Archive for the ‘Financial Markets/ Finance’ Category

Small Finance Banks: Have They Delivered on Their Financial Inclusion Promise?

December 11, 2019

Nice webinar by Amulya Neelam of Dvara trust. The webinar was held yesterday and recording is available.

The webinar summarised findings from her research paper. She points to financials of Small Finance Banks and shows how they look much like private sector banks.

We see from the discussion above that SFBs have largely done well in maintaining profitability despite the more stringent regulatory mandates of the RBI, such as higher priority sector lending requirement and loan size restrictions. This has been driven by the high spread between deposit and lending rates
and holds despite their cost of funds for SFBs being double that of public and private sector banks.

However, one must not jump to conclusions about the success of the SFB model towards meeting the objectives of financial inclusion as they are still very nascent in their functioning as full-service banks. It appears that the SFBs’ strategy and expansion are most akin to that of private sector banks.

What is notable is that despite being erstwhile microfinance institutions, the SFBs’ business, lending and to an extent deposit-taking, do not see rural centres being serviced considerably more than what is being done by existing banking models (except for RRBs). Thus, given the strategy adopted so far by SFBs, it
brings into question how well the business-model-level regulatory prescriptions help in fulfilling a financial inclusion mandate. Additionally, a more granular understanding of the benefits at the customer level is required.

We need to understand how many of the previously unbanked/underbanked populations are being catered to by SFBs. We see currently that much of the
SFB branch network is in the semi-urban and urban areas. It is unclear whether these branches are catering to such customers of these areas. It may, however, be a positive sign that all the ten applicants are still functioning and appear to be continuing operations smoothly and expanding. A repeat of the
analysis using data for a longer period (of operations) would yield more insights into the sustainability of the SFB Model and the utility of having a business model-level regulatory approach as laid down by the RBI.

It is surprisingly actually. Most of these SFBs were earlier microfinance institutions and should have done much better on financial inclusion and may be struggled on profitability. What we see is the opposite…

If Wealth Is Justified, so Is a Wealth Tax

December 11, 2019

Katharina Pistor of Columbia Law School in this Proj Synd piece:

Not surprisingly, American billionaires have dismissed recent wealth-tax proposals as an affront to the entrepreneurial spirit to which they attribute their massive wealth. But the ultra-rich never would have their great wealth without legal subsidies from the state and reliable enforcement by the courts.

….

The private empires over which today’s billionaires preside are organized as legally chartered corporations, which makes them creatures of the law, not of nature. The corporate form shields the personal wealth of the founders and other shareholders from the corporation’s creditors. It also facilitates the diversification of risk within a company, by allowing discrete pools of assets to be created, each with its own set of creditors who are barred from making claims on another asset pool, even though the parent company’s management controls all of them.

Further, the company’s own shares can be used as currency when acquiring other companies. When Facebook bought WhatsApp, it covered $12 billion of the $16 billion purchase price with its own shares, paying only $4 billion in cash. And, as with Facebook, corporate law can be used to cement control by founders and their affiliates through dual-class share structures that grant them more votes than everyone else. As such, they need not fear elections or takeovers of any kind.

Finally, companies whose assets take the form of intellectual property (IP) and other intangibles tend to rely even more on the helping hand of the law. As of 2018, 84% of the market capitalization of the S&P 500 was held in such intangible assets. It takes a legal intervention to turn ideas, skills, and knowhow – which are free to be shared by anybody – into exclusive property rights that are enforced by the full power of the state. And in recent years, Microsoft and other US tech companies have boosted their earning power significantly by promoting US-style IP rules around the world through the World Trade Organization’s body for Trade-Related Aspects of Intellectual Property Rights (TRIPS).

To be sure, there are good reasons for states to adopt laws that empower private agents to reap the rewards of organizing businesses and developing new products and services. But let’s call a spade a spade and a (legal) subsidy a subsidy. While Bezos, Bloomberg, Gates, and Zuckerberg may well be savvy entrepreneurs, they also have benefited on a massive scale from the helping hand of legislatures and courts around the world. This hand is more contingent than the invisible one immortalized by Adam Smith, because its vitality depends on a widely shared belief in the rule of law. The erosion of that belief, not a tax, poses the greatest threat to billionaires’ wealth.

