The Lasting Impact of the Crisis on the Global Financial System

Transcription

1 The Lasting Impact of the Crisis on the Global Financial System Remarks by Superintendent Julie Dickson Office of the Superintendent of Financial Institutions Canada (OSFI) to the Economic Club of Canada Toronto, Ontario September 26, 2011 CHECK AGAINST DELIVERY For additional information contact: Brock Kruger Communications and Consultations

2 Remarks by Superintendent Julie Dickson Office of the Superintendent of Financial Institutions Canada (OSFI) to the Economic Club of Canada Toronto, Ontario September 26, 2011 Introduction The Lasting Impact of the Crisis on the Global Financial System Good morning. I have been seeking a narrative to help describe the global financial crisis that began four years ago and is still being felt: from how these events are changing the way we look at the financial system worldwide, to approaches to help us better anticipate and moderate the impact of future crises. It occurred to me that there are several striking parallels between financial markets and the controversy surrounding concussions in sports. I would not describe myself as a sports fan, but sometimes I catch what is going on before I have time to change the channel! And a topic that I have heard a lot about over the past several months is concussions. What are the parallels between the financial crisis and concussions? I have noticed striking similarities in their vocabularies. According to the Merriam-Webster dictionary, a concussion is a stunning, damaging, or shattering effect from a hard blow, especially: a jarring injury of the brain resulting in disturbance of cerebral function. The Mayo Clinic adds that, effects are usually temporary, but can include problems with headache, concentration, memory, judgment, balance and coordination. Another parallel is that concussions and financial crises are serious events. Recovery is slow and uneven. Over time, we are learning just how very complex and severe both phenomena can be, and both have lingering effects. In my remarks today, I will begin with a brief review of the financial crisis and its impact. Then, I will discuss three topical issues: consumer debt, systemically important financial institutions (often referred to as SIFIs,) and the importance of supervisory oversight. Finally, I will say a few words about the risks of complacency. 1

3 The serious and lingering effects of concussions and financial crises The global financial crisis that began in 2007 and escalated a year later has forced painful adjustments and, as the events of the past summer remind us, recovery is neither quick nor smooth. Processes such as deleveraging by households, firms, and governments cannot be done quickly or without pain. Finding solutions to seemingly intractable problems, such as Europe's sovereign debt crisis, is extremely challenging. Policymakers find themselves in uncharted territory with rarely used tools, such as quantitative easing, that could bear unintended consequences, for reactions are complex and cannot always be anticipated. Of course, financial crises are not new to any of us. Remember the U.S. savings and loans crisis, the Mexican peso crisis, the Asian financial crisis, Long-Term Capital Management, and the dot-com bubble to name just a few. But the recent worldwide financial crisis is in an entirely different league. And recessions that follow financial crises are also more severe than the typical, garden-variety, cyclical recession exactly the situation that we now observe globally. Given the unusual nature of the current situation, predictions about the future course of the world economy are especially difficult to make. What we now know is that the financial crisis like a severe concussion will have lasting effects, and there is no quick fix. Everywhere, economic expectations must be adjusted to reflect a new reality of slower growth, tighter government spending as a result of sovereign debt levels, and constrained consumer spending. This is the new normal and it is not nice especially for the unemployed, investors saving for retirement, and people living in countries undergoing huge structural adjustments. It is also the new reality in which financial institutions (as well as regulators) must operate. The new reality I will now focus on three particular issues related to this new reality that are now being viewed in a new light: consumer debt levels and real estate-based lending, SIFIs, and supervision. 2

