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Banks Under Fire: Why Canada Will Suffer for Other Countries’ Mistakes

A Review of

Banks Under Fire:

Why Canada Will Suffer for Other Countries’ Mistakes

By

Ashibuogwu Cletus

Abstract

The global recession that commenced in 2008 was triggered by the Sub-prime mortgage crises in the USA which led to the financial downturn around the world. Attention is drawn to the implications more stringent International Banking regulations would have on both the Canadian Banks, and the entire Canadian economy, despite general domestic success weathering the recession storm. The new set of rules would, on the one hand, negatively impact the subsequent profitability of banks, investments, and returns on investments. On the other hand, market for the management of sovereign debts could suffer less liquidity thereby leading to a rise in borrowing costs for governments. It is recommended that, firstly, the Canadian banks need to explore other sources of generating revenue. Secondly, Canadian Financial Sector along with the Federal Government pursues the negotiation already begun with the BRIC countries to fruition in order to break the US dominance and dictation of Canadian international market and financial services as it is apparent that NAFTA, with regard to this very situation, may be ignored.

Key words: Global Recession. International Banking Regulations. Profitability. Liquidity. Return on Investment. Global Financial Services. Sovereign Debt.

Banks Under Fire: Why Canada Will Suffer for Other Countries’ Mistakes

The success and prosperity of Canadian Banks during and after the much publicised recession that began in 2008 has been heralded around the world. In his article, “Banks Under Fire: Why Canada Will Suffer for Other Countries’ Mistakes,” Joe Castaldo observes that while many banks in Europe and the United States were posting lower returns, huge losses, bank failures and bankruptcy, Canadian Banks were making history by posting huge profits that did not reflect the global financial realities. Castaldo notes that Canada appears to be moving in the direction of becoming a global financial power-house. Despite all these, the Country’s apex bank and the entire banking sector feel very uneasy because of another round of stringent International Banking Regulatory Forces (Volcker Rule and Basel III). They are also concerned about the profitability of banking business, global financial services, banking management, return on investment, sovereign debt management, fund availability and liquidity.

The implication of more International banking regulations is the main crux of the article. In Canada the Financial sector is neither struggling nor new to rigorous banking regulations. These banks remain the strongest in the world for four years in a row owing largely to managerial prudence and adherence to banking regulations. Painful as it is, more stringent banking regulations are taking effect in 2012. The most trying is the Volcker Rule designed following the 2008 recession in the US, the provisions of which claim that it is designed to “prevent insured deposit-taking institutions in the US from engaging in certain risky activities” and “potentially putting the broader financial system in serious danger.” It is meant to limit losses during the financial crises. Though specifically for the US banks, its scope affects foreign financial institutions including those in Canada. Generally, laws affect businesses (Nickels et. al, 2010). The global business environments are beyond the borders of any one country and its vicissitudes should be regularly studied for necessary adjustments. Canadian banking businesses that are going international must face the ever dynamic global market challenges (Nickels et. al, 2010). The international financial market has its own respective protective regulations and components and this varies country by country. The challenges in the international arena are tremendous (Nickels et. al 2010) and the Canadian banks should therefore brace for the consequences of venturing into this field.

Similarly, the Basel III Committee on Banking Supervision recommends more capital reserve and buffers against losses up to 7%, so as to make banks safer in the event of crisis. Though a good idea, the implementation of this recommendation will impact profitability and substantially reduce return on equity, as the volume of idle cash increases, as well as reduce the banking sector’s ability to invest and lend to consumers and businesses. This has two effects: firstly, businesses cannot readily take off owing to lack of funding, and secondly, consumer spending shrinks, leading to a cash-squeeze in the economy. Businesses look at the economic environment as one of its prior studies to investing, since the economy affects both the businesses themselves and target consumers (Nickels G.W. et. al., 2010).

