Chris Gay is a contributing columnist for The Globe and Mail. He is a former Wall Street Journal staffer and writes the newsletter Figure at Center.
Canada’s banks should pay close attention to what its counterparts are doing south of the border, where U.S. regulators are loosening the rules dictating how much capital banks must maintain as a cushion against shocks. It’s a move some see as a slippery slope to the next financial crisis, and one that could encourage Canada to take similar measures, in a kind of regulatory race-to-the-bottom.
The U.S. Federal Reserve provisionally approved a measure on March 19 that would ease capital-adequacy regulations tightened after the 2008 financial crisis in an effort to make Wall Street safe for capitalism. The proposed rules – put out for a standard 90-day comment period – would lower capital requirements for the biggest banks, for instance, by up to 4.8 per cent on average in dollar terms, freeing up about $40-billion in core capital for lending, dividends and share buybacks. The changes would be among the most significant liberalizations since the crisis.
But the specifics are less important than the change in direction. Recall that stricter capital rules were imposed after undercapitalized American financial institutions collapsed into the arms of taxpayers in 2007-09 when their reckless bets went south. Congress responded with the Dodd-Frank Act, which among other things raised mandated capital-to-asset ratios as a buffer against future shocks.
Some see the move toward lower ratios as a first step in the time-honoured American process of manufacturing financial crises, which goes something like: 1) easy credit, lax regulation and overpriced assets, 2) market crash and recession, 3) government bailouts, 4) a new round of prudential regulations. Closing the circle, once steps 2 to 4 are well down the memory hole, Wall Street has an easier time securing deregulations that loop back around to step 1.
Canada should ease capital constraints to boost lending to small businesses, National Bank CEO says
The American bank lobby, which has chafed against Dodd-Frank for years and resisted tighter requirements proposed by the Biden administration, understandably applauds last week’s proposal. But there are critics, like lone dissenting Fed board member Michael Barr, who says the new rules “would harm the resilience of banks and the U.S. financial system.”
Canada has fairly tight capital rules that make its banking sector one of the world’s most stable. There’s also a more concentrated landscape, with the country having some 80 banks compared with the United States’ more than 4,000.
But all the same, some say stability comes at the cost of suppressing lending, and warn that Canadian banks will suffer a disadvantage vis-à-vis less-restrained American banks unless its rules are eased, too. National Bank of Canada NA-T chief executive officer Laurent Ferreira is calling for some form of looser capital constraints to bolster lending to small businesses. The country’s regulator, the Office of the Superintendent of Financial Institutions, is leaning in a similar direction.
They might want to be careful what they wish for. While such loosening in Canada would still be far from U.S. levels of permissiveness, the slope is slippery. The narrative arc of boom-bust cycles, particularly in the U.S., persists despite a well-known history of financial crises and their antecedents. Many blame the 2008 crash on a series of deregulations that left American banks overleveraged and undercapitalized. Many on the political right deny that deregulation had much, or anything, to do with the crash of 2008, arguing that poorly conceived regulation itself was to blame.
These arguments – often by people who get paid to denigrate government and extol markets – tend to discount the relentless logic that drives unrestrained financial institutions toward ever higher risk in order to reap ever higher returns, putting innocent bystanders at risk. This is what Citigroup CEO Chuck Prince had in mind when he famously said in 2007 that “as long as the music is playing, you’ve got to get up and dance.” Financial regulation exists partly to protect banks from themselves.
American banks complain that excessive capital requirements raise costs and constrain profits. Maybe, but the vast majority of them exceed current requirements and net profit margins remain strong. Yet the Fed may prove correct: Looser rules don’t necessarily guarantee a crisis. Indeed, one hopes that a decade from now, people like Mr. Barr will simply look like alarmists.
But it’s prudent to consider that regulation is vulnerable to criticism partly because of the “preparedness paradox,” which renders its successes invisible: You don’t see the crises that never occurred, precisely because regulations prevented them, allowing critics to say the rules are unnecessary. It’s true that regulations can create perverse incentives and moral hazards, but given the lamentable history of financial crises and the mass immiseration they can cause, it’s prudent to privilege public safety over maximal profits.
Society doesn’t typically erect complex institutions and elaborate rules for no reason. That’s why people eager to weaken the regulatory edifice might want to acquaint themselves with an aphorism often attributed to the early 20th-century British critic G. K. Chesterton: “Do not remove a fence until you know why it was put up in the first place.”