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THE ECONOM

Y

L’ÉC O N O M

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T he world economy is now emerging from the shock ofthe first global financial crisis and synchronized world-wide recession since the 1930s. Given the perceived

sophistication of financial markets, the regulatory and surveil-lance structures established by major countries and interna-tional bodies, and the perception of structural changes to betterabsorb risk, how did this happen? And why did some countriesavoid the full brunt of the financial market disruption?

As a recent Financial Times article by Chrystia Freelandnoted: “One of the most important policy debates today…iswhat caused the crisis and what should be done to preventa repetition…That’s where Canada comes in. It is a real-world, real-time example of a banking system in a medium-sized, advanced capitalist economy that worked.Understanding why the Canadian system survived could bea key to making the rest of the west equally robust.”

While Canada was hit by the worldwide recession, theCanadian financial system weathered the global financial cri-sis relatively well. Canadian financial institutions were notunscathed by the financial crisis, but none was excessivelyimpacted by toxic assets, no public funds were injected intofinancial institutions, Canadian banks remained profitableand dividend-paying and, importantly, they continued tolend. Interestingly, in the halcyon years before the financialcrisis, Canadian practices were often criticized in New York

and London as being too conservative, too prudent and toounwelcoming of the new financial innovations sweepingglobal balance sheets.

The sharp contrast between the Canadian experienceand how differently the financial crisis impacted the US, theUK and much of Europe reflects different regulatory regimes,as well as different corporate governance systems, financialinstitution lending practices and different structures.

O n the regulatory side, Canada has integrated regula-tion of banks, insurance companies and large invest-

ment dealers. The Office of the Superintendent ofFinancial Institutions (OSFI), Canada’s regulator, meetsregularly with the management of the largest financialinstitutions and their boards of directors to ensure thatthey are governed to be sound and stable. In the bankingsector, Canada allows securities firms to be bank-owned(and the largest are), and the OSFI regulates the banks ona consolidated basis (retail, commercial, investment andwealth activities) worldwide, in contrast to the regulatorysilos of the United States. The Canadian regulatoryapproach is both prescriptive and principles-based. Thiscombination put the onus on a financial institution toassure itself that it has met the intent of the legislature inaddition to what is explicitly prescribed.

AVOIDING THE FINANCIALCRISIS: LESSONS FROMCANADAKevin Lynch

Canada, rather uniquely among major industrialized countries, weathered the globalfinancial crisis relatively well. As the G20 countries grapple with how best toproceed with financial reform, there are important lessons to be drawn from theCanadian experience, and why the Canadian system worked. Going forward,Contributing Writer Kevin Lynch observed, “the risk is that the urgency andcohesion of 2009 could give way to complacency as the recovery strengthens andpolicy divisions among countries reassert themselves.”

Par rapport à l’ensemble des pays industrialisés, le Canada a relativement biensurvécu à la crise financière mondiale. Tandis que les pays du G20 s’apprêtent àexplorer les meilleures pistes de réforme financière, d’importantes leçons méritentd’être tirées de l’expérience de notre pays et des raisons de l’efficacité de sonsystème, et c’est ce à quoi s’attache Kevin Lynch dans cet article. Avec une mise engarde : dans la période à venir, le sentiment d’urgence et la cohésion de 2009risquent de faire place à une baisse de vigilance à mesure que se renforcera lareprise et que resurgiront les divisions politiques entre nations.

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However, there remain areas ofthe financial services sector that fallunder provincial regulation and,given both the inefficiency of 13 reg-ulators in a market the size of Canadaand the risk of regulatory gaps andarbitrage as highlighted by the finan-cial crisis, many believe structuralchanges are needed to make theCanadian system even safer and more

efficient. The federal government ismoving forward with a proposal toestablish a national securities regula-tor to ensure comprehensive andconsistent coverage of financial mar-ket activities.

