Canadian banks still vulnerable to financial shocks: study

Former finance minister Jim Flaherty is gaining praise for how he helped lead Canada through the last major recession, but we might not be as lucky the next time it happens – and it has nothing to do with his recent departure.

While Canada’s regulatory system has been effective in protecting the country from financial shocks, it’s far from immune, argues a recent report from the University of Calgary’s School of Public Policy.

“Each financial crisis is different and future crises are always over the horizon,” writes author John Chant, emeritus professor of economics at Simon Fraser University. “Success in avoiding the brunt of the last crisis does not guarantee that Canadian financial institutions will escape unscathed from the next one.”

He put the onus on Canadian regulators, which he says are too often playing catch up to new innovations impacting the financial sector. What’s more, issues that led to the last crisis, including shadow banks and over-the-counter derivatives, have yet to be resolved.

“The success of international efforts to reverse ‘too big to fail’ by allowing troubled financial institutions to fail safely cannot be assured,” Chant argues.

(“Too big to fail” is a term used to describe the belief that certain financial institutions are so big that letting them collapse would have a devastating impact on the economy, and need government backing to survive. It’s also the name of a book written by Andrew Ross Sorkin to describe the events of the 2008 financial crisis in the U.S.)

Chant calls on regulators to strengthen policies that will ensure big banks and insurance companies are “too safe to fail.”

The paper was released days before Flaherty announced he was retiring, and was replaced Wednesday by former natural resources minister Joe Oliver.

It will now be up to Oliver to ensure the country’s finances remain on track and achieve the balanced budget his Conservative government promised before Canadians are expected to heads to the polls in 2015.

Part of the gig will be working with regulators to maintain the stability of financial systems. Chant says there’s much room for improvement.

“The class, as a whole, has spent too much attention on how to pick up the pieces of financial failures and not enough on how to prevent this breakage in the first place,” he writes. “Financial institutions need to be regulated and supervised in a way that makes failure a remote possibility.”

He recommends regulators reduce the need for rescue measures in three ways: limiting activities of financial institutions; caping the overall size of institutions and making them safer.

According to Chant, it’s largely about maintaining consumer confidence in the system, which he sees as crucial.

“If this confidence breaks down, the business of these institutions will be put at risk,” he writes.

What’s the worst-case scenario look like? For banks, a loss in confidence will cause depositors and short-term creditors rush to withdraw their funds, similar to what we’ve seen in places such as Cyprus. “Given their dependence on short-term funding, banks can collapse quickly, even if they could be fundamentally sound in the long run,” he says.

For insurance companies it would be a longer, drawn out death as they draw in less business and premium revenues shrink.

Insurance funds would see a more orderly reduction, given that investors are entitled to a portion of the fund’s assets and not a fixed payment, he notes.

“Runs could happen, however, if customers suspect fraud through the diversion of assets, such as schemes linked to the names of Ponzi, Cornfeld, Madoff and in Canada, Portus,” Chant writes.

It all sounds far-fetched as the markets trade near record highs, banks post record profits and pension funds are more flush than they have been in years.

Of course, this is how it also looked before the financial crisis struck in 2008-09.