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The real reason for maintaining artificially low interest rates – and what banks can do


A remarkable (if hard to read) piece from Martin Wolf highlights the underlying reason that artificially low interest rates are essential to prevent “uncontrolled collapse .. mass bankruptcy”

Why we have to live with low interest rates | ft.com – Martin Wolf

The deepest question is whether current policy risks generating huge disturbances in future. As both Ms Altmann and Mr Smithers note, encouraging spending by raising asset prices evidently risks creating another round of what Austrian economists label “malinvestment”. Credit may also surge, once more, generating another round of irresponsible behaviour in the financial sector and ultimately another wave of financial and economic crises, quite possibly in emerging economies. It would be foolish to ignore those evident risks.

Yet it would be just as foolish to ignore the just as pressing present dangers. Today, the UK and a number of other economies, including the US, are both excessively leveraged and have weak financial sectors. The low interest rate policy is designed to prevent an uncontrolled collapse of this mountain of leverage into mass bankruptcy and, instead, allow debt to be paid down and the financial system to return to health more gradually.

Thus, we have to choose between low interest rates on current assets or better returns on what would soon be shrunken assets: with higher rates, house prices would fall further, unemployment would rise, more loans would default and banks would fall back into difficulties. Ms Altmann argues that the bubble economy was partly an illusion. So, then, must be a big part of the financial claims on which savers now depend.

The question becomes whether this approach will prevent such events or will merely introduce delay.

Relevance to Bankwatch:

Martin is as close to the ‘powers that be’ as anyone.  The fact that there is a low interest rate policy indicates that it is temporary in nature with en eventual end.  This is where banks should come in.  When that end occurs obviously interest costs will rise and there will be people in a problem.  Banks if they were smart and thinking about their customers and also their own future bad debts, should be migrating loan products away from credit cards and lines of credit towards amortised loans.  This would take advantage of the low interest environment to pay down debt.  The alternative is to require customers to pay down debt when rates are higher – that hardly sounds like a smart alternative. 

Written by Colin Henderson

December 10, 2010 at 23:44

Ontario Canada is becoming the new California, and not in a good way


Canada continues to be held in high regard throughout the ongoing crisis but the devil lies in the details.  Ontario which represents about 40% of Canadian GDP is beginning to look like Nero … fiddling while Rome burns. 

Even at the Canada level the savings rate is going in the opposite direction of western economies, and adding to debt, ie not saving.  This perplexing environment is hard for Canadian Banks to formulate a credible strategy around.

The Boeckh Investment Letter

While Canada has deservedly had a good ride in recent years particularly through the global recession, due to strong Federal Government finances and a strong balance sheet, all is not quite as rosy as meets the eye. Chart 16 shows that, while the U.S. savings rate has gone from 2% to 6.5% since 2007, the Canadian savings rate, after a brief rally, has collapsed to about 2 1/2%.

Canadian households have continued to add to their debt, oblivious to the changed world environment. House prices rose to new highs during the recovery, while U.S. house prices are down over 30% from their peak.  Moreover, while federal debt levels and trends are good by world standards, provincial debts are disastrous. There is even some talk of Ontario going the way of California. Its per capita public debt is ten times that of California whose bonds are rated slightly less risky than Croatia’s.

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Written by Colin Henderson

August 27, 2010 at 17:27

What makes Canadian Banks different in this crisis? | OECD


This 21 page document reviews the circumstances prior to the crisis of Canadian Banks and other OECD Banks.  The relative abundance of retail deposits (compared to more volatile wholesale deposits)  seems to have been key for the resilience of Canadian banks, supplemented by a risk averse financial culture.

The differences from the summary were as follows – Canadian Banks were:

  1. better capitalised
  2. Capital ratios before the crisis were a key determinant of bank performance
    during the turmoil; and Canadian banks had ample capital

  3. more liquid
  4. Compared to OECD peers, Canadian banks had slightly above-average balance
    sheet liquidity

  5. enjoyed relatively more retail deposits
  6. During a liquidity crisis, access to stable funding is key to survival; Canadian
    banks had a high ratio of retail to wholesale deposits

In addition and as discussed here before, the risk tolerance in Canada is much lower than elsewhere, and this manifests across several areas, highlighted in the report.

7. Regulatory and structural factors contributed to the resilience of Canadian banks by reducing their incentives to take risks. Canadian capital requirements are significantly more stringent than Basel minima (national targets of 7 percent for tier 1 capital and 10 percent for total capital,  versus 4 and 8 percent prescribed by the Basel Accord).

Banks are also subject to a maximum assets-to-total-capital multiple of 20 (corresponding to a leverage ratio of 5 percent). Besides providing an enhanced cushion, stringent capital requirements have beneficial incentive effects: they impede rapid balance sheet growth, restrict wholesale activities, and limit foreign expansion to niches where banks have clear competitive advantage not related to low cost of capital.

