Marshall Auerback: Bank of Canada Governor is Wrong on Too Big To Fail and Wrong on Canada’s Banking System

Yves here. It was very telling, and disappointing, to find out that the Governor of the Bank of England in waiting, Mark Carney, has been critical of the ideas of Andrew Haldane, the executive director of financial stability of the Bank. Haldane has the goods on major banks, and has come up with both colorful and insightful critiques as well as creative solutions. It now becomes clear why George Osborne made this surprising pick: Carney sees nothing wrong with large, universal banks, while the departing Governor, Mervyn King, Haldane, and the head of the soon-to-be-disbanded FSA, Adair Turner, were unified in their desire to cut the mega-banks down to size.

By Marshall Auerback, a portfolio strategist, fellow with the Economists for Peace and Security, and a research associate for the Levy Institute. Cross posted from New Economic Perspectives

As a Canadian, perhaps I should feel a surge of patriotic pride now that Mark Carney has been designated the new head of the Bank of England – quite a step up for the current governor of the Bank of Canada. There is no question that Mr. Carney is a market-savvy guy (he did, after all, work for the vampire squid), and his experiences as Chairman on the Financial Stability Board (FSB) suggests that he is sensitive to the ongoing systemic risks present in our increasingly complex global banking system.

That said, his recent attack on the Bank of England’s Andy Haldane in a Euromoney interview last month, does give one some cause for concern, particularly as it evinces the usual complacency that most Canadians seem to feel about the basic soundness of their own banking system, which essentially upholds the universal banking model as a viable one. By contrast, in his famous “dog and frisbee speech” delivered last August at Jackson Hole, Wyoming, Haldane suggested that: “Regulation of modern finance is almost certainly too complex. That configuration spells trouble… Because complexity generates uncertainty, it requires a regulatory response grounded in simplicity, not complexity.”

In contrast to Andy Haldane, Governor Carney is comfortable with the “universal banking” model, so long as they have sufficient capital buffers and do not put taxpayers at risk. Well, there’s a number of things to be said in response to that. For one, even though Canada’s banks are large within the context of the Canadian economy, their asset size is still relatively paltry in relation to, say, JP Morgan/Chase.

Second, not wanting to put the taxpayers at risk sounds as all-American as baseball and apple pie, much as the new “safeguards” put in place to avoid taxpayer funded bailouts in Dodd-Frank sound great on paper. But in reality, we all know that absent effective anti-fraud regulators, there is only one “shock absorber” that can be used once the looters who head up these institutions have caused the catastrophic failure of an SDI. If Citicorp or, say, Barclays, is insolvent by $400 billion there is only one “shock absorber” that can reduce (1) cascade failures among the counterparties and (2) sending a shock throughout the financial system as investors and creditors realize that there is an enormous bubble (whatever bubble comes next), that asset values are grossly inflated, and that there is widespread fraud covering up losses at many banks. That shock absorber is money — massive amounts of money.

The reality, which politicians and now (it appears) regulators like Mr. Carney, like to assume away, is that most of this money will come from public funds. As long as banks are allowed to be so large that their failure can cause a crisis they will be bailed out. If, like Lehman, they are not bailed out their failure will cause so much damage that the subsequent SDI failures will be bailed out. Hence, the calls by figures such as Andy Haldane to break up the larger banks – a proposal which also appeared to have the backing of current Bank of England Governor Mervyn King, but which appears to be running into opposition from both Mark Carney and the current UK Chancellor of the Exchequer, George Osborne, who indicated: “I want Britain to be the home of big successful banks.”

Carney is staking his credibility and reputation that Basle III – the third global regulatory effort in around two decades – is the world’s best bet to reduce the risk of another global financial meltdown. But in fact, it is loss of the basic simplicity in banking’s traditional credit intermediation role which has played a huge role in creating the odds of another financial Armageddon, even in Canada, the new golden boy as far as banking goes.