Management is also a major issue of the financial industry. As stated by Castaldo: “An incredible 400 U.S. banks failed between 2008 and 2011 […] Age-old institutions such as the Royal Bank of Scotland and Northern Rock in the United Kingdom were so badly mismanaged that they became wards of the state.” These institutions suffered from poor management, inefficient allocation of resources, ineffective contingency, strategic and crisis planning, non-adherence to regulations, poor leadership and poor growth control in relation to organisational goals and stakeholders interests (Nickels G.W. et. al, 2010). Again, in a market economy, banking crises have tended to occur when financial markets were recently liberalised and supervision and regulation were not upgraded to cope with the expanded activity (M. Goldstein and P. Turner, 1996).

Though regulation and supervision play an essential role in fostering stable and effective financial system, Goodhart argues that regulation should serve to support and enhance market functioning, by establishing basic “rules of the game” and seeing that they are observed rather than displacing the effectiveness of the established financial system (Goodhart, et. al., 1998). By so doing governments respond to and assist in the growth and needs of businesses (Nickels G.W. et. al., 2010). Supervision and regulation are essential to effective management and market discipline. Effective financial regulation and supervision, therefore, provide a necessary public good (Arner 2007). On the other hand, regulation can be a source of vulnerability, among other things, if applied too intrusively or overstretched (Arner 2007).

Meanwhile, concerning profitability and return on investment, the Canadian banks, need to consider other sources of generating revenue to strike a balance and maintain reasonable profitability and return on investment. Filipelli and Lowe (2012) believe that the “global regulatory implementation presents enormous challenges of scale and complexity but Canadian banks can balance the spirit of regulatory change with an acute focus on new sources of revenue and customer profitability- will be a step ahead when it comes to managing growth in the new regulatory environment.” The gains from the past regulatory environment should be brought to bear in these challenging new international banking regulations. Canadian Banks have already proven themselves capable of weathering a recession and so can embrace any international regulatory storm and effectively manage sovereign debt burdens. It is acknowledged that the cost of compliance will initially increase bank operating costs and this is normal for a new venture, often resulting in a return to large-scale profitability with each financial year (Filipelli and Lowe, 2012). However, in doing so, countries like the United States should avoid protectionist policies (Nickels G.W. et. al 2010). Similarly, a more serious consideration for the US is the North American Free Trade Agreement (NAFTA). The Volcker Rule contains possible violations of NAFTA. The case of Spain or Greece does not apply in this instance as they are outside NAFTA territory.

Financial crises tend to result from ineffective regulation and supervision, as well as a lack of financial prudence. This then calls for responsible financial oversight, risk management, and compliance to the Canadian financial structure (especially the banks) (Filipelli and Lowe 2012). A more serious concern for businesses in Canada is the anticipated reduction in banks’ lending ability to businesses and consumers, as reduced bank liquidity will generally slow both bank investment and other economic activities that rely on bank credits. Whether the Volcker Rule and Basel III will protect bank customers, investors and prevent instability as well as address market failures, is not clear. The recent move by the Canadian government and business community to seek for larger market (the BRIC countries: Brazil, Russia, India and China) outside the US should be pursued to prevent further US dictation of Canada’s financial services overseas. Canada should then be more concerned about how their long term strategies would assuage any international financial turbulence.

Reference

Arner, Douglas. (2007). Financial Stability, Economic Growth and the Role of Law. New York: Cambridge University Press.

Filippelli, Mary and Diana Lowe (2012). Achieving Regulatory Balance in the Changing Landscape.KPMG LLP. Retrieved 22nd May, 2012 from http://www.kpmg.com/ca/en/issuesandinsights/articlespublications/insights-into-canadian-banking/pages/achieving-regulatory-balance-in-the-changing-landscape.aspx

Goldstein M. and P. Turner. (1996). Banking Crises in Emerging Economies: Origins and Policy Options. BIS Economic Paper, No. 46.

Goodhart, C. et al. Financial Regulation: Why, How and Where Now? London: Routledge 1998).

Nickels, W. G. et. al. (2010). Understanding Canadian Business. (7th ed). Toronto: McGraw-Hill Ryerson.