Humanity is all about double standards…

Fiscal stabilisation in monetary unions

December 11, 2019

Plamen Nikolov and Paolo Pasimeni in this piece:

In the EMU fiscal transfers are constrained by the lack of a political union, but we find that fiscal stabilisation through a common budget is relevant in a monetary union. There is a case for addressing both common and asymmetric shocks, but the instruments we choose will have different capacities to address these stabilisation needs. 

The design of the budget, in particular the balance of revenue and expenditure, can maximise its stabilisation effect. The key is to bridge the gap between higher mobility of capital and lower mobility of labour, by collecting revenues based on the income of the most mobile factor (corporate income tax) and providing support to the income of the least mobile factor (social security).

A discretionary program of extended unemployment benefits, mainly funded by the federal level and supported by the borrowing capacity of the federal government, proves a powerful example of a timely and effective stabilisation instrument when we require a specific, contingent stabilisation function.

Hmm..But how to have a common budget?

The Problem With “Green” Monetary Policy

December 6, 2019

Otmar Issing in this Proj Synd piece says there is no thing as Green monetary policy:

Although there is increasing support for the idea that central banks should actively contribute to the fight against climate change, monetary policymakers have no mandate to do so, and for good reason. Tackling climate change is – and must remain – the responsibility of elected governments and parliaments.

Further:

the growing public demand that central banks contribute more actively to the fight against climate change leads to a different dimension. In theory, central banks could introduce preferential interest rates for “green” activities – thus driving up the prices of “green bonds” – while adopting a more negative attitude toward noxious assets, such as those tied to fossil fuels. And yet, assessing whether and to what extent an asset is environmentally harmful or helpful would be extremely difficult.

Putting aside these more technical issues, the broader question remains: Should central banks assume responsibility for implementing policies to combat climate change? A number of prominent central bankers have already argued that they should. And current proposals for extending central banks’ mandate have come on top of growing concerns about income distribution and other issues tangentially related to monetary policy.

One is reminded of an ironic comment by the great Chicago School economist Jacob Viner. “If you were to ask me what are the professed goals of most central bankers,” Viner wrote in 1964, “I would say on the basis of what I have heard them say that if they were appearing before a commission … they would either include a wide range of goals, including virtue and motherhood and also everything they could think of which is nice and good, or insist on the lack of power of central banks to serve effectively any specific important goal.”

After having played a decisive role in preventing the world from falling into another 1930s-style depression, central banks after the 2008 financial crisis have been held up as saviors of the world. The title of “maestro,” once accorded just to former US Federal Reserve Chair Alan Greenspan, has now been extended to the entire field. With central bankers at the height of their reputation, it is not surprising that many would now want them to make a substantive contribution to the fight against climate change.

But central bankers should never forget what they are appointed for: namely, to preserve price stability and, in some cases, to support high levels of employment. Central bankers are not omnipotent, and they should not be made to feel as if they were. Confronting climate change is above all the responsibility of governments and legislatures that are exposed to the risk of losing elections. Climate policies that will affect social and economic arrangements across all of society belong in the hands of those who are directly answerable to voters.

NSE’s RH Patil Memorial Lecture 2019: Prof Robert Engle

December 5, 2019

NSE organised the RH Patil Memorial lecture for 2019. This time Prof Engle delivers the lecture.

Last year it was Robert Merton..

Which country will be the king of digital currency: A currency war of a different kind..

December 4, 2019

My new piece in moneycontrol.

From a hands-off approach to a gradual embrace, central banks are fighting a pitched battle to assert their digital monetary supremacy

Why Russian Empire’s banking system was always doomed to failure?

December 4, 2019

Interesting piece on history of banking in a region which I know least about.

The first money lender in Russia was the Orthodox Church. It was followed by the state, which set up banks. However, the banks also existed to credit the state itself. The Russian Empire’s banking system was doomed to failure. Here is why it collapsed.
Most empires barring may be British got banking wrong and working only for themselves and the elites..

