We may trumpet to the rest of the world about how sound our banking sector is but contrary to popular belief, Canada is not immune to the banking problems we see abroad, warns a recently released report.
In "No More Swimming Naked — The Need for Modesty in Canadian Banking", a report released by the Canadian Centre for Policy Alternatives (CCPA), Wilfrid Laurier University professor Ellen Russell makes the case that Canadian banks are as structurally vulnerable to instability as any elsewhere in the world.
"Canadian bankers and politicians brag a lot about Canada's banks," remarks Russell. "All banks are vulnerable. It's inherent in the way banking is done. The banks are highly leveraged. Anything that diminishes the confidence in the banking system can provoke a run on the banks, which any bank -- whether well-run or not -- will not be able to withstand without government help."
Are financial regulations the answer?
The report also cautions that current regulations governing the financial services industry have not eliminated these problems.
"From my point of view, regulations alone don't do it," she says. "The more severe underlying problem is if banks choose to pursue risky activities, these regulations aren't going to be sufficient if they're intent on exploiting any loophole in those regulations."
To that end, incentives to pursue risky activities have grown since the 2008 financial crisis, when it became obvious that very large banks are "too big to fail", Russell says. Since governments have no alternative but to support large banks when systemic stability is threatened, this additional security "creates a perverse incentive for banks" to increase their appetite for risk.
Maura Drew-Lytle, spokesperson for the Canadian Bankers Association in Toronto, agrees that no country or banking industry is immune to adverse global economic developments, such as the developments we're seeing now in Europe.
But of the CCPA report, she says it gives the impression that, because the Canadian banks did not have the same difficulties during the global financial crisis that other banks had, they are resting on their laurels. "This is not the case at all," Drew-Lytle says.
She highlights that the Canadian banking system is subject to prudential regulation and supervision by the Office of the Superintendent of Financial Institutions (OSFI), one of the most highly regarded regulators in the world.
"Canadian banks have sound risk management systems and practices in place, which were tested and proved successful during the global financial crisis of 2008-2009 and continue to be proven today," she tells Yahoo! Canada Finance. "Part of the reason that the Canadian banks weathered the global financial crisis so much better than banks in other parts of the world is that they are, and continue to be, well-managed, well-regulated and well-capitalized."
Canadian banks constantly monitor the possible international and domestic challenges and will change their risk management practices to avoid difficulties and take other steps that they feel are necessary. They also perform regular "stress-tests" to ensure that they aren't taking on too much risk in the changing environment.
"All this has contributed to the World Economic Forum naming the Canadian banking system as the strongest in the world for four years in a row," she adds.
Some in the banking industry believe we've entered a new era of slower growth, caution, and smaller investment deals. For example, CIBC's CEO Gerry McCaughey was recently quoted stating that, "financial services are no longer a growth industry". Russell scoffs at the notion that the big banks have learned a lesson that will ensure a financial meltdown will never happen again.
"I see a cycle. After a financial crisis like 2008 and during difficulties like the one in Europe at the moment, banks are always eager to say 'we learned our lesson, we'll be much more conscious from here on out' and in fact they can be quite cautious when they're worried," she says. "The problem happens when memories fade over the last financial crisis and overconfidence grows. Then banks begin reevaluating that cautious approach … in the heat of the moment, they're always well-behaved."
Drew-Lytle says steps are being taken by the banks and their regulators to avoid the difficulties seen in other countries during the global financial crisis.
"The Canadian banking system is currently undergoing the largest regulatory implementation exercise in its history. These regulatory initiatives include: Basel III capital and liquidity requirements, recovery and resolution plans (RRPs), a comprehensive review of capital requirements for the trading book (financial instruments), and new mortgage underwriting guidelines," she explains.
"The opportunity for Canada through the current process of international reforms is to ensure that our banks retain their reputation, and their position, as being the strongest and soundest in the world."
Systemic change needed in the industry
But the CCPA report recommends systematic change. It adds that if banks were compelled to return to more traditional roles, they'd be deprived of the temptation to gamble on speculative financial activities.
"Banks owe a debt to the public because the government has their backs in a crisis," Russell says. "We're entitled to put more requirements on banks than we currently do because in a really bad situation, (the public) will be left holding the bag."
The CBA's Drew-Lytle says Canadian banks do rely heavily on their more traditional roles such as retail banking and consumer and business lending. As for the CCPA report recommendations, the CBA doesn't agree that Canadian banks should separate their retail banking from other operations.
"One of the strengths of the Canadian banking system is the ability of banks to diversify business lines. Canadian banks conduct business in retail banking, commercial banking, insurance, capital markets, wealth management, etc.," she says. "These activities are regulated and supervised by the OSFI on a consolidated basis. We believe this diversification of business lines to be one of the strengths of the Canadian banking system. Indeed, a domestic Canadian bank has not failed since the removal of the pillars separating the various financial sectors."
Canadians should, and do, continually discuss ways to avoid future financial crises, Drew-Lytle adds. There has been extensive dialogue on these issues between the Canadian banks and the official sector, both domestically through the Department of Finance, the Bank of Canada, OSFI, the Canada Deposit Insurance Corp., and globally via the Financial Stability Board and Basel Committee on Banking Supervision.
"In addition, the federal government undertakes a statutory review of the Bank Act every five years, which it just completed this year," she says. "We believe this dialogue to be extremely helpful."