4 1. Consumer debt and real estate-based lending Let me begin with the issue of consumer debt and lending based on real estate such as mortgage lending and home equity lines of credit. The Governor of the Bank of Canada has warned that consumer debt loads are too high and that Canadians need to understand that eventually, interest rates will go up. The Minister of Finance has intervened three times in the past three years with respect to the insured mortgage market to tighten the rules, including a move earlier this year to reduce amortization periods, increase mandatory down payments, and lower the maximum loan-to-value ratio on refinancing. 1 In parallel, we, at the Office of the Superintendent of Financial Institutions (OSFI), have been very focused on home equity lines of credit, and mortgage lending by institutions both insured and uninsured books. The Financial Stability Board (FSB) the body created by the G-7 and G-20 countries to promote financial stability at the international level is also focusing on this type of lending, and developing principles for what constitutes safe mortgage lending. These principles would cover such areas as down payments, income verification, loan-to-value ratios, and so on. This work is being done because the global crisis showed that the consequences of weak underwriting practices in one country can be transferred globally through securitization. And individual countries have seen once again that imprudent mortgage lending and imprudent home equity lines of credit can cause major problems. With regard to North America, recent economic developments, as well as the U.S. Federal Reserve Board s decision to maintain current interest rates until 2013 reinforce the view (in both Canada and the US) that extremely low rates will be with us for even longer than envisaged before the summer. This has likely increased the incentive for consumers again to borrow. Banks also have an incentive to lend, given low margins and the need to compete. 1 J. Flaherty, Minister of Finance speech to the International Insurance Society. 20 June

5 The message from OSFI to financial institutions is that current levels of interest rates have already made borrowing extremely attractive to all borrowers. Further, institutions should guard against loosening historical underwriting standards for example, by moving to higher loan-to-value ratios or waiving any due diligence requirements. As well, institutions should focus on controls around this activity more so than they have historically, because of the behaviours created by abnormally low interest rates. 2. Global Systemically Important Financial Institutions I will now turn to Global Systemically Important Financial Institutions (also referred to as G-SIFIs.) Assessing the risks associated with global systemically important financial institutions, as well as finding solutions for concerns around this issue, is not a simple matter. The sheer size, complexity, and interconnectedness of these institutions mean that a disorderly failure could cause serious disruption to the wider global financial system and to economic activity. 2 There are some who strenuously argue that these institutions should be broken up into smaller enterprises, whose actions or failures would have less impact on the overall stability of the global financial system. The Financial Stability Board is suggesting a different approach. After considering the options, the FSB suggests the best solution is to impose a capital surcharge on such very large banks, while focusing on how to deal with such banks if they were to get into trouble. The FSB is also considering whether it should make public a list of global systemically important institutions that will be subject to a capital surcharge. Some note that there is no good way to avoid a public list because investors need to know what capital requirements are being imposed on institutions. Others point out that such a list could, in fact, worsen matters by generating moral hazard. That is, if markets assume that the designated institutions have been deemed systemically important to the world financial system, they may also assume such institutions are safe havens for investors and others who would be protected in the event of their failure. 2 Financial Stability Board. Reducing the moral hazard posed by systemically important financial institutions: FSB Recommendations and Time Lines. 20 October

6 To counter the risk of moral hazard, the FSB has been clear that institutions must be allowed to fail. If they are kept open by governments because of their systemic importance, then their management, shareholders, and investors must bear consequences as part of that arrangement. This is why the Basel Committee (and the FSB) have agreed that all non-common forms of bank capital have to be issued in the form of contingent capital, which may be written off or converted to common stock, as necessary, to prevent the issuer from becoming insolvent. Thus, contingent capital allows governments to impose costs on those responsible. It is also why the FSB is placing a high priority on living wills. Living wills require institutions to have detailed plans covering how they would deal with a crisis, and require regulators to have a detailed plan covering how an institution could be resolved in an orderly fashion if it were determined to be non-viable. This is a very sensible approach because it makes it more likely that if a serious problem were to arise, a solution would be found without resorting to a taxpayer-funded government bailout. Institutions and agencies of the federal government, including OSFI, the Canada Deposit Insurance Corporation, the Bank of Canada, and the federal Department of Finance, are currently focused on the issue of living wills (with CDIC being the lead on the part of living wills focused on how to deal with a failed institution in the least disruptive way.) This is a new activity started since the financial crisis began, and although it is time-consuming work for both institutions and the government sector, it is necessary work. This two-pronged plan of capital surcharges and a focus on resolution is shaped by our understanding of incentives, and how they drive behaviour. I suspect that this plan will continue to be debated by many. Designing policies that will create the right incentives as well as make sense is always a challenge. Hockey provides an interesting example of how difficult it is to design policies. A colleague suggests the following as an appropriate way to discourage dangerous behaviour: if one player's hit leaves an opposing player with a concussion, the offender's suspension should match that of the injured player even to the point where causing a careerending injury would mean the end of both players' careers. 5

