On Canadian Banks and “Bail-ins”

Over the last four decades, financial institutions in many countries have grown to an unprecedented

scale and degree of concentration. In the 2008-09 financial crisis, a wholesale collapse of the dominant banks might have portended a freeze of credit and capital markets—without which a modern economy cannot function. Rather than entertain that risk, policymakers in countries like the U.S., U.K., and continental Europe used a combination of public funds and liquidity created by central banks to rescue several major financial corporations. In other words, these institutions were “bailed out”; the costs of their errors have since been transferred in different forms to various stakeholders, including salary-earners in both the public and private sectors, savers and pensioners, debtors, and taxpayers.

The “bail-in” alternative

On the small island nation of Cyprus, in 2013, uninsured depositors and pensioners at the country’s two largest banks faced the choice of either sacrificing a substantial portion of their savings to keep the financial institutions afloat, or losing a much greater amount in the event of a bank collapse. This is arguably the most (in)famous contemporary example of a “bail-in”—the rescue of an ailing financial institution by its own creditors.

That same year, Canada’s Conservative government proposed a “bail-in” regime for Canadian banks as part of the 2013 federal budget. In its 2016 budget, the current Liberal government offered a virtually identical proposal, and even promised a concrete policy framework to follow. On page 223:

“To protect Canadian taxpayers in the unlikely event of a large bank failure, the Government is proposing to implement a bail-in regime that would reinforce that bank shareholders and creditors are responsible for the bank’s risks—not taxpayers. This would allow authorities to convert eligible long-term debt of a failing systemically important bank into common shares to recapitalize the bank and allow it to remain open and operating. Such a measure is in line with international efforts to address the potential risks to the financial system and broader economy of institutions perceived as ‘too-big-to-fail’.”

A few key details are worthy of note here:

1.    The word “creditors” is ambiguous; it may encompass not only investors and bondholders, but depositors too.

2.    Canada is not Cyprus. Unlike the Eurozone states, our country has its own sovereign currency and central bank, which means our government needn’t go cap-in-hand to a foreign central bank to borrow in its own currency. This enables potential policy alternatives to the kind of “bail-in” that Cypriots endured. For example, the Bank of Canada could theoretically pump liquidity into insolvent banks by acting as the buyer of last resort for those banks’ bonds.

3.    Canada has an insurance program covering various categories of deposits up to $100,000 through the Canada Deposit Insurance Corporation (CDIC). But the CDIC’s total holdings amount to a small fraction of the total value of insured deposits across Canada. In the CDIC’s 2015 annual report, the ratio was $3.044 billion in cash and investments held by the agency, plus a $20 billion borrowing limit, to $684 billion in insured deposits.

4.    The government’s “bail-in” proposal doesn’t actually rectify the too-big-to-fail problem—in fact, it doesn’t even purport to do so. Rather, the stated goal of the policy is to keep “systemically important” (i.e. too-big-to-fail) institutions “open and operating”, and transfer the costs of doing so from taxpayers to bank creditors.

Assuming the proposed “bail-in” regime takes effect, would the full value of your deposits in Canada’s major banks be safe in the event of another 2008-magnitude crash?

Maybe, but not certainly. At the very least, if you have a bank account in excess of $100,000 in any of the big Canadian banks, it might be a good idea to split it so that all of your deposits remain below the CDIC-insured limit.

Obama and Small Businesses

In his recent State of the Union address, U.S. President Obama presented a bold, economic initiative to help bolster his nation's struggling economy. Obama proposed making $30 billion available to small community banks so that they, in turn, can make these funds available in the form of credit to small businesses.

From a patriotic standpoint, Obama is worthy of praise in his concern for small businesses, part of the backbone of America. From an economic standpoint, many feel he has missed the boat.

Many bankers and economists agree that the problem in the U.S. economy is not the lack of credit but the lack of demand by small business and consumers. Simply put, Americans are not interested in borrowing money at this point in time. Unsure of their country's economic future, Americans prefer to save rather than spend. Herein lays the problem for small businesses. Their market has shrunk, due to fewer customers. As a result, they cut costs by hiring less and purchasing less from suppliers. At the end of the chain are the businesses that face closure. In order to keep afloat, these businesses attempt to obtain credit to pay their bills. But, these are the high risk customers that the banks don't want. The banks want the solid customers who can repay their loans. After all, banks make money from repaid credit, not defaulted loans.

At this point, the only banks that would require funds from Obama's $30 billion are those holding problematic loans, and they probably won't qualify. Bank regulators are examining records with magnifying glasses. High risk banks will most probably fail, rather than receive federal relief.

