Banks brace for fallout from debt storm

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Canadian financial institutions are bracing for a potential liquidity crunch, as the economic and financial turmoil in Europe and the United States begins to ripple through the world's banking system.

European banks are growing more leery of lending to each other. The rates that European banks charge each other for short-term loans have risen to heights they haven't reached in two years, in a situation that has echoes of the financial crisis of 2008.

Canadian banks say that, as a result of the lessons learned at that time, they have been preparing by reducing their trading with parties that aren't solid enough, stockpiling cash by issuing bonds, and hedging their investments.

Regulators and officials here say that the country's financial institutions are in good shape. But no amount of preparation will make them entirely immune if the European banks' faith in one another isn't restored and the situation deteriorates.

"The market hates uncertainty, and therefore liquidity disappears," said Royal Bank of Canada chief executive officer Gordon Nixon. "The ability of the marketplace to function in a normal way becomes more challenging."

In 2008, interbank lending rates shot up after the failure of Lehman Brothers Holdings Inc. Banks became skittish about lending to other banks because of fears that the borrowing institutions were holding large amounts of bad debt tied to subprime mortgages, credit cards and other forms of consumer debt.

Now, the trigger is government debt – especially in the euro zone. Late yesterday, the European Central Bank signalled that it would purchase the bonds of Italy and Spain, a major intervention designed to ease the selling pressure on the bonds of those two countries, the third- and fourth-largest euro zone economies.

One of the lessons learned from 2008 crisis is that the problems in Europe will not be contained on that continent, if conditions in the interbank lending market continue to deteriorate.

"The largest financial institutions are interconnected and you could have stress in North America, although it's not evident right now," said Peter Routledge, an analyst at National Bank Financial.

The current situation is not nearly as severe as it was when Lehman went under in September, 2008, but it is worsening at a troubling pace. Reuters, citing an unnamed source at the European Central Bank, said that the ECB is considering emergency liquidity measures to prevent money markets from freezing.

The troubles in Italy, the world's third-largest bond issuer, are front and centre. The decline in value of Italian bonds will put more stress on Europe's already weak banking system. Many European banks could not withstand large losses on government bonds.

The situation is resulting in paralysis in the Eurobond market, Mr. Nixon said.

"Large investors don't know whether they should sell, whether they should buy. And therefore you've had not only very little activity, you've had a significant reduction in liquidity markets. And when markets become illiquid, that's when you tend to get a lot of problems."

Bankers say they have taken to heart the lessons from the recent financial crisis in an effort to protect themselves. The downturn in 2008 "was such a lesson, most of us have been ready for something like this," said a senior brokerage official who spoke on condition of anonymity.

The situation erupting in Europe has overshadowed the potential blow of the U.S. debt downgrade. The direct impact on Canadian financial institutions of Standard & Poor's decision to strip the United States of its triple-A credit rating are expected to be relatively minor.

"We are watching developments closely," said a spokesperson for the Office of the Superintendent of Financial Institutions. "We believe the impact of the U.S. debt downgrade will be minimal on Canadian institutions."

Basic capital rules do not distinguish between triple-A and double-A-plus securities, which are both deemed to be the highest-quality securities that banks can hold.

In a note to clients, Desjardins analyst Michael Goldberg said that Manulife Financial Corp. holds $19-billion in U.S. Treasury securities. A one-notch downgrade from triple-A to double-A-plus requires that it add less than $20-million to its reserves, which is an immaterial amount for the company.

Sun Life Financial Inc. chief executive officer Donald Stewart said the insurer is well placed to withstand the downgrade, though the indirect impact remains uncertain if markets go into a full-fledged panic.

"The direct effects aren't a big deal; it's the indirect effects that are scary," echoed Mario Mendonca, an analyst at Canaccord Genuity. "What really scares me is if long-term government bond yields collapse because of the weak-growth argument and stay low for the long term."

In that case, stocks would be a bad place to invest and life insurance companies with large stock market exposure, including Manulife Financial, will likely take a beating.