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Remarks by A. Michael Andrews to the

 

Annual Meeting of the

Canadian Financial Services Insolvency Protection Forum

Ottawa—October 25, 2007

 

 

Thank you and good evening—it is a pleasure to be here.

 

When Andy and Guy invited me to speak tonight, they suggested some issues I might address in my remarks:

 

Given developments since late spring, these topics are certainly timely for this audience. Despite the temptation to explore at length some of my favourite topics, I will touch very selectively on the issues rather than trying to cover the entire waterfront. My first draft of this speech was far too ambitious—I would have kept you here until midnight.

 

Let me start by suggesting that the risks inherent in the financial system today are pretty much the same as they were six months or a year ago—but today we may be more aware and hopefully better understand some of those risks. Let me also foreshadow my conclusion. With the risks still the same, you should not be too surprised if my suggestions for mitigation strategies sound pretty familiar.

 

Over the last ten years I’ve had the opportunity to try to understand markets and institutions in countries around the world, and if I have learned one thing, it is that there is always a lot more than initially meets the eye. During my first visit to Nigeria for the International Monetary Fund, I was responsible for assessing the performance of the Nigeria Deposit Insurance Corporation, which I found to be a surprisingly professional organization. One of the most remarkable things was the success in dealing with 33 banks closed in the early 1990s—not only had the Corporation recovered enough to recoup all the payments to insured depositors, in most cases it had also been able to pay the claims of uninsured depositors and other creditors.

 

Some of you may recall that Nigeria in the early 1990s was a military dictatorship. When banks began to fail, the President, quite correctly, thought that a major cause was dishonest owners who had absconded with depositors’ funds. One thing about being a dictator—if you wake up in the morning and decide to set up something called the Failed Banks Tribunal, it is operational by that evening. Troops started picking up the shareholders of failed banks to take them before this military tribunal. When the first few shareholders emerged from the tribunal proceedings—I’m told it was a pretty harrowing experience and some were missing a few body parts—a strange thing started to happen. Shareholders in other failed banks began to queue at the Corporation offices, pleading for an opportunity to make restitution.

 

There is a simple point to this story—the Nigeria Deposit Insurance Corporation was surprisingly professional, but that alone was not a full picture of its remarkable record.

 

It seems to me there are a few things overlooked by some market participants that could have provided a better picture of the risks in the burgeoning structured credit market before recent events brought them so sharply into focus.

 

A lot has happened over the last few months—it may be helpful to just briefly recap the international context for the recent turmoil. The proximate cause was cracks starting to appear in the U.S. sub-prime mortgage market. Sub-prime delinquencies had been stable around 10 percent in 2004 and the first half of 2005, but then began to climb in the second half of 2005, reaching 15 percent in the first half of this year.

 

Contagion first became apparent in the second half of June. Bear Stearns announced significant losses in two of its hedge funds that had invested in sub-prime related debt. Other funds, including some in Europe and Australia, also announced losses and started to freeze redemptions. Some of these funds were using the asset-backed securities as collateral for further borrowing, which meant that as the value of the securities fell, the funds were required to provide additional collateral or repay the loans—a classic margin call. Seeing the risk of further loss as funds had to sell at fire-sale prices, investors in many hedge funds and mutual funds ran for the exits, putting prices and liquidity into a downward spiral.

 

In mid-July rating agencies downgraded some sub-prime mortgage backed securities and related collateralized debt obligations. In early August, BNP Paribas suspended withdrawals from funds that had invested in U.S. sub-prime related debt, saying it was no longer possible to value the underlying exposures.

 

At the same time, investor concern was spreading to asset backed commercial paper more broadly. As conduits—the vehicles used to package the underlying assets and sell the commercial paper—were unable to roll over their maturing securities, they had to turn to the banks which had provided back-up liquidity facilities. Suddenly the banks in Europe and America were themselves squeezed for liquidity, which triggered intervention by central banks, including expanding the range of acceptable collateral to facilitate injecting more liquidity into the financial system.

 

Against the international background, one thing that seems significant to me is that the “credit crunch” has a different character in Canada than in the U.S. or Europe. On reflection, it is easy to identify some reasons why.

 

The contagion from international markets hit Canada in August when the asset-backed commercial paper market dried up, but the impact for banks was much less severe. One reason is that the standby credit facilities extended by banks to conduits in Canada did not actually commit the banks to provide liquidity. Thus, most of the pain has not been inflicted on Canadian banks, but rather on non-bank investors, who likely never considered that instruments rated highly by Dominion Bond Rating Service (DBRS) would suddenly become illiquid and go into default. The Montreal agreement and some repurchases notwithstanding, the Canadian banks appear to have their capital and liquidity pretty much intact.

