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Remarks by A. Michael Andrews to the
Annual Meeting of the
Canadian Financial Services Insolvency Protection Forum
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.
ten years I’ve had the opportunity to try to understand markets
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.
first visit to
of you may
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.
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
appear in the
became apparent in the second half of June. Bear Stearns
losses in two of its hedge funds that had invested in sub-prime
Other funds, including some in Europe and
rating agencies downgraded some sub-prime mortgage backed
related collateralized debt obligations. In early August, BNP
withdrawals from funds that had invested in
time, investor concern was spreading to asset backed commercial
broadly. As conduits—the vehicles used to package the underlying
sell the commercial paper—were unable to roll over their
they had to turn to the banks which had provided back-up
Suddenly the banks in Europe and
international background, one thing that seems significant to me
is that the
“credit crunch” has a different character in
from international markets hit
difference is that there is much less concern about the
underlying quality of
Canadian assets, both on the books of the banks and in
paper. Consider that sub-prime mortgage originations in
of comfort is that despite regional variations—housing prices in
have risen more rapidly—overall house prices in
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.
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
is certainly a lot to worry about—the potential that the
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.
gloomiest outlook is for pensions—defined benefit plans are
concentrated in the
sectors being hardest hit by the rising dollar and decreasing
other manufacturing, and forest products.
and caisses populaires are more vulnerable to sectoral and
than banks. The good news in
Which brings me to my final topic for this evening—mitigation strategies that you as compensation funds might consider.
awareness of the compensation schemes is a key mitigation
unfortunately was notable by its absence with respect to
Northern Rock, the
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
for compensation funds around the world arises from the fact
that we have
enjoyed an unprecedented period of robust financial markets and
institutions. I’ve had conversations with senior
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.
can look at
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.
©2013 A. Michael Andrews and Associates Limited
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