In contrast to the suggestions of Mr. Carney (and other Canadian politicians, such as Prime Minister Stephen Harper and his Finance Minister, Jim Flaherty), the Canadian banking system is not as sound as they would have you believe. In fact, both the Canadian banking system and the economy as a whole display many of the pathologies of the US economy, in terms of its increasingly financialised character and the corresponding evolution of its banking system. Consider the following chart (courtesy of Mario Seccareccia “Financialization and the Transformation of Commercial Banking: Understanding the Recent Canadian Experience before and during the International Financial Crisis”)

It has got worse since then. Although different in degree, the Canadian economy has become excessively financialised. The practical disappearance of household saving and the ever growing household indebtedness has fueled the expansion of speculative derivatives because of the demand arising from the growing savings of the non-financial corporate sector. As Seccareccia notes,

owing to the corporate sector’s position as net lender, rentier speculative behaviour (that Keynes had so vehemently criticized in the General Theory) has slowly prevailed in the financial sector and has probably been the largest impetus in pushing this financialization frenzy into hyper drive over the last decade. It is, therefore, in large part due to the growing proportion of corporate saving that has been directed towards speculative ventures in a way that household and even, say, group pension funds would be less likely to do, because of legal restrictions imposed on portfolio managers regarding the risk structure of their portfolio of pension assets.

The reality is that Canada’s banks were “saved by the bell”. The regulatory apparatus established over many years and upheld during the Chretien/Martin Administrations, was gradually being dismantled by the Harper Government, when it came into power in 2006. The traditional view of the Canadian banking industry is that there was a quid pro quo: Canada’s banks were essentially given a protected and profitable oligopoly, the quid pro quo being that the banks would engage in less of the buccaneering type of activities of their US counterparts, if such a profitable environment for traditional banking activities was implicitly guaranteed. Even with that implied guarantee, there were nonetheless sufficient incentives to engage in high stakes mortgaging of the type that resulted in the subprime crisis in the U.S.

According to industry statistics, in 2006 sub-prime mortgages accounted for less than 5 percent of overall outstanding Canadian mortgages, while in the U.S. this figure was 22 percent. However, the oil and commodity price boom and the resulting strong real estate market generated growing demand for looser mortgage lending. Indeed, under pressures to deregulate further the financial markets (in the name of providing competitive financial services under NAFTA), the door was opened wide for the subprime market to move north in May 2006.

As Seccareccia notes:

This was so largely because of the lobbying effort of American International Group (AIG) that recruited the support of some former officials of the federally-owned Canada Mortgage and Housing Corporation (CMHC) who finally succeeded in persuading the federal cabinet to open Canada’s mortgage insurance sector to greater foreign competition. Hence, in 2007 and early 2008, subprime mortgages were rising precipitously in Canada, despite the growing problems south of the border and despite even the formal opposition of the Governor of the Bank of Canada at the time, who feared possible inflationary consequences of this type of credit expansion in the hot Canadian housing market that could then spread to the overall product market, thereby possibly frustrating the Bank of Canada’s own low inflation targeting policy. In a sense, it was the U.S. financial collapse itself in 2008 that actually aborted the process, thereby preventing a home grown subprime problem in Canada. The fact that the federal government offered $125 billion through CMHC to buy up mortgage assets would suggest that there was, indeed, a significant number of such high risk mortgages in the banking sector that have slowly been absorbed by CMHC, a public institution, in 2009, much as Fannie Mae and Freddie Mac in the U.S.

The upshot of all of this is that financial innovations, together with these economies of scale and unlimited securitization, was starting to transform the Canadian banking sector into what some have described as a giant “transaction generating machine” — a securitised model of credit that increases turnover of assets while increasing commissions, fees and bonuses via the trading of complex derivatives – much like its American counterparts. Indeed, facilitated by deregulation, computerization and globalization, this process of financialization has brought about a complete transformation in the source of revenues for the banking sector in Canada. As Seccareccia illustrates:

From as much as 90 percent of total revenues being derived in the early 1990s from the traditional interest rate spreads related to their activities in making loans to creditworthy borrowers, by the 2000s this had gone down to less than 50 percent, with more and more of these bank revenues earned from commissions, administrative and user fees, and other forms of compensation unrelated to their traditional role in providing loans to the public. (our emphasis)

This is the world of Basel III, which Mr. Carney looks set to uphold in his new role at the Bank of England and Chairman of the FSB. It’s all very well to understand complex financial plumbing and make sure it runs with a minimum of leaks and plugs But if the pipes are situated on top of a ticking time bomb, it’s not a skilled financial plumber one requires in a key regulatory position, but an architect with a broader vision required to redesign the entire structure which houses the plumbing. As a supporter of a discredited model of financial intermediation, Mr. Carney, for all his market savvy, is yesterday’s man. Andy Haldane deserves a fairer hearing.