Maybe Obama should re-direct his funds. Stimulus funds need to get into the economy right away. Rather than strengthen the banks that are in trouble, strengthen the small business sector. When consumer spending is stimulated, the wheels of the economy will be oiled and the system will move forward.

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Risk Management: The Financial Safety Margin

Investing is a part of our culture. Many of us invest a portion of our income for our needs, present and future. However, investing carries with it an element of risk. Therefore, it makes good sense to build a safety margin into your personal investment plans.

Playing the stock market is virtually a national pastime. However, as recent history has proven, the value of stocks can plummet, sometimes quite rapidly. Therefore, some investors will attempt to pay the lowest possible price for stocks. If the floor should fall out from under that stock, you stand a good chance of recouping most of your money.

Even if your cash flow is healthy at present, always be prepared for the inevitable. Many jobs today are not 100% secure. Take a couple of months of living expenses and tuck the money away in a savings account or money market.

The dream of many newlyweds is the purchase of their first home. Many, though, make the mistake of sinking all their available cash into that purchase and further committing both their salaries to make the monthly mortgage payment. If you can't afford the mortgage on one salary, think twice! If one job should disappear, you could face serious problems.

At the other end of the spectrum are those heading into their retirement years. Is your investment portfolio secure? Will you be able to rely on it? If you assume that the portfolio will generate a double-digit annual return, you may be surprised. Markets have proven to be rather volatile. It would be wiser to assume a much lower rate of return. Also, when you calculate withdrawals from your initial portfolio, experts advise withdrawing no more than an inflation-adjusted 4% each year. This amount will allow you to remain in a fairly stable condition, however the market moves.

Remember that investments mean risks and a safety margin is your best insurance policy.

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Three Cheers for Canadian Finances

Let's face it – Canada's reputation is not one of the glitzy stars of the world. It is rather conservative, moderate, and perhaps even a bit dull at times. But, those exact qualities allowed the nation to remain strong and secure during the recent recession. At the same time that the U.S. economy has been floundering with no end yet in sight, Canada weathered the storm that lasted just eight months.

Canada's well managed banking sector was a key factor in saving the day. The country's strict regulatory system, combined with a conservative banking culture and superior credit conditions, paved the way for stability. The recession saw the loss of more than 122 banks in the U.S. Not a single Canadian bank closed and none needed bailouts.

Certainly there has been Canadian unemployment. But, our workforce shrinkage of 2.5% was half of our American neighbours.

Let's look at the GDP. Canada's fell 5.4% but that's far less than other nations like Germany's 14.4% fall or Japan that plummeted by a whopping 15.2%.

Sub-prime mortgages dealt a death blow to U.S. banks, comprising almost 20% of the mortgage market. Canadian banks were a lot more cautious and only 7% of the market was comprised of sub-prime mortgages. Furthermore, banks in Canada rarely sold their mortgages and kept a tight reign, thus reducing the risks of default.

Conservative Canadians are more reserved? Quite possibly so, if one considers personal finances. Canadian household debt measures approximately 102% of income while the U.S. ratio is 114%. When Americans had to start repaying their debts, Canadians were able to take advantage of low borrowing rates and boost consumer spending.

Do Canadians have the last laugh? Not really. The recession has hurt everyone and is far from over around the world. But, whereas the great credit bubble burst in other countries, and many are still reeling from the effects of the recession, Canada has shone brightly as a model of fiscal prudence and responsible financial management.
 
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A Stronger Financial System

Ever wonder what happens behind the scenes of banks? For example, how does the bank manage its money?

Part of the system involves banks lending money to one another for short terms. The system is known as repurchase agreements, or repos for short. In order to raise money, a bank sells bonds or other collateral to another bank but agrees to buy back the collateral at a later date. Repos are part of a market that involves traders at the various banks trading with each other and shuffling the collateral back and forth.

All was well and good until the recent recession. The banks began to be leery of the solidity of other banks. The time proven system of trading began to fail, leaving even the healthiest of banks with a potential cash shortage.

Anticipating a possible major blow to the Canadian banking system, the Bank of Canada, together with the country's securities industries, began creating a plan to revamp the system and ensure crucial funding for the country's banks.

The plan involves establishing a central clearinghouse. Banks would no longer trade with each other but, rather, with the clearinghouse. This would eliminate questions of stability of other banks. Also, a central clearinghouse would be able to give a bank a clearer picture of their repos transactions, thus affording the bank a better way to manage its capital.

The Bank of Canada hopes that this new system will begin to be implemented by mid-2010 and will increase the overall safety and solidity of the Canadian banking system.

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