Notable structural factors in Canada include high franchise values, a mortgage market characterized by prudent underwriting, and an overall prudent and conservative culture in the financial sector. Limited exposure to U.S. assets was a key additional factor behind the resilience of Canadian banks to the crisis.

Canada: Selected Issues | OECD

Written by Colin Henderson

May 22, 2009 at 20:17

Posted in Bank+of+Canada, Canada

Memo to BofC | Canadian lesson ought to be benefit of early co-operative action – not “it began outside … “


I have to take issue with this statement by the Bank of Canada Deputy Governor made this morning to the House of Commons Standing Committee on Finance.  Without a full and proper understanding of the crisis, how can our leaders be exepcted to appropriately address it.  In particular this is central bank advice to the House of Commons.  Yes a global solution is required, but no it begain inside all countries borders, and here is the Canadian experience followed at this blog.

Opening statement by Pierre Duguay Deputy Governor of the Bank of Canada to the House of Commons Standing Committee on Finance

Because the crisis we are facing is global in nature and began outside our borders, most solutions must be found at the international level. …   I would note that there has been a great deal of interest worldwide in the resilience of Canada’s financial institutions in the face of the global economic crisis. Unlike their counterparts in other major economies, Canadian banks have not been materially affected by the financial crisis.

To state that the global problem began outside our (Canadian) borders is just incorrect.  I imagine his defense of that statement would be to make the point that the sub prime crisis was American. But that statement belies the now understood nature of the problem being derivatives and SIV’s that were assessed in mathematical terms with improper understanding nor accounting for risk.

The global problem of derivatives which are still over $600 trillion exists because those instruments were a result of real assets being dissected into different components and repackaged as new instruments that bore no resemblance of, nor clear line of sight to the original asset.  This is well known now, and to suggest that world market passed Canada by, is disingenuous at best.

All countries had banks participating in the international money market investing in securities they did not understand and Canada is not exempt from that fact.  Back when I started counting the extent of the problem when frankly few acknowledged it publicly (early 2007), Canadian banks were north of $6bn in write offs associated with sub prime and other very high risk investments, such as the 3/4 billion natural gas speculation at BMO.  CIBC though led the way with $3bn of sub prime losses at that point.  In July of 2008 Dundee Securities painted CIBC as a takeover candidate.  I have since lost track of the sub prime losses in Canada, but they have not gone down.

Then there was the Pan Canadian Investments arrangement orchestrated by Purdy Crawford on behalf of the Bank of Canada (yes, the place where Duguay works) and Government of Canada, whereby some $31 Bn in derivatives, involving secondary players in Canada, were removed  from the financial system and sheltered in an arrangement that ensured no immediate demand for payment on the Canadian banking system would occur.  This was a visionary move taking place in 2007, and before the extent of the world crisis was understood.  But those $31 bn do exist, and I believe Canada could have had its own “Lehman Brothers” crisis in 2008 had that action not occurred in 2007, and being wrapped up in January 2009.  Pages 1 & 2 of this pdf prepared by Pan Canadian and hosted on the E&Y site, highlights the direct involvement of the banks, including $21 bn of it relative to CDS (Credit Default Swaps).

So to say Canadian banks were not materially affected is something of a glossing of the facts.  A better approach for the speech would be to focus on Canadas natural conservative tendencies, early action to address problems,  foresight etc.

Canada took conservative and early action to prevent becoming embroiled in the fiasco being played out in US and UK particularly whereby even Lloyds, that bastion of risk adversity is on brink of full government ownership.  With Debt to Equity ratios ranging from the excellent TD at 14 :1 to CIBC at 25 :1 Canadian banks are on average in better shape now than many others around the world, assuming their bad debts allowances are reasonable and assets well valued, however at the lower end care and watchful eyes are required to ensure stability.

All this to say that Canada is not exempt from the roots as well as the woes of the crisis, and there are lessons to be learned from early action, and proactive work between the government, the central bank and the banks’ – lessons that the US could learn, rather than their naturally adverserial approach.  But lets not pretend we are being dragged into someone elses problem and unwillingly help to fix it.

Written by Colin Henderson

March 5, 2009 at 15:39

banking 101 | All banks are vulnerable to runs


This is a fascinating and insightful paper by Willem Buiter and Anne Sibert on the failure of the Icelandic banking system, but with scary parallels to the UK system and others.  In particular though, and of interest to everyone possibly is section 2.1 copied below in full.  It defines the generic vulnerability that all banks’ have to “run a on the bank” even in good times.

Thus the argument goes, accept reality, nationalise the banks, and treat basic banking as a utility, just like water and electricity, until a better model can be developed that would have a better chance of surviving the coming sovereign debt crisis and transitioning into the new economic world that we are facing.

