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Toronto bank towers and skyline Nov. 10, 2010.Moe Doiron/The Globe and Mail

Modern banking regulation has become "highly complex and prescriptive" but doesn't deal with the fundamental problems that cause financial crises, a new report argues.

A study released Wednesday by C.D. Howe Institute vice-president Finn Poschmann proposes bold changes to the banking regulatory system. Notably, he argues in favour of reducing and capping government-provided insurance on bank deposits, and requiring major banks to issue a new form of bonds that would convert to equity to shore up banks in times of trouble.

"The key lesson is that there are simple alternatives and supplements to the current high prescriptive approaches to bank conduct and its regulation," Mr. Poschmann argues in the report.

"Thinking more deeply about the role of incentives in steering bank behaviour and market responses to it would likely be beneficial to all participants in the financial marketplace."

Mr. Poschmann writes fondly about the early days of bank regulation in North America, when shareholders – who were often also the bank's senior managers – held a now-defunct form of shares that required them to contribute funds if a bank was failing.

While small banks proliferated and failures were far more common than today, the report says depositors typically lost less than five cents on the dollar when the dust settled, according to studies of the U.S. banking system between 1865 and 1920. Though regulators were virtually non-existent and there was no deposit insurance, financial crises tended to be "sharp, brief and localized," while crises today are long and contagious.

But reverting back to such a system today, while not impossible "seems implausible; winding back clocks or putting genies back in bottles, rarely can be done," Mr. Poschmann acknowledges. Instead, the report says regulators should build in old-fashioned style incentives, in a more modern form.

A key step, Mr. Poschmann argues, is to cap the amount of insurance provided by governments to protect depositors' money in the event of a bank failure, saying excessive insurance reduces everyone's incentive to operate carefully.

Mr. Poschmann says federal deposit insurance that provides maximum coverage of $100,000 per bank account offers reasonable protection to small depositors. But he takes issue with moves by several provinces – including Manitoba, Saskatchewan, Alberta and British Columbia – to offer unlimited guarantees for credit union deposits, which are provincially regulated, as well as other provinces' moves to raise the cap on insured deposits to $250,000.

"This is dangerous, not least because deposit insurance rarely is priced according to risk: the system provides a taxpayer-backed subsidy to risky institutions at the expense of less-risky ones, and potentially at significant risk to taxpayers," he writes.

Mr. Poschmann says provincial coverage "must be wound back to a common and more prudent national standard."

An even more dramatic reform in the study would be the creation of a new form of bank debt to make banks more secure in case of failure.

Mr. Poschmann says recent reforms in Canada, the United States and Europe following the 2008 financial crisis focused on banks' required liquidity and capital ratios, but should have put more onus on the marketplace to curb unsafe behaviour.

He favours creating a new form of debt called Equity Recourse Notes (ERNs) – first proposed last year by academics Jeremy Bulow and Paul Klemperer – which would be long-term bonds issued by "large systemically important financial institutions" in amounts to match their unsecured debt. The bonds would see interest paid out in bank shares, rather than cash, if the institution's share price drops below a pre-determined price threshold.

If the share price recovers, cash interest payments would resume, but in the meantime banks would increase their liquidity when most needed at a time of major stress. The conversion to equity would be "entirely automatic" and determined by market forces, and would not require judgment calls on the part of a regulator, the report argues, which means there would be no behind-the-scenes lobbying and no reliance on valuations to determine a bank's regulatory capital ratios.

The conversion to equity would also automatically reduce a bank's leverage ratio and increase its regulatory capital ratio, avoiding the normal cycle of requiring banks to boost their capital at the exact time when the institution is under greatest financial distress, Mr. Poschmann argues.

"Regulators should rely less on capital adequacy rules, which are subject to lobbying and to gaming through regulatory capital arbitrage, and tend to be procyclical," the report says.

Mr. Poschmann concludes there is "value in simplicity: sometimes, perhaps often, simple is better."

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