Toronto skylineFred Lum/The Globe and Mail
Everyone seems frustrated with the progress of reforming the global financial system. We, heads of the six major Canadian banks, say: bring it on. We all agree the need to pick up the pace - but also to focus on the real issues.
Bankers see significant change and uncertainty around mooted reforms. But the general public is increasingly frustrated about the lack of action.
To this end, policymakers should concentrate on addressing the main causes of the financial crisis. There were three issues: first, excessive leverage in the banks and investment dealers. Second, a lack of common standards for the quality and level of capital. And third, weakness in risk and liquidity management.
The good news is that many reforms to the Basel bank capital accords under discussion address the core issues. New trading rules, due to go into effect at the end of 2010, will begin the process of deleveraging the dealers. Other proposals would go even further in future.
There is pressure within the industry for backsliding on implementation of the 2010 rules. But we should not delay: we should stick to the schedule, provided that the rules are applied across all jurisdictions equally.
The reforms have also focused on setting shared standards for the quality and level of capital. Here the issues are trickier. There is a real risk of trying to do too much, and ending up with too little.
The problem is that regulators around the world enforced different standards. Some allowed banks to operate close to the minimum 4 per cent levels of core, so-called Tier 1, capital, or to count significant amounts of subordinated bonds and other non-equity capital. We should have a common standard. But, in addressing this problem, regulators propose to increase certain deductions which reduce how much common equity can be counted, removing, for example, the value of goodwill and deferred tax assets.
We should be very careful here. There is no evidence that the current rules on deductions to equity were a cause of the crisis. Many of the items that some want to deduct produce steady earnings streams that help to cushion the effects of a crisis. Furthermore, getting agreement on this complex reform takes time, may delay final rules and uses up capital that could be better deployed to address the real issues.
In addition, current proposals would supplement the approach of measuring risk-based assets by adding a leverage test on all assets, whatever their risk, based on Tier 1 capital. In effect, no distinctions would be made between low-risk and high-risk assets. This would encourage financial institutions to take more risk.
This could, obviously, make the financial system less stable. In Canada, banks continue to hold the mortgages they originate, not using the securitised model that ran into such trouble elsewhere. This provides discipline to the housing market and a cushion of reliable earnings for banks. A bank-wide leverage test, unless properly calibrated, would make it uneconomic to hold mortgages, undermining our strength.
Why would policymakers propose a bank-wide test? They are responding to fears that excessive leverage in investment banking businesses was one of the causes of the crisis. We agree that excessive leverage was a primary cause - not just in trading books but in large concentrations of high-risk lending assets, primarily related to US residential property. But the proposed solution of a leverage test fails to address the most important issue: to ensure that appropriate capital is applied to reflect the risks in different asset classes.
Policymakers have a unique opportunity to refocus banking on economic growth and job creation. For this to happen, policies must address the root causes of the financial crisis.
So what should be done? Get the capital allocated for trading assets right. Get a common capital standard. And, at the risk of sounding parochial, adopt a capital regime similar to the Canadian system. Tier 1 capital should be at least 7 per cent of risk-weighted assets. Make common equity represent at least 60 per cent of Tier 1 capital. Standardise the deductions at about the Canadian level. And use a leverage test that is based on total capital, not Tier 1, and calibrated to avoid unintended consequences.
Regulators do not need to specify which businesses banks should enter, but they must get the right level of capital for the risks taken, as well as robust risk and liquidity management systems. By doing so, we will dramatically change the financial system for the good.
The writers are Ed Clark, CEO of TD Bank Financial; Bill Downe, CEO of BMO Financial; Gerald McCaughey, CEO of CIBC; Gord Nixon, CEO of Royal Bank of Canada; Louis Vachon, CEO of National Bank of Canada; and Rick Waugh, CEO of Scotiabank