Let our banks go - Appeared in the Financial Post

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Appeared in the Financial Post
Banks are increasingly willing to invest in risky assets that offer high returns, warned an assistant superintendent at the Office of the Superintendent of Financial Institutions in a recent speech, raising the risk of another global financial crisis.

If banks are moving in that direction, regulators should not be surprised. Banks need to generate a return on capital, so escalating regulatory costs, including higher regulatory capital and liquidity requirements, will naturally drive banks up the risk curve. A healthy return on capital is not only necessary to satisfy shareholders but regulators as well. For example, OSFI's assessment methodology for banks incorporates profitability, on the basis that earnings absorb normal and expected losses in a given period and provide a source of financial support by contributing to the institution's internal generation of capital and its ability to access capital externally.

The assistant superintendent's remarks suggest that more regulation is the solution. However, this would just perpetuate a cycle where banks keep reacting to higher regulatory costs by moving further up the risk curve. However, one policy change the next federal government can make to strengthen the resilience of Canada's financial sector and reduce the risk of a taxpayer bailout is to review the ownership regime for large Canadian banks and life insurers.

Reviews of ownership restrictions in other sectors, such as telecommunications, were initiated by the Harper government in an effort to find ways to improve access to foreign capital and encourage innovation and competition. The same rationale applies to the financial sector. However, another reason to ease ownership restrictions in the financial sector is to add acquisition by a foreign institution to the options for resolving the failure of a large Canadian bank or insurer.

A classic example of how an acquisition was used as a solution to a failed institution is the takeover of Barings Bank in the United Kingdom by ING. After a rogue trader wiped out the bank's capital in 1995, ING acquired Barings for £1 plus a capital investment of £835-million ($1.3-billion). In contrast to more recent actions by the U.K. government to address failed banks including nationalization, the Barings transaction allowed the bank to continue with no loss to depositors and no cost to taxpayers. The New York Times reported that the only losers in the transaction were subordinated bondholders of Barings' parent company.

Even when the deposit insurer has to provide some support, acquisitions by another financial institution is often the preferred resolution option in order to minimize the insurer's losses. For instance, the U.S. Federal Deposit Insurance Corporation (FDIC), which dealt with 140 failures in 2009, noted in that year's annual report that it is common practice to enter into losssharing agreements to facilitate the acquisition of a failed institution by a healthy one. The FDIC's rationale for entering such transactions is that the shared loss retention is likely to produce a better net recovery than immediate liquidation. At the height of the recent financial turmoil, U.S. authorities exercised moral suasion to facilitate acquisitions of large insolvencies, such as the Bank of America's takeover of Merrill Lynch.

Internationally, politicians and regulators can't stop talking about how taxpayers should never bail out banks in the future. A Financial Stability Board report to the G20 noted that its members should have a resolution framework and other measures to ensure that all financial institutions can be resolved safely, quickly and without destabilizing the financial system and exposing the taxpayer to the risk of loss. In Canada, OSFI is compelling Canadian banks to draw up living wills explaining how operations can be dismantled in the event of failure. It may be useful for banks to identify what steps can be taken to reduce disruptions to payment systems or markets. However, a stepby-step dismantling plan would involve endless assumptions about the extent and nature of the bank's difficulties, market conditions, and the reactions taken by depositors, other creditors, courts and even regulators.

In contrast to living wills, acquisitions have a history as a tool for effective resolution of a troubled institution. However, the Bank Act prohibits anyone taking a controlling interest in a Canadian bank with equity in excess of $8-billion, effectively blocking foreign acquisitions as an option for resolving a major insolvency. A similar prohibition exists for Canada's largest life insurers, except Great-West Life. Only mergers of equals can take place under current legislation.

Regrettably, regulators have ambitions to designate larger banks as systemically important and impose extra regulatory requirements on these institutions. In addition to the moral-hazard consequences of signalling to markets that these banks are too big to fail, this will also likely make banks more reluctant to take over insolvent institutions, even when that takeover is the best solution for taxpayers and will enhance the solvency of the acquirer through the diversification of its risks and earnings. Nevertheless, the possibility that a foreign institution may be willing to take over a troubled Canadian bank or insurer cannot be ruled out and Canadian legislation should be amended to permit these transactions.

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