 

A second difference is that there is much less concern about the underlying quality of Canadian assets, both on the books of the banks and in asset-backed commercial paper. Consider that sub-prime mortgage originations in Canada were about six percent of the total in 2006, versus almost 25 percent in the United States, about 12 percent in Australia and eight percent in the UK.

 

A further source of comfort is that despite regional variations—housing prices in Western Canada have risen more rapidly—overall house prices in Canada have risen only 65 percent over the last 10 years, in sharp contrast to the U.S. and Australia at 103 and 149 percent respectively, and over 200 percent in England. This makes the twin spectres of a housing bubble and sharp rise in defaults less ominous in Canada than elsewhere.  

 

I said a moment ago that the direct impact for Canadian banks was minimal. Undoubtedly, details of more losses will come to light, and I’m sure that many investors holding now illiquid paper of indeterminate value will disagree about the magnitude of the impact. However, bank runs, plunging profits and institutional failures don’t really seem to be on the horizon. Some of you will have noted that the takeover of Credit Union Central of Ontario by BC Central has been deferred, reportedly due to difficulties in valuing assets. So, I certainly don’t discount the possibility we may learn that some institutions—hopefully not too many insurance companies—are paying a high price for having been chasing yield, but overall the financial sector still looks pretty sound.

 

There will, however, be lots of indirect fallout. One of the big things will be capital adequacy. The reservations that many supervisors have had about capital adequacy models developed during an extended period of financial stability, which have long been whispered in the hallways during Basel Committee meetings, are now being spoken out loud.

 

Similarly, reservations about valuing financial assets, particularly complex instruments lacking liquid markets and thus “marked-to-model” are now at the forefront of discussions.

 

It’s too soon to predict specifics, but I will go out on a limb and say we are likely to see some unscheduled tweaking of Basel II. The Basel Committee’s October 9 update discloses a new initiative to establish standards for banks to hold capital against the default risk associated with “complex, less liquid credit products in the trading book.” To me, that sounds an awful lot like “we don’t trust your models any more, so we are going to set some standards rather than let you tell us how risky these things are.”

The reputation of DBRS has been damaged—it remains to be seen how badly. Other rating agencies are not unscathed—downgrades in July may be seen by some as confirmation that ratings are a good lagging indicator of financial distress. However, only DBRS was putting its stamp of approval on issues by Canadian conduits lacking the committed back-up liquidity lines standard in other markets.  

 

We are clearly in a transition period where risk is being re-priced. Companies and consumers will pay more to borrow, and investors will be less tempted, at least for a while, to buy exotic instruments in pursuit of yield. Higher costs of credit will be a damper on domestic demand, but last week the Bank of Canada suggested that the impact will be small—about the same as a one-quarter percent increase in the Bank rate.

 

This leads me to one of the key questions in the business press—whether the credit crunch will trigger an economic slowdown—perhaps by compounding other vulnerabilities. There is certainly a lot to worry about—the potential that the U.S. may slip into recession—that the cracks in the financial sector in Europe and the U.S. are bigger than they appear right now—that growth in China may overheat and collapse, dragging down commodity prices.

 

I wouldn’t presume to suggest that I have any special insights, but I do find it comforting that even after recent downward revisions in forecasts there seems to be broad consensus that Canadian growth will remain solidly above 2 percent for 2008 and perhaps a bit stronger in 2009—fairly stellar performance.

 

This rather sanguine outlook might seem inconsistent with the loss of almost 10,000 manufacturing jobs in September—but the losses in manufacturing are not the whole story. Unemployment at 5.9 percent is at historic low levels, but perhaps more importantly the average hourly wage rate for permanent workers was 4.1 percent higher in September than a year earlier.

 

Why is this important? It suggests that the service economy is creating new well-paid jobs faster than the manufacturing sector is shedding them. Sure, some of the jobs are part-time burger-flippers, but with overall wages increasing despite the loss of high-paid manufacturing jobs, there are clearly lots of good jobs being created as well. This is not much consolation to autoworkers or furniture makers or paper-mill employees—it is going to be a difficult transition for those without the education and skills now in demand. But, for the economy as a whole, it suggests that domestic demand will continue to be strong.

 

The recent strength of the dollar will be an ongoing challenge for the manufacturing sector, and also squeezes sectors dependent on commodity prices—oil and gas, mining and agriculture—since world prices are still set in US dollars, while Canadian producers incur Canadian dollar costs. One benefit, however, is that Canadian consumers and manufactures have been insulated to a large extent from commodity price increases—for example, oil at 90 dollars a barrel sounds pretty scary. For US consumers it has meant a 20 percent increase in retail gasoline prices between January 1 and October 15 this year. You and I, by comparison, are getting a real deal because the price we were paying at the pump on October 15 was only about 5 and a half percent above January 1 prices, and is still lower than when oil surged above 60 dollars a barrel in the summer of 2005.   