 

Risks and benefits of modern financial technology: Lessons from a 17th century stablecoin

December 3, 2019

Nice speech by Klaas Knot of Netherlands central bank.

He points how Bank of Amsterdam was doing similar things as today’s proposals for stablecoin:

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Economics as a profession: from science to practice

December 3, 2019

Benoît Cœuré of ECB in this speech:

It is a true pleasure to be back here at the Paris School of Economics (PSE).

You are now on the home stretch. I well remember how I felt during my own final year: excited, anxious and curious all at once.

Over the next few months, you will need to take serious, life-changing decisions. The data suggest there is about a two-in-three chance that you will pursue further studies.

For many, a master’s degree is a natural step towards a PhD. And a PhD is essentially a promise of employment. In the United States, for example, the unemployment rate for PhD economists is about 0.8%, the lowest among all sciences.[1] Not a bad place to start from.

But a PhD is not about financial optimisation. Estimates for the United Kingdom suggest that British men with a master’s degree earn 23% more than those who could have gone to university but chose not to.[2] The earnings premium for a PhD, which often takes three to five times as long, is just 26%. For some subjects, the premium for a PhD even vanishes entirely.

So first piece of advice: your PhD should be fuelled by your passion and your love for research rather than by hopes of earning more money.

Money was clearly not the reason for me to join the labour market in 1992 when I graduated from PSE with a Master in Analysis and Policy in Economics.

My first appointment took me to the National Institute of Statistics and Economic Studies, or INSEE, before I moved on to the French Treasury and then, in 2012, to the European Central Bank (ECB).

The path that I chose to explore is just one of many that are open to you. The good news is that the solid training you receive here at PSE makes it your choice.

The world of economics is incredibly broad. I will leave it to the participants of the two roundtables this evening to make a convincing case for their respective institutions, although I would not be surprised if many of you take the lead from the English author G.K. Chesterton who said, “I owe my success to having listened respectfully to the very best advice, and then going away and doing the exact opposite”.

But I wouldn’t be here tonight if I hadn’t planned to use this opportunity to make at least some publicity for the public sector.

 

Germany’s most famous financial export: Pfandbrief’s (covered bond) 250th anniversary..

December 2, 2019

I did blog about the 250th anniversary of Pfandbrief earlier. Pfandbrief means bonds in German and is basically a covered bond.

On the website of German Pfandbrief Banks, these bonds are called as German’s top financial export:

In the course of its 250-year history, the Pfandbrief has evolved into one of Germany’s top financial exports and is rightly regarded as playing a leading role in shaping the European covered bond market. The Pfandbrief has also had a significant impact on Germany’s long-term culture in the financing of real estate and local authorities, and has since established itself as an indispensable element of the strategic refinancing mix within the banking industry. A brief and concise overview of the various milestones in the history of the Pfandbrief can be found here.

In a recent speech, Jens Weidmann of Bundesbank gives a speech to commemorate the occasion. Title of his speech: Consistency as a mandate as Pfandbriefs have consistently helped finance multiple projects nit just in Germany but across the world too:

Boredom is less desirable for a festive occasion such as this, but all the more so for Friedrich Nietzsche, to whom boredom was a precondition for original thought and productive action.[2]

Central bankers do not find boring to be all that bad, either. As former Bank of England governor Mervyn King used to put it, “boring is best”. With a view to predictable monetary policy, he explained that “a successful central bank should be boring”.[3]

As regards the Pfandbrief, a reputation for being boring is at once a compliment and a seal of confidence. Once money is put on the table, many lose their lust for adventure.

What makes these bonds tick?

Let me begin with this question: what is the recipe for the success that the Pfandbrief has enjoyed over such a long life?

Its unique selling point is undoubtedly its high level of security: Pfandbrief holders enjoy two layers of protection against default. That is like circus acrobats who are protected by a net and a safety line – or someone who wears both a belt and suspenders.