I fear the feeble attempts by heads of state of the western world to address banking and banks’ problems is failing, because banking is not understood.

The Icelandic banking crisis and what to do about it CEPR Policy Insight No. 26

2.1 All banks are vulnerable to runs

There is no such thing as a safe deposit-taking bank on its own, even if its assets are of good quality and it has enough liquid assets to cope with normal variations in the net flow of deposits and other short-term liabilities. The events since August 2007, and in particular the demise of Northern Rock in the United Kingdom and Bear Stearns in the United States, have made it clear that any highly leveraged institution with assets that are mostly long term and illiquid and liabilities that are mostly short term can be subject to a catastrophic liquidity shortage.

In the case of deposit-taking institutions, the canonical liquidity crisis is a bank run. Deposits can be withdrawn on demand and those who wish to withdraw are paid on a first-come, first-served basis. A bank run can occur if it is believed  rightly or wrongly that a bank is balance-sheet-insolvent (with assets worth less than liabilities).  But, as assets are illiquid, a bank run that cripples the bank is always possible, even if the bank is not believed to be balance-sheet insolvent: if each depositor believes that all other depositors are going to withdraw their assets then each depositor’s rational response is to withdraw his own. The outcome a bank  run validates the depositors’ beliefs: it is individually rational, but socially disastrous. The risk of cash-flow insolvency inability to meet one’s obligations including the obligation to redeem deposits on demand for cash is always present when assets are illiquid.

For highly leveraged institutions that fund themselves mainly in the wholesale capital markets, including the asset-backed securities and asset-backed commercial paper markets, an analogous event is  possible: in the belief that other creditors will be unwilling to roll over their loans to a borrower whose obligations are maturing or to purchase the new debt instruments the borrower is issuing, each  creditor finds it optimal to refuse to roll over his own loans or to purchase the new debt instruments the borrower is trying to issue, let alone to extend new credit. As with a classic bank run, this scenario can occur even when the assets of the bank are believed to be sound, if only they could be held to maturity.

Written by Colin Henderson

January 20, 2009 at 22:02

The G20 ought to consider only regulation that assesses the outcome of good and bad decisions


President Bush makes an important point and distinction here [emphasis mine].  The couch economists and newly found supporters of a new President are tempted by talk of new regulation and government control. 

Bush defends free-market system | BBC

Returning to the cause of the credit crunch, Mr Bush admitted that failures had been made "by lenders and borrowers, by financial firms, by governments and independent regulators".

But that the answer was "not to try to reinvent the system".

Instead, he said the solution was to "fix the problems we face, make the reforms we need, and move forward with the free market principles that have delivered prosperity and hope to people around the world".

He added that while capitalism was "not perfect", it was "by far the most efficient and just way of structuring an economy".

"It would a terrible mistake to allow a few months of crisis to undermine 60 years of success," said President Bush.

Clearly there are issues that caused the current problem, and the first paragraph is one I have discussed frequently here.  The lack of transparency, in the orchestration of securitised mortgages as they are converted into ABCP is certainly at the core of the issue here.  Whether regulation, control, bank audits, new financial alternatives – this must be fixed.  But if we think about it, new regulation on that would only serve to protect banks from purchasing securities that they did not understand.

Huh?

Did I just understand what I just said.  We need protect banks from themselves and their own uninformed decisions?

This is why the notion of regulation is hard. 

Relevance to Bankwatch:

The nature of the regulation that what the G20 ought to consider this weekend is regulation that assesses the outcome of good and bad decisions, rather than attempt to regulate markets, and their processes.  That result is determined by measurement (accounting rules) and capacity to absorb losses (capital requirements).

All President Bush is saying with that headline is that lets not throw the bay out with the bath water.  Worse, lets not become so technocratic that business decision making is over-ridden by government controls that could well produce dysfunction the likes of which might make the current crisis seem like a walk in the park.

Written by Colin Henderson

November 13, 2008 at 21:41

Canada banking sector is avoiding the troubles in US and UK


The press is all doom and gloom at the moment.  Not without reason, but the causes and implications are getting blurred.  So I did a simple analysis comparing three stock markets, their fall since mid 2007, and the relative importance of the banking sector in that fall.  The results suggest that it does depend where you live.  There is an all out banking crisis in the US and UK, based on market sentiment.

 

us can uk comparison 

Somehow Canadian banks are not regarded with such fear as the others.  This no doubt partly due to the early work of Purdy Crawford and the Federal Governments efforts last year to manage the $35bn in ABCP.  In retrospect this was a far-sighted move (Fall 2007).  In a very complex manouvre, they carved the $35bn held by smaller banks and investment houses into tranches that were backed by hastily arranged lines of credit from the Banks.  In any event the outcome was an orderly shift away from certain bank or investment house bankruptcies.

Written by Colin Henderson

October 5, 2008 at 13:21

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