 

Continued strong domestic demand and some insulation from world commodity prices is good news for the financial sector overall, but the unevenness of economic performance suggests some potential trouble spots for supervisory authorities and compensation funds.

 

Perhaps the gloomiest outlook is for pensions—defined benefit plans are concentrated in the sectors being hardest hit by the rising dollar and decreasing exports—auto and other manufacturing, and forest products. Ontario is the only Canadian jurisdiction with a pension compensation fund—like its American counterpart, the Ontario Pension Benefits Guarantee Fund has stormy seas ahead.  

 

Credit unions and caisses populaires are more vulnerable to sectoral and regional weaknesses than banks. The good news in Ontario is that many of the industrial-bond credit unions have already been wound-up, merged or become community-based over the last twenty years. The bad news is that some still remain, and the worse news is that regions in Ontario where credit unions are strongest, Northern and Southwestern Ontario, are the hardest hit by cyclical downturn in forest products, and the manufacturing downturn—which is not cyclical, but rather a long-term trend now accelerated by the sharp appreciation of the dollar. Similarly, caisses populaires in Quebec will be dealing with a less favourable economic climate than credit unions in the west.

 

Which brings me to my final topic for this evening—mitigation strategies that you as compensation funds might consider.

 

Raising public awareness of the compensation schemes is a key mitigation strategy, which unfortunately was notable by its absence with respect to Northern Rock, the UK mortgage lender. Deposit insurance, although introduced in the United Kingdom in 1982 and revised in 1995 to meet European Union standards, was not widely known or understood by the British public. There was no track record—the UK had traditionally dealt with bank failures through rescues orchestrated by the Bank of England—and there was no certainty that if Northern Rock failed, depositors would be swiftly compensated. Being deprived of access to your funds can be almost as great a hardship as losing them. As a result, deposit insurance did not mitigate against bank runs in the UK. It took a government guarantee, which everyone clearly understood, to stop the run. The danger now is that the public will continue to expect government to explicitly support institutions under pressure.

 

Another mitigation strategy, if you’ll pardon a military analogy, is keeping your powder dry and being ready to march on a minute’s notice. One of the challenges for compensation funds around the world arises from the fact that we have enjoyed an unprecedented period of robust financial markets and few failing institutions. I’ve had conversations with senior U.S. regulators who are concerned about the FDIC’s capacity to deal with bank failures. Today, most of the people who became experts through practicing on thousands of bank failures in the 1980s and 1990s have retired or left the FDIC and not been replaced, because, to extend the military analogy, a large standing army has nothing to do in peace-time. What I have advised deposit insurers in developing and transition economies will sound familiar to people in this room. Completing the military analogy—you need to have a small professional army, and a mobilization plan to call up the reserves when needed.     

 

Let me now close with a third mitigation strategy—which is closely related to, but not quite the same as raising public awareness—educating politicians and policy advisors. Few people not in the business really understand the purpose and role of compensation funds. Among the small number of people who pay any attention to these issues, the most outspoken groups are academics, many of whom are staunchly opposed to deposit insurance and even more vehemently opposed to compensation funds for purchasers of other financial products. Their arguments are theoretically sound—compensation funds can incite riskier behaviour and remove the incentives for consumers to exercise diligence and discipline firms by voting with their feet.  

 

I believe there are two practical flaws in the arguments against compensation funds. First, the average individual can’t assess the claims paying ability of an insurance company or the likelihood that the caisse populaire will be solvent in five years when the GIC matures, so the idea of mass-market discipline is a bit of a myth. Second, in the absence of a defined and limited compensation scheme there will be political pressure for bailouts, so instead of the market discipline that sophisticated uninsured consumers—the ones with large deposits and insurance policies—might exercise, there may be no market discipline at all without compensation schemes. Even more importantly in my view, if there is no mechanism to ensure that small depositors, investors or policy-holders are protected, it may be politically impossible to execute the prompt closures sometimes necessary to stop the bleeding in insolvent institutions.

 

We can look at Australia as a practical example—deposit insurance and compensation funds have been a political non-starter, in part because of the fears of moral hazard. However, the history is that when banks were in trouble in the 1980s and 90s, they were bailed out by the state governments, and when HIH, the largest general insurer failed in 2001 the federal government stepped in to compensate policy-holders. What is the bigger moral hazard—a limited compensation scheme, or the now well entrenched belief that government will always come to the rescue?

 

So, my final message is to encourage you to continue your work with government policy advisors and elected representatives to make sure they understand how the limited compensation schemes can help depositors, investors and policy-holders, and that this has the side-effect of providing protection for governments and politicians. When your funds are allowed to do the job properly, you provide a means to quickly deal with weak institutions, minimizing the systemic threats and costs to the economy. The protection provided minimizes the political pressure and lets the prudential and market conduct regimes operate the way they are supposed to, maintaining soundness and protecting consumers, while facilitating the exit of weak institutions.    



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