Not only is the issuer liable, but the Pfandbrief is also covered by a pool of assets subject to statutory quality standards and conservative measures of value. If the issuer becomes insolvent, the Pfandbrief holders have the right to the cover pool, access to which is denied the other creditors.

This double layer of protection comes with a further advantage: as the cover assets remain on the issuer’s balance sheet, it is in the issuer’s own best interest to avoid a creditor default and to handle risk-relevant information carefully. Experts refer to this as having “skin in the game”.[4] The expression illustrates that, in the event of a default, the issuer will not get away with his skin intact.

This mitigates the moral hazard of issuing loans without performing due diligence on clients and sufficiently monitoring them. This incentive problem is often seen as one of the factors leading to the onset of the sub-prime crisis in the United States.[5] Pfandbriefe can therefore make an important contribution to financial stability. On the other hand, it is also possible that, in extremis, the issuance of covered bonds can get out of hand.

What is good for the Pfandbrief holder can put the other creditors of a bank at a disadvantage: the more covered bonds an institution issues, the more collateral is set aside to cover them – and the smaller the quantity of unencumbered assets available to cover the rest of the bank’s creditors.[6]

Such asset encumbrance must always be kept in mind. This is why transparency is decisive, and institutions are required to disclose their holdings of encumbered assets. However, the Bundesbank does not believe that regulatory intervention, such as by setting a cap on asset encumbrance, is necessary.

What the topic shows us is this: the security of the Pfandbrief is not necessarily identical to the security of the issuer. And, during the financial crisis, individual issuers did, in fact, encounter severe distress. This was due, not least, to attempts to use short-term funds to finance long-term business. However, not a single Pfandbrief defaulted. This is why Jean-Claude Juncker has found that “[c]overed bonds have proved themselves to be a reliable and stable form of financing, particularly during the financial crisis”.[7]

Hmm..

He also talks about Grüner (Green) Pfandbriefs:

Risks, interactions and keeping sight of the big picture are critical factors when it comes to another topic, too: climate change. When Alexander von Humboldt witnessed the environmental damage caused by plantations on his travels in Venezuela, he was able to join the dots and warned of the human impact on the environment and its consequences for future generations. In particular, he noted the important role played by the forest in cooling the air, storing water and protecting against soil erosion.[13]

Climate change is a challenge that we all face. Christine Lagarde, President of the ECB, has said that all public and private institutions should act, within their mandates, to address it.[14]

The first “Grüner Pfandbrief” was issued back in 2015, even before the Paris Agreement was signed. Without wanting to flatter, it is now safe to say that this product innovation, which was designed to finance energy-efficient buildings, was a little ahead of its time.

The green bond market as a whole can make a substantial contribution to financing environmentally friendly projects. In Germany, sustainable investment has risen by over 70% in the past four years. What is more, strong market growth can be observed globally as well.[15] And yet the role played by green finance remains fairly small. Green bonds account for only just 2% of the international market as a whole. In other words, green finance probably still has considerable potential.

A key requirement here is a clear, generally accepted definition of what “green” and “sustainable” actually mean. This could also strengthen confidence in green finance, as it would counteract the effect of “greenwashing”. What this means is that a financial product is, for example, marketed as being green without actually being environmentally friendly.

A variety of standards and principles aimed at preventing such deceptive labelling and providing investors with clarity already exist. Expanding on this, the European Commission is currently working on its own classification system. This taxonomy will make it possible to classify sustainable financial products in a way that is uniform, clear and reliable. It is the centrepiece of the EU’s Sustainable Finance Action Plan and is intended to serve as a reference framework for investors so that Europe can reach the climate goals set as part of the Paris Agreement.

More here on the Banks website

Nice speech giving a glimpse of history of financial instruments..

Three papers discussing the stormy birth of “Europe”:

December 2, 2019

Joseph Halevi of INET has written three interesting papers on Europe.

He explains these papers in this post:

hese three INET Working Papers analyze the gradual emergence of the European Union and its monetary systems through early years of the introduction of the Euro. Their point of departure is the crucial role oligopoly plays in the evolution of modern capitalist economies and the dominating influence of the principle of effective demand in the dynamics of these systems.

