So Royal Bank of Canada chief executive David McKay thinks Canada’s housing market is just fine. That’s reassuring, to a point. It would be more so if Canada had a public authority in place to verify Mr. McKay’s confidence. The fact there is no such entity undermines Ottawa’s belief that it has something to teach the world about financial regulation.
Mr. McKay’s presentation in New York this week capped an interesting couple of days in the ongoing – and critically important – debate about whether low-forever interest rates are creating the conditions for a financial crisis of some sort. A housing bust is the thing people talk about most. Mr. McKay inadvertently showed us why we shouldn’t assume the banks will steer Canada clear of trouble.
Remember moral hazard? We talked about that a lot after the financial crisis. Those too-big-to-fail banks took on too much risk because they knew the government would save them from death. Moral hazard exists in Canadian banking, too. The country’s biggest banks were captured by an international effort to apply levies on financial institutions whose failure would cripple domestic financial systems.
But the bigger moral hazard is Canada’s housing policy. Most Canadian mortgages are insured, and that insurance is backed by the federal government. There is little reason for a banker to worry much about warning lights in a system like that. In fact, it is a selling point. “What we keep trying to educate is our first loss is covered by government guaranteed insurance,” Mr. McKay said.
In other words, if you are thinking about buying RBC stock, no need to assume the bank would suffer big losses in the event of a housing crash: it will be taxpayers who take the hit. Mr. McKay and the leaders of Canada’s other big banks can make bets on the positive indicators – and play down the bad stuff – because they have relatively little to lose. They have every incentive to go all in on housing – and they have. The chartered banks are holding almost $1-trillion in outstanding residential credit, according to Bank of Canada data.
The other thing that stirred up the housing debate in Canada this week was a blog post by a couple of economists at the International Monetary Fund. Hamid Faruqee and Andrea Pescatori noted that Canada ought not get complacent about housing prices that have pushed household debt to over 150 per cent of disposable income – one of the highest among OECD countries. (Today, Statistics Canada said Canadians’ household debt burden hit a record 163.3 per cent in the fourth quarter of 2014).
In contrast to Mr. McKay, the IMF economists called Canada’s housing market “overheated” and homes “overvalued.” They observed that Canada may have gotten lucky during the financial crisis. The dominance of a handful of conservative banks likely had as much to do with the country’s success as Ottawa’s vaunted approach to financial regulation. A bigger test may await as the officials contend with the fallout from the collapse of oil prices.
Mr. Faruqee and Mr. Pescatori were the latest to observe that Canada could struggle to spot fragilities in the financial system, and respond in a timely manner. In that way, the financial crisis was easy: it was all hands on deck. But recall, Canadian authorities didn’t see the asset-backed commercial paper fiasco coming. The next crisis is more likely to resemble the latter. The Bank of Canada has beefed up its ability to monitor financial markets. Unfortunately, it lacks the authority to act effectively if it sees a problem brewing.
There is no single entity that is in charge of deflating the asset-price bubbles that turn into busts if left unchecked. The Bank of Canada has no regulatory power. It could adjust interest rates, but that is a blunt response to a potential bubble in housing, farmland or some other asset. The priority of the Office of the Superintendent of Financial Institutions is making sure none of the big banks fail, not keeping an eye for other weak spots in the broader financial system. That job technically falls to the Finance Department, which, until Canada starts appointing technocrats to run its ministries, will inevitably be controlled by a politician. And a politician always will have an incentive to avoid unpopular decisions such as making it more difficult to buy a home.
“While informal cooperation between key agencies worked well during the crisis, future shocks will inevitably look different,” Mr. Faruqee and Mr. Pescatori wrote. “From our perspective at the IMF, having robust frameworks with more formal arrangements already in place to identify and respond to future shocks would enhance resilience.”
Gordon Thiessen, a former governor of the Bank of Canada; Paul Jenkins, a former senior deputy governor at the central bank; and David Longworth, a former member of the Bank of Canada’s policy committee all have flagged this problem. Mr. Thiessen and Mr. Jenkins published their critique in 2012. All three former officials concluded Canada needs to designate a non-political body with full-time responsibility for watching over the financial system. The entity – the central bank, a committee of senior regulators, a new agency – also should have the ability to respond when it sees trouble on the horizon.
For whatever reason, this very serious flaw in Canada’s regulatory regime goes undiscussed in Ottawa. There is an election coming. A party that is serious about the economy will address this shortcoming in its platform.
Kevin Carmichael is a senior fellow at the Centre for International Governance Innovation, based in Mumbai.Report Typo/Error