With respect to how they use theirbalance sheets, Canadian financialinstitutions were less highly leveragedthan their international peers in theprecrisis period. This reflected the factthat Canada has a regulatory cap onleverage at an asset-to-capital ratio of20 to 1. As a result, major Canadianbanks had an average asset-to-capitalmultiple of 18 in 2008, while the com-parable figure for many US banks wasover 25, and numerous Europeanbanks were well over 30.

A key asset class that fuelled theglobal financial crisis was subprimemortgages. The vast majority ofCanadian mortgages are originated bybanks to hold, thereby providing a“front-line” incentive to not lendwhere there is a high risk of default; inthe US, the majority were originated tosell. In Canada, this practice is furtherbuttressed by government regulationsthat require insurance for high-ratiomortgages and impose high creditstandards on the eligibility for mort-gage insurance. Interestingly, notwith-standing Canada’s more stringentcreditworthiness system for mortgagesand the absence of tax expendituresfor mortgage payments, home owner-

ship levels are slightly higher inCanada than in the US.

Capital requirements for Canadianfinancial institutions were above interna-tional standards, and higher than injurisdictions such as the US and the UKbefore the financial crisis. Canadianbanks typically maintained capital abovethese minimum requirements. Further,Canadian banks rely more on depository

funds than on wholesale funding com-pared to banks in many other countries,providing more stability in times of mar-ket volatility. These structural features,which make Canadian banks among themost resilient in the world, are well doc-umented in a recent InternationalMonetary Fund report by Lev Ratnovskiand Rocco Huang.

This financial sector framework hasto be overlaid on a Canadian economythat has strong fundamentals. Thisreflects a decade of sustained govern-ment surpluses, solid corporate balancesheets, low and stable inflation, low netforeign indebtedness (less than that ofthe US), the lowest net government debtas a proportion of GDP among the G7countries and a national pension planthat is actuarially sound even withtoday’s demographics. Taken together,this combination of macroeconomicmanagement, regulatory systems, cor-porate governance structures and bank-ing practices has produced what theWorld Economic Forum rates as thesoundest financial system in the world.

C anada was one of the very fewadvanced Western countries to

avoid the financial crisis, although it,like the rest of the world, was hit withthe ensuing recession. There are manylessons to be drawn from this extraor-dinary crisis for the global economy,and Canadian experience provides use-ful counterfactual insights. The follow-

ing are eight observations on the crisis,and possible lessons and reforms to bedrawn from it.

First, macroeconomic behavioursand microeconomic systems don’texist in splendid isolation from eachother. Prudent long-term fiscal andmonetary policies impact positively onfinancial sectors; conversely, macroeco-nomic policies that contribute to

imbalances will eventuallyinfect financial markets, nomatter how sound the regu-latory systems.

This highlights theimportance of designing andimplementing rigorousmedium-term “exit strate-

gies,” so that the necessary short-termcontracyclical policies do not becomethe source of new global imbalances. Thefaster the recovery, the more rapid thefiscal consolidation should be. It alsohighlights the need for a better earlywarning system for imbalances, includ-ing asset bubbles, both at the nationallevel and for the international system asa whole. Such an early warning systemshould take lessons from the last decade,when too much liquidity led to a franticsearch for yield, real interest rates werebelow sustainable levels and risk was sys-temically underpriced. This decadeshould reasonably expect a return tohigher real interest rates and full pricingof risk.

Second, globalization and the per-vasive interconnections among marketsit has spawned have to be better under-stood. This should inform both thestructure and the operation of regulato-ry systems. It requires getting the“perimeters of regulation” right: theyshould be sufficiently broad to avoidregulatory arbitrage, sufficiently com-prehensive to cover all systemicallyimportant firms, and sufficiently“smart” to allow firms to intermediateefficiently. Further, something as basicas information sharing and better com-munications among regulators, nation-ally and internationally, is essential tobe able to better spot incipient prob-lems, given the degree of complexity ofglobal financial markets.

Avoiding the financial crisis: Lessons from Canada

Canadian financial institutions were not unscathed by thefinancial crisis, but none was excessively impacted by toxicassets, no public funds were injected into financialinstitutions, Canadian banks remained profitable anddividend-paying and, importantly, they continued to lend.

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Third, prudence may be boring,but it pays off, particularly whenviewed over the complete economiccycle. Despite some ill-timed pro-nouncements to the contrary, econom-ic cycles have not been consigned tothe dustbin of history. Regulatory sys-tems and business planning shouldassume economic cycles as the norm,not presume benign economic growth.And they should stress-test accordingly.

T he value and effectiveness of safetynet systems, whether they are

financial system capital requirements oreconomy-wide programs such asemployment insurance or access to basichealth care, have to be evaluated overthe complete business cycle, not just inthe growth phase of a cycle. The very dif-ferent levels of consumer confidence inCanada and in the US through the reces-sion — a recession where Canadianunemployment rates were below thoseof the US for the first time in generations— are in part due to the fact that theCanadian safety net cushioned the econ-omy from extreme shocks.

Fourth, while regulatory systemshave to be made more effective, theycan’t be the first line of defence in ourcomplex, decentralized, market-basedsystem. That first line of defence has tobe at the level of the firm, and has to beimbedded in its corporate governancestructures, procedures and values. Sinceincentives to innovate around regula-tory systems are a market reality, thissuggests there needs to be a better bal-ance of principles-based regulation andprescriptive rules, and sim-plicity over complexity inrule setting. Regulatory sys-tems have to put more onuson firms and their boards ofdirectors to manage for safe-ty and soundness as principles, in addi-tion to meeting the requiredprescriptive rules. This is the regulatoryequivalent of general anti-avoidancelegislation in the tax system.

Fifth, better and smarter regula-tion, not simply more regulation, iswhat financial reform should focus on.New regulations should aim first and

foremost to remove the weaknesses thatmost contributed to the crisis. Policy-makers need to be wary of building toomuch complexity into the reforms;sometimes simple rules are most effec-tive. The Canadian leverage ratio limitof 20 to 1 on a consolidated enterprise,without complex carve-outs, was bothsimple and effective. Indeed, if the pur-pose of policy is to change behaviour, ithas to be reasonably clear and certain toachieve its objective.

Sixth, financial sector reform needsto increase the quantity and quality ofcapital that financial institutions arerequired to hold, and there is little dis-agreement with this in principle,although there is much debate aboutwhat the optimal capital levels might be.But it also needs to address the problemof procyclicality, and build cyclicalityexplicitly into the regulatory framework.

Procyclicality, which is a feature ofcurrent regulatory systems, effectivelyrequires more capital in downturnswhen you actually could use the capitalbuffer you have established against justsuch rainy days. This can lead to delever-aging, which exacerbates the economiccycle. The solution, which is easier intheory than in practice, is to take a com-plete-cycle view of appropriate averagelevels of regulatory capital, and allowadditional capital accumulation duringthe expansion phase that can be drawndown during the contraction phase ofthe cycle. As in the implementation ofall theories, the devil is in the details.

Seventh, there is much considerationbeing given to the twin challenges of sys-

temic risk and moral hazard. These arenot easy issues. Some argue that the solu-tion to “too big to fail” is to introducemore functional separation in what afinancial institution can or cannot do;others make the case that more consoli-dated management, strengthened regula-tion and greater transparency are a morepractical way to proceed. In seeking the

right balance, policy-makers need to bearin mind that any separation of functionsmay make an institution, but not the sys-tem, less risky depending on where andhow the separated functions are regulat-ed. The paucity of information about, andregulatory oversight on, over-the-countertrading, hedge fund positions and coun-terpart risk concentrations played a rolein the dynamics of the financial crisis.These activities have to be better integrat-ed into the regulatory environment.

Eighth, we need to move to a newand more effective stage of internation-al regulatory cooperation. Whilenational regulatory systems need to bestrengthened, we cannot lose sight ofhow integrated the global financial sys-tem is, something that became shock-ingly evident during the crisis. Thispoints to the necessity of regulatoryreforms that are consistent across themajor economies to the extent possible,lest incentives for regulatory arbitrageor regulatory black holes are createdanew. The reformed system also needsto balance national sovereignty andinternational coordination. All systemi-cally important economies need to befully engaged, and there needs to bereal and rigorous peer review of theirsystems and mutual assessment of theirmacroeconomic policies and the poten-tial to contribute to global imbalances.