These factors, though, cannot be understood apart from specific institutional and political conditions not simply in relation to fiscal and monetary policies but, and especially, in relation to the context of the international relations ruling in any given period. Arrangements that would have been conceptually and politically all but unthinkable prior to 1945 became the main pillars of Western Europe’s recovery undertaken under the aegis of the United Sates: The Marshall Plan, the creation of the European Payments Union, and the London Conference of 1953 leading to the drastic reduction of the German debt. In each of these the external factor, i.e., the balance of payments positions of the countries concerned took center stage. The balance of payments issue encapsulated the question of effective demand since for virtually all the Western European countries, including the Federal Republic of Germany, overcoming the external constraint by getting a slice of external demand, became the necessary condition for the expansion of investment in the domestic economy.

 

25 years of independence of Central banks of Mexico and Spain

November 29, 2019

Central Bank Independence seems to be a great deal in Latin American countries. There is a reason why Central bank of Mexico organised a seminar to reflect on the 25 years of its independence.

Pablo Hernández de Cos, Governor of Central Bank of Spain gives a speech at the seminar:

The Banco de España was granted institutional independence in July 1994. So this year, as is also the case for the Banco de México, marks the 25th anniversary of our Law of Autonomy. The independence of the Banco de España came about as part of the European economic integration process. Following the requirements laid down in the Maastricht Treaty, central banks in the European Union were meant to pursue the primary objective of price stability and be vested with a large degree of independence, both political and operational. Participation in the monetary union also entailed a change in the relationship
between Treasury and central bank so as to incorporate the prohibition of monetary financing of government deficits.

Central bank independence was granted with a large degree of legal protection and, as a matter of fact, no country in the European Union can change it at its own discretion. Of course, the independence of the central bank does not mean arbitrariness, as it is well counterbalanced by high transparency and accountability requirements and practices. 

Granting independence to the Banco de España some years before the introduction of the euro as a common currency reflected Spain’s strong ambition to become a founding member of the European Economic and Monetary Union. It was also the result of a firm political conviction as to the benefits of price stability and the advisability of delegating the pursuit of this goal to an independent central bank. Price stability requires a medium-term orientation and the independence of the monetary authority creates credibility by helping to keep inflation expectations anchored while avoiding time inconsistency problems.1 These reasons were particularly compelling for the Spanish economy in light of the previous experience of relatively high inflation.

 

 

Central bankers as explorers/navigators such as Vasco Da Gama, Columbus…

November 29, 2019

Klaas Knot of Dutch Central Bank in this speech:

We are drawing closer to the end of the year in which the ECB has been celebrating its twentieth anniversary. Typically, this type of event leads one to look back and reflect on the lessons learnt over time. And to evaluate how the lessons learnt can be taken on board in future endeavors. Indeed, the year has seen many conferences and papers dedicated to the tale of the ECB’s first two decades. For European central bankers, the second of these two decades has been particularly challenging.

In the last decade, the ECB has been navigating uncharted waters with unconventional monetary policy, just like Magellan, Sir Francis Drake and Columbus. We were not without compass, nor without a clearly set course. But nevertheless, the waters we navigated were new to us. No maps were available. And, again like those famous explorers, we were vigilant, alert and prudent. Now that we seem to have reached a harbor of some sort, and a new captain is aboard, we should consider charting the unchartered. We should draw maps of the coasts we discovered. We should mark where the sea monsters live. We should be the cartographers of unconventional monetary policy.

….

Not sure many would agree to this comparison!

What drives interest rates? Central bank policy rates or something else?

November 29, 2019

Òscar Jordà and Alan M. Taylor in this short paper look at evidence from Japan, Germany, the United Kingdom, and the United States.

People generally attribute a great deal of discretion to a central bank’s ability to set interest rates. This might be an overstatement. Our analysis suggests that most of the variation in interest rates can be explained by conditions beyond the central bank’s control: the aging of the population, declining rates of productivity growth, and other slow-moving factