuses on the Swiss banking sector.
"Apart from the planned reduction of risk, these improvements can also be achieved in other ways, such as by suspending dividend payments, or even by raising capital on the market through share issuance," the SNB said.
In a statement, Credit Suisse said it exceeds current Swiss requirements, which are slowly stiffening until 2019, when stricter rules come into full force.
"In view of the Swiss 'too big to fail' regulation under Basel 3, Credit Suisse has already put in place its high strike buffer capital requirement - CoCos - adding 3 percent of loss-absorbing capital to its end of 2012 common equity ratio," the bank said.
"Credit Suisse has also established transparency on its plan for both building up common equity through retaining earnings and further asset reduction," the bank said.
Credit Suisse paid out 0.75 Swiss francs per share to shareholders in 2011, down from 1.30 francs in 2010. Meanwhile, UBS last year paid its first dividend - just 0.10 francs per share - since the financial crisis.
The bank's stock slumped more than 8 percent after the report became public. At 08.37 a.m. British time, Credit Suisse shares were 8.2 percent lower, lagging a 1.5 percent fall in the European banking sector .SX7P.
While Credit Suisse was singled out - unusual for the SNB - rival UBS, which had to be bailed out by the Swiss government in 2008, was also cautioned to keep course with its strategy to stow away profits instead of paying cash out to shareholders.
In a statement, UBS reiterated its strategy to reduce risk-weighted assets to below 150 billion Swiss francs in the investment bank and building its common equity Tier 1 ratio to 13 percent under Basel III. UBS shares fell more than 3 percent following the SNB report.
Neither bank are being asked to hold more capital than required under new rules, but instead are being urged to reach higher requirements sooner.
Both hold more capital than rivals according to existing rules, but fall behind under international Basel III rules coming into full force in 2019, the SNB said.
The SNB also criticized that leverage at UBS and Credit Suisse remains "very high", despite cutbacks on risky assets at both banks. UBS and Credit Suisse should trim their balance sheets, and not merely slash risk-weighted assets, the SNB said.
Chief among the SNB's worries are the collapse of a euro zone bank, the bursting of a bubble in the Swiss housing market as investors flee towards assets perceived as safe, persistently low interest rates, and increased funding difficulties.
Though Credit Suisse and UBS are only moderately exposed to euro zone debt and loans, they both face "substantial losses" should European banks fall further into crisis, due to counterparty links to Switzerland, the SNB warned. "The risk of a major bank failure remains substantial," it said.
The SNB's report highlights that Credit Suisse, an early adopter of the central bank's push for contingent convertible bonds, or CoCos, is at a disadvantage because the instruments aren't likely to be recognised under Basel III.
While Credit Suisse issued CoCos - bonds which aim to absorb losses by converting to equity under certain conditions - UBS has been more cautious about the instruments, saying it did not want to dilute shareholders following repeated cash calls in 2007 and 2008, as it struggled under the weight of more than $50 billion in mortgage writedowns during the subprime crisis.
Credit Suisse and UBS are also in the crosshairs of ratings agency Moody's, which could cut their ratings by as much as three notches in coming weeks as part of a ratings review of global banks. UBS's long-term debt is rated Aa3 by Moody's, Credit Suisse's Aa1.
The SNB cautioned that a potential collapse of Swiss real estate prices poses a threat to banks with big mortgage books. More personal insolvencies and an uptick in Swiss household debt to gross domestic product highlight banks' increasing vulnerability, the SNB said.
The central bank has repeatedly warned of overheating after a flood of demand in hot spots such as Lake Geneva, Lake Zurich, Zug and ski resorts fuelled a surge in prices.
After repeated warnings to Swiss banks to tighten their lending standards went largely unheeded, the SNB pushed for an emergency buffer. Earlier this month, the Swiss government said it can impose another 2.5 percent additional buffer to underpin mortgage lending if credit growth gets out of control.
Editing by Jon Loades-Carter and Elaine Hardcastle