How Canada Avoided the Financial Crisis

You have to admit, they completely avoided the problems the US ran into, and they are offering some advice through the pages of the FT.

Chrystia Freeland , the paper’s managing editor who is Canadian, weighed in with  “What Toronto Can Teach  New York and London at the end of January.

She amusingly weighs the arguments that Canadians are too nice or too dull. I recall a discussion about an equities matching pool being set up in Toronto and I asked whether they were concerned about firms’ gaming the system, only to be assured that would not be permitted.  As if the mere fact it was impolite was enough, but if not, they were ready to ban the gaming institutions. Refreshing, in part because it was not exactly the prescription you would expect to work in New York.

“In my conversations with Canadian bankers, one of the things that struck me was how often they referred to mothers. Nixon mentioned his mother and her good opinion when explaining why he gave back his bonus in 2008; [TD CEO Ted]Clark uses the mother-in-law test, as in ‘Would you sell it to your mother-in-law?’ to help TD employees figure out if they should be hawking a product to their customers. In an era when Wall Street investment banks issue notes warning their clients they may be short-selling the investments they are marketing, this sounds like a charmingly Canadian attitude. But it is easier to be nice if you don’t need to be nasty just to make a buck. ”

I seem to remember reading a quote from the head of TD, presumably Clark, who asked someone in the bank to explain a complex instrument. He couldn’t follow and said he wanted the bank to get out of any instrument that couldn’t be readily explained. Ah, if only Citi and a few others had followed such a path.

Clark and several other Canadian banking chief appeared more recently in the FT suggesting some basic reforms, and citing three basic problems.

“…first, excessive leverage in the banks and investment dealers. Second, a lack of common standards for the quality and level of capital. And third, weakness in risk and liquidity management.” While Freeland said Canadian banks securitized some mortgages, Clark said holding them is key to stability. Perhaps some mid point can be found where banks must hold some of their mortgages, combined with standardized details fed into a database and a way around relying on the ratings agencies — since fixed rates mortgages can be a useful investment for pension funds and insurance companies.

Clark’s big point is important and often overlooked.

“Policymakers have a unique opportunity to refocus banking on economic growth and job creation. For this to happen, policies must address the root causes of the financial crisis.”

In some ways, the “too big to fail” argument for smaller banks addresses this issue. Financial industry profits have risen to a huge chunk of total corporate profits in both the US and UK. Some historians have pointed out that an overly financial economy often leads the way to a crash, citing the Netherlands and a few others I don’t recall.

It’s probably hopeless optimism to think Parliament or Congress will address these issues intelligently, but in Washington the Obama administration seems ready to take at least a few useful steps toward reform.

See also Julie Dickson, superintendent of financial institutions in Canada, who looks to market forces, appropriately tied to bank liquidity, to provide effective self-regulation.

“…embedded contingent capital. This is a security that converts to common equity when a bank is in serious trouble, instantly increasing the core capital of the bank without the use of taxpayer dollars. The principle is similar to “CoCos”, the convertible bonds already issued by some banks. But it would apply to all subordinated securities and would be at least equivalent in value to the common equity. This would create a notional systemic risk fund within the bank itself – a form of self-insurance pre-funded by private investors to protect the solvency of the bank.

“As an example, consider a bank that issues $40bn of subordinated debt with these embedded conversion features. If the bank took excessive risks to the point where its viability was in doubt and its regulator was ready to take control, the $40bn of subordinated debt would convert to common equity, in a manner that heavily diluted the existing shareholders. While other, temporary measures might also have to be taken to help stabilise the bank in the short run, such capital conversion would significantly replenish the bank’s equity base. ”

In other words, tie investors tightly to the bank’s potential for failure. As Samuel Johnson said, “When a man knows he is to be hanged…it concentrates his mind wonderfully.”

About Tom Groenfeldt

I write - mostly about finance and technology, sometimes about art, occasionally about politics and the intersection of politics and economics. My work appears on Forbes.com and International Finance Magazine. The Financial Brand ranked me 20 on a list of the top 25 global influencers in financial services and Jay Palter included me in his list of 250 fintech influencers to follow in 2016 http://bit.ly/1SSRXC6
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