Now more than ever, markets andconsumers want signs of concreteprogress, and financial institutions wantcertainty about the reformed systemand its rules. Protracted and divisivedebates about fundamentally different

regulatory approaches will not restoretrust and rebuild confidence.

The financial crisis made self-evi-dent the necessity for reform of nationalfinancial systems, particularly in the USand the UK; the requirement for greaterharmonization across national financialsystems in a world of pervasive globaliza-tion; and the need for more effective

Kevin Lynch

Prudence may be boring, but it pays off, particularly whenviewed over the complete economic cycle. Despite some ill-timed pronouncements to the contrary, economic cycles havenot been consigned to the dustbin of history.

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international cooperation. More funda-mentally, global reform has to rebuildtrust in the financial system, in financialinstitutions and in financial regulation.

The G20 took the lead in organizingthe international response to the globalfinancial crisis in a series of pivotal meet-ings in Washington, London andPittsburgh. The Washington G20 sum-mit in November 2008 created the con-sensus for large fiscal stimulus packagesand unprecedented monetary policyinterventions. The April G20 2009 sum-mit began to lay out the framework forfinancial sector reform and establishedthe Financial Stability Board, with amore inclusive membership (all G20countries) and a broader mandate. At thePittsburgh summit in September 2009,the G20 leaders made several far-reach-ing governance decisions.

They designated the G20 as the keyforum for international economic cooper-ation, with all the responsibilities, chal-lenges and expectations that entails.Beyond that, they set out an ambitiousagenda for strengthening the internation-al financial regulatory system and mod-ernizing the Bretton Woods institutions.

The reforms agreed to at the threeG20 summits are solid steps forward.They include consolidated regulation,caps on leverage, more and higher-quality capital, mutual assessments ofnational systems, governance reformsto make international cooperationmore effective and the reinvigoratedFinancial Stability Board.

As this complex internationalprocess unfolds over the comingmonths, it will also have to interact withnational proposals for financial sectorreform coming forward in the UnitedStates (the Restoring American FinancialStability Act in the Senate and the WallStreet Reform and Consumer Protection Actin the House), the European Union, theUK and elsewhere.

T he risk in all this is that theurgency and cohesion of 2009

could give way to complacency as therecovery strengthens and policy divi-sions among countries reassert them-selves. Neither development would

serve the global economy well. Canada,as both chair of the 2010 G8 summitand co-chair of the G20 summit, hasthe opportunity to play a leadershiprole in an effective reform process.Canada’s unique experience in avoidingthe worst of the financial crisis gives itthe credibility to lead.

The financial crisis was both stun-ningly modern and as old as marketsthemselves. Financial products of amaz-ing complexity were traded 24/7 aroundthe world, but markets were sufferingfrom excess liquidity, asset bubbles,greed and the ascendancy of hope overcommon sense, which is hardly new.Markets are efficient but not alwaysright, as they can only process the avail-able information. Transparent informa-

tion and early warning systems for bothmarket investors and policy-makerswere less than stellar. Regulatory gapsand regulatory arbitrage opportunitieswere evident, as were shortfalls in regu-latory cooperation across nations andeven within certain major countries.

The financial crisis provides theimpetus to learn from what wentwrong, and to introduce reforms thatwill make such crises less likely andless traumatic in the future. It will beimportant to learn these lessons well.

Contributing Writer Kevin Lynch is Vice-Chair of BMO Financial Group. He is theformer Clerk of the Privy Council andhead of the public service as well asdeputy minister of finance and industry.

Avoiding the financial crisis: Lessons from Canada

The bank towers of downtown Toronto, a symbol of the strength of Canada’s commercialbanks, and in the recent financial turmoil, their stability. A model for other countries to look

at, writes Kevin Lynch.

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