7 Whether such an incentive-based policy for professional hockey which is certainly at the far end of the spectrum is the right policy is debatable and involves much discussion of the costs and benefits. The same is true of policy options in the financial sector. Identifying the pros and cons of policy proposals and coming to a judgement is the challenge and not an easy challenge, especially in a global context, and especially in an area such as systemically important financial institutions. 3. Supervision The third issue I want to discuss is the importance of supervision. Ignoring supervision would be like creating a new rule book for hockey, but taking the referees out of the game and having players themselves decide when the whistle should be blown and who to send to the penalty box. In analyzing the failures that led to the global financial crisis, gaps in supervisory quality were evident across the member countries of the G-20. These gaps remain evident. The FSB has recognized supervision as an important area that must be dealt with, and will be issuing a new report on the state of supervision in the autumn. In the meantime, both financial institutions and regulators must ensure adequate resources are assigned so that everyone can properly do their jobs. Where necessary, supervisory agencies around the world must address resource issues, and must have the powers to act, along with mandates that provide an incentive to act. Supervisors would not tolerate banks operating businesses without the right people, and we cannot accept situations where supervisory agencies themselves do not have the resources they need to oversee such activities effectively. OSFI has fortunately been able to recruit talented resources over the years. Regulatory policymakers must also recognize that capital rules are only effective if they are accompanied by enhanced supervision. Some people seem surprised to learn that risk-weighted assets (RWAs), which are calculated by different banks on the same assets, could yield different results. Yet this should not be a surprise. It is why day-today supervision is so important, as such intense scrutiny reveals what banks are actually doing. Too many people are advocating increased capital as the cure-all, but it is not an effective treatment if it is not accompanied by enhanced supervision. 6

8 Complacency At the outset of my remarks, I noted that I would say a few words about complacency. In general, Canadian financial institutions managed risk quite well in the period leading up to the financial crisis, and weathered the global storm in good order particularly when compared with many of their international peers. As a result, we, in Canada, have been fortunate that our system has held up well. But as I have said many times before, and will continue to repeat because it is such an important point: We must not become complacent. The new normal that I referred to earlier demands a much greater awareness of risk, and better management of risk, here and around the globe. Canadian financial institutions must continue to invest in their risk controls and systems. In fact, control expectations are rising and spending must follow, particularly on data aggregation. Many financial institutions are responding well; however, there may be a temptation on the part of some, perhaps feeling complacent after surviving the worst of the global crisis, to imagine that improvements in areas such as risk management, governance and information systems are not necessary. They may feel that given their status and strength, they should be allowed more leeway while others catch up to them, in the meantime allowing them even more flexibility to grow and expand. As you might guess, OSFI has not followed that path. We made this very clear earlier this year, for example, announcing that Canadian banks must meet Basel III capital requirements early in the transition period, which starts in January Here again, the parallels with sports concussions are very apt. Consider the response of the hockey community to the intense public spotlight now being shone on the issue of concussions. 3 OSFI Advisory: Non-Viability Contingent Capital. 16 August OSFI Advisory: Treatment of non-qualifying capital instruments 4 February OSFI Letter to industry. "Basel III implementation." 1 February

9 Concussions have been viewed as a part of hockey, known to be a rough and tumble sport, and fans like excitement. Some concussions were accepted as unfortunate byproducts of otherwise great hockey plays. Risk has been part of the sport. But today there is a growing demand for a less violent game. We can say much the same about the world of finance, especially in light of the severity of the global financial crisis. As for Canada, I do not sense that Canadians are seeking a less prudent regulator. At OSFI, guided by our legislated mandate, we are staying the course. Conclusion In Canada, our financial institutions are playing from a position of strength. But we cannot let down our guard; we must continue to work hard at maintaining this enviable position. Our current strength should not be taken for granted it was hard-won and it will be harder to maintain in the future, unless it is improved and supported now. Thank you. 8