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  1. readerOfTeaLeaves

    Oh, dear.
    Mr. Carney needs to read Bookstaber’s “Demons of Our Own Design”, as well as ECONned (special attention to the Magnetar episode), ASAP.

    I suspect that Mr. Haldane may well have read both, and with close attention.

  2. craazyman

    you are so right Marshall.

    As the true proverb says, “the dog is turned to his own vomit again, and the sow that was washed, to her wallowing in the mire.”

    Although to be precise, this sow was never really washed. Just a few lazy spurts from a hose and a little mud came off and the cleaner went home. That’s it.

    They can’t imagine their cult doesn’t have the blessings of God himself. It’s always like that from the Aztecs on down. before that even, if we’re counting.

    It’s not that it’s hard to understand, but the rationalizations block all ability to understand and become their own perfect hedge against every form of reality. ecce homo.

    somebody must have made it like this just to f–ck with our heads, why that is, is hard to say. maybe some 9th grade science class experiment got loose from a petri dish a long time ago in a galaxy far far away. Voila! From that moment to this, a connection of dots. But no more ludicrous a theory than what these fellows do at the office every day.

    Too bad Mr. Haldane didn’t get the nod. I need to buy some suits and if I could look like him I’d be very pleased. If he was now head of the Bank of England I’d go out tomorrow and get three new ones to celebrate. Three expensive ones even. That’s how happy I would have been and I hate shopping for anything except Spanish wine.

    1. Hypothetical_Taxpayer

      Now I’m confused. I thought Andy was all excited about math modeling the complex system, like derivatives are derivatives or something.

      But really, you don’t think London would ever get out of International Banking do you? Even if they could wear nice suits anyway? What else would they do? Sell fish&chips?

      But it is exciting to hear that AIG is insuring Vancouver real estate. Wonder how much that’ll cost us. Maybe you should buy the suits now, then you can always declare bankruptcy later.

      Does make me wonder how Mr. Carney can be so sure higher capital is all banks need when Basel III keeps getting postponed indefinitly.

      Been wondering for a year now if it’s wise to keep my TD Ameritrade account. Says my cash is an FDIC insured Toronto Dominion Bank account. Not sure how that would work out if things go POOF! again. Thinking about maybe getting a US Bank account – sort of a Too Big To Ignore Bank.

      But anyway, give the suits some more thought, and give a Chilean Red a try too.

      1. craazyman

        they’re all crazy, but some are crazier than others.

        sometimes in life, you have to choose. :) And I don’t mind a nice suit, to be honest.

        I used to drink Concha y Toro when it was $3.29 a bottle!

      2. LucyLulu

        I have one of those FDIC TD accounts too (and a UBS which is set up similarly…… I know…. moving the UBS one is not so simple). I’m not sure how that works as far as if its considered a US or Canadian bank. There are two different entities, one for Canadian banking and one for US banking (with headquarters in Maine), but both are subsidiaries of the same group. As long as the US banking system doesn’t crash along side the Canadian banks, I’d assume FDIC would cover any losses. Or is that not a safe assumption?

        1. JEHR

          Where have you been, LucyLulu. The US banking system has already crashed and the Canadian one won’t be far behind. There is $67 trillion floating around in the shadow banking system. That amount is just what banks owe other banks and all the banks are looking to governments to make good all their derivative debts. I don’t think any banking system is safe and won’t be for a long, long time. Try a credit union.

          1. Birch

            Credit Unions (in BC anyway) are fully insured by their own deposit insurance corporation. I’ve often wondered how and what that is, but it gives me a fuzzy feeling that it isn’t the insurance corp of the big five.

            There are still a bunch of jurisdictions in Canada with no credit unions. And, of course, Canada has no small banks. You have to cozy up to a credit union manager in another jurisdiction so he allows you to open an account anyway.

        2. Hypothetical_Taxpayer

          The pat answer is foreign banks that have subs in the US are regulated by the FDIC, pay into FDIC, and would be covered by FDIC, so no problem.

          It’s just that the combo of broker-foreign parent-housing bubble sounds like an uncomfortable place to be (post MF Global, Lehman corporate looting Brit Lehman sub, Canadian housing bubble) and my first preference would be to avoid the great big sucking sound rather than see if the FDIC works for me :)

  3. Hugh

    London is the Wild West of banking. It was always unlikely that a marshal was going to be chosen who represented the farmers and not the cattle barons.

  4. H. Alexander Ivey

    Let me get this straight. He admits that Basel I drove the financial world off the cliff, but that Basel III will fix the problems. Righttttt…. I don’t think so.

    He, like most mainstream economists, doesn’t understand money or risk. Both are strictly local. Basel and Carney think that money and risk are global, that a US dollar is the same everywhere, worth the same everywhere. It sounds like a gold bug – someone who thinks that something (gold) has intrinsic value. But gold does not have intrinsic value, it has value only in terms of what humans think it has. Value is in the mind of the beholder (same thing with risk).

  5. JEHR

    I am so glad that someone finally saw that the Canadian Emperor has no clothes!!! All that treacly talk about how great the Canadian banks are and we know that the Canadian government bailed out the Canadian banks for between $75 billion and $114 billion and even lied about it (gasp!).

    Our Canadian bailout was even bigger per capita than the TARP bailout. Our banks also fed at the US discount window too. You can’t trust bankers to either tell the truth or do what is right.


    1. Expat

      I totally agree! Lying and smug self-congratulation are Canada’s najor exports under the Harper government.

    2. Patccmoi

      Thanks so much for linking this. I just moved back to Canada after living in the US for a while and I was always looking for more info on how things really are on this side of the border in terms of the banking system because everything sounds so rosy when Harper talks about it, but Harper has shown to be quite the little dictator that gives no damn at all about hiding and distorting truth repeatedly and you just can’t trust his government’s word on anything.

    3. Up

      Bigger per capita than TARP? You say that like it’s some sort of scandal.

      There are less people in Canada than in the U.S. It’s not surprising that a Canadian bank bailout would be larger on a per capita comparison with the U.S. If we assume a Canada pop. of circa 40mill and an America pop. of circa 300mill, then American population exceeds Canadian population by a factor of 7.5.

      There are far less heads to tax in Canada, so the taxing per head (for something like a bailout) will be greater. The per capita comparison you made doesn’t delineate a scandal. A greater per capita bailout burden in Canada is just what one would expect.

      If a Canadian bank bailout is a scandal, the scandal needs to be depicted in some other way.

      1. Birch

        The scandal is that it never made the news in Canada. All we heard about at the time was TARP TARP TARP. Very few people know now that it happened.

      2. Patccmoi

        Per capita comparison is fine… Yes, there is a lot less people in Canada. There’s also a hell of a lot less money in its banks, do you think any bank in Canada has assets (or liabilities) comparable to JP Morgan or Goldman?

        When you compare Canada’s health care cost vs USA (which is something like 2-2.5 times lower), you also do it per capita. If you have a better way of scaling the numbers for the comparison than per capita, please let us know what it is.

        But I also mostly agree with Birch, the real scandal here is mostly that we never even heard about it at all. All the government says is how other countries needed banks to be bailed out while Canada’s banks did so much better. I don’t really care if it’s proportionally slightly more or slightly less than TARP (and then again what value are you going to use for TARP, the official 700B$ or so or the other values that came up like 16T$?), but the fact that they’re acting as if everything was perfectly good for them when they needed just as much bailout proportionally is pretty frustrating.

        1. Up

          Per capita comparison is fine if you want to make it. Do them until the cows come home, if you wish. I didn’t understand JEHR’s tone. As if the per capita Canadian bailout being higher than America’s is somehow surprising or shocking; it is neither. It is just what one would expect, for the reasons I already gave. Let’s get excited when it is appropriate to get excited.

          I too agree with Birch.

          Re: Your healthcare costs analogy.

          When you compare Canada’s health care cost vs USA (which is something like 2-2.5 times lower), you also do it per capita. If you have a better way of scaling the numbers for the comparison than per capita, please let us know what it is.

          A better way of scaling the numbers? Who cares really? A per capita comparison is often a starting point in a broader analysis. It’s the broader analysis that tells a story and shows a picture that should be important to an inquiring citizen. The Mona Lisa’s eyebrows are not important on their own, the picture as a whole is important.

          After an inquiring mind notices the per capita spread in health care costs between America and Canada, they should ask “why”? Not get excited just on the per capita difference; they still need more. What they discover is that Canada funds healthcare through taxes. America funds healthcare through profit driven private firms. The scandal is in the private vs. public financing models. Finding an optimal scaling of numbers wasn’t my point.

          Lastly, it is not incumbent on those who find a fault or make a criticism to have a solution. It is nice to have a solution but it is not a prerequisite for discussion. And some of discussion will involve disagreeing and criticism whether you like it or not. Those who insist that one must have a solution before making a criticism are just engaging in games of control.

  6. Fiver

    Why would anyone have bought into the manufactured myth of Carney’s “competence” or the supposed “superiority” of the Canadian banking system in the first place?

    Not only was the back-door bailout of Canadian banks by the Federal Government via its mortagage insurer (Canadian Housing and Mortgage Corporation) reported back in late 2008, but by early 2009 it was being reported in all the business pages (later verified) that at least 1 Canadian bank would’ve failed. The Bank of Canada, and Carney’s role, in this matter was relatively minor. And yes, he participated with Bernanke, BoE etc., in actions aimed at global “stabilization” (that is, saving banks) but he simply did what he was told by much more powerful institutions.

    Canada is a very big accident waiting to happen. Not only has household debt gone through the roof, but as noted in this piece, corporations, rather than keeping pension plans flush or investing in research or expansion, are engaged in heavy speculation. In addition, many Provincial governments are fiscal basket cases (Ontario, Quebec in particular).

    Worst of all, the bet-the-farm development of the Alberta tar sands has sucked an enormous amount of Canadian capital away from all other lines of productive activities that create far more permanent jobs. As a result, along with historic lows in intereste rates and a very high Canadian dollar caused by oil, housing/real estate now constitutes 17% of the Canadian economy. In other words, the whole country is hocked to the hilt, backed by a resource the further development of which is both ecologically insane and unbelievably risky in that any significant and lengthy decline in the price of oil would now be an economic disaster. Can’t happen, you say?

    Of course it can. What have we learned in the last couple decades if not that what we thought was “given” wasn’t? Just consider, for instance, that all that would be necessary would be for the US to adopt a rational attitude towards Persian Gulf producers. Iraq and Iran have a couple hundred billion barrels of proven reserves of cheap, relatively far cleaner oil. Why on earth would it not make sense to use that cleaner resource as the bridge to an alternative-energy future? Why would Americans prefer to make their own incredibly dangerous bet on ecologically problematic oil shales rather than simply becoming a customer of peaceful Persian Gulf oil producers like everyone else? Are we so very certain we know what is or is not possible politically 5 years hence?

    It should also be understood how poltically divisive oil sands development is in Canada. Prime Minister Harper would clearly see the country split up before he’d relent on further development, even though a large majority of Canadians support it only if it can be done “cleanly”, which it can’t.

    So be very, very careful where you put your money in Canada. The Federal debt is relatively small, and Harper would doubtless shovel a ton a borrowed money at a financial crisis – but absent that huge tar sands bet, and given the household over-leveraging binge, just what Canadian assets would back up some future calamity? Not much that I can see, having destroyed so much of our truly productive base.

  7. Roland

    The meltdown of the Canadian real estate bubble will mean the publicly-guaranteed mortgage insurance scheme will have to bail out the banks.

    The resulting massive hit to government finances will destroy what remains of the Canadian welfare state.

    Carney made good his escape at the right time. Canada’s very own hometown Vampire Squid has made good.

    Carney will spend a few cosy years at the BoE, since Cameron & chumps will take all the blame for the double/triple dip. Then Carney will be ready to move on to the IMF, at which point he will tell Canadians about all the Structural Adjustments they’ll have to make…

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