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Regulations on the anvil could hammer banks Add to ...

The CEOs of Canada's largest banks convened in a downtown office yesterday morning to meet first with Bank of Canada governor Mark Carney and afterwards with Julie Dickson, the head of Canada's banking regulator.

The meetings occur once each quarter and are par for the course. While yesterday's meeting might have lacked the tension and anxiety that characterized the gatherings during the height of the banking crisis, there were still plenty of high-stakes items on the agenda.

The banks are struggling to plot their business strategies in an environment where they can't gauge what the rules will be a year from now. Global regulators and policy-setters are still hammering out details on proposals that will affect everything from proprietary trading businesses to capital levels and taxes.

The Canadian bank CEOs have very strong views on a number of the proposals. They fear that some of them could inadvertently do real damage to their businesses - most troubling, they say, is the impact certain rules could have on their bread-and-butter mortgage operations.

The banks are receiving support from Ottawa on many of the key items. Ms. Dickson wrote a comment piece for the Financial Times, published last Friday, in which she argued that new bank taxes are the wrong way to go when it comes to protecting taxpayers from risky banking activities.

"A strong financial system needs market discipline," Ms. Dickson wrote. "Unfortunately, as a result of the global financial crisis, there is now a deeply embedded presumption that governments will use taxpayer dollars to bail out banks, creating a strong incentive for banks to take undue risks. Should this be allowed to continue, it will leave bank supervisors as the main restraint on excessive risk taking - not the banks themselves or their investors."

While noting that one of the proposals to deal with this moral hazard is new bank taxes, Ms. Dickson wrote that "there is a better way."

What she proposes is something she has been talking about for awhile - "embedded contingent capital." It's a mouthful that basically means a security that converts into common equity when a bank is in serious trouble, instantly increasing the bank's capital levels without taxpayer dollars, she noted.

Finance Minister Jim Flaherty has also spoken out against new bank taxes, taking a position that could be fairly contentious among his G20 counterparts.

Bank investors should keep an eye on Ms. Dickson's proposal, BMO analysts John Reucassel and George Lazarevski wrote in a note to clients. "Should the concept of embedded contingent capital gain momentum, it could increase the cost of capital and reduce future ROE by 50-100 basis points and earnings by 4-7 per cent," they wrote.

Nevertheless, they were supportive of the proposal, which they say would encourage equity and debt investors to actively monitor and retrain bank risk taking.

"A strong financial system needs market discipline as a cornerstone of a comprehensive regulatory regime," they wrote.

"Financial intermediaries have historically found paths to circumvent new regulations or taxes and, given the pace of financial innovation, we believe that regulators will need market discipline to manage future risks."

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