Krugman should talk to the CD Howe about Canadian Banking policy

Canadians’ need to be mentioned south of the border will probably find some glee in Krugman’s musings on the Canadian policy conversation. But as edifying as it is to be talked about in such a positive light by such a luminary as Paul Krugman and under the New York Times flagstaff no less; is Krugman right to characterize the policy conversation as “defying conventional wisdom” especially when it comes to the conversation about financial regulation in Canada?

Unfortunately the answer is no. Since the latter half of the 1990s, the Major Canadian banks (MCBs) have been pushing for deregulation that would allow them to, besides become bigger, go global and get into global financial markets. Indeed in the run-up to the Great Financial Crisis (GFC) there was mounting pressure to allow just the kinds of mortgages that were being offered to the south, and for awhile at least, a zero down, teaser rate, 30 year mortgage was allowed. That the product came late market in Canada and was cut short by the GFC is sure luck (or perhaps laggard nature of Canadian financial deregulation).

But if Mr. Krugman would like an indication of not only the intense lobbying that was going on in Canada to allow the MCBs to be more like his banks he need only peruse the CD Howe web site. In 2007 it released a Commentary titled: Branching Out: The Urgent Need to Transform Canada’s Financial Landscape and How to Do It. Inter alia it was argued that mergers should be allowed to go forward and not just among the big five themselves but that the MCBs should be allowed to merge with big insurance companies as well. Allowing banks to become this big would enable them to become significant international players that would be able to behave and mitigate risk like the other big international banks:

Size is also important for a bank in dealing efficiently with financial risk. Larger banks have more ready access to modern risk management techniques that allow them to achieve better diversification and, hence, lower risk. Modern ways of managing bank risk rely increasingly on direct access to international capital markets. Credit risk derivatives, loan syndication and especially securitizing asset positions have become the prevalent tools to reduce the risk that banks take on . However, in order to effectively securitize assets, banks have to offer pools of assets that are well diversified and of sufficient size in order to ensure enough liquidity in the market.

Hmm pretty standard pre GFC thinking here. All that liquidity. Remind me again Paul what is the US in right now (and Canada also looked to be in)? A liquidity trap…how can that be? What with all the risk reduction which comes from diversification into credit derivatives, magic turtles and the goose that lays golden eggs. What indeed could possibly go wrong?

Banks clearly benefit from operating broadly across different segments in their core business of taking deposits and granting loans. But banks can also benefit from diversifying geographically and across different financial products. Historical evidence shows that when banks were able to operate across various regions (such as in Canada and Europe) failure rates were lower than when banks faced geographical branching restrictions (such as until recently in the US). Similarly, as fee revenue has been steadily increasing for banks over the last 15 years relative to interest revenue, the product mix a bank can offer has become an important instrument to hedge general business risk and ensure stable profitability.

Yah those fees… think of all those fees! Originate to distribute; that is Mosses and the prophets. What a model. Especially if it comes with a tax payer funded rescue when it all goes pop.

Maybe Paul is right, size does not matter all that much, what matters is what banks intend and are allowed to do with their size. But whatever the case may be, as the commentary by the CD Howe makes clear, circa 2007 the policy conversation was very much one of follow the leader. As the economists advising for the CD Howe and thus must be considered some of the sharpest tools in the economics shed illustrate, this had nothing to do with the enlightened nature of the policy conversation going on in Canada prior to the GFC.

It is good thing Canada suffers from policy lag and a populist suspicion of the MCBs and bankers and had the good luck of successive minority parliaments in which giving the economists and the banks they were shilling for what they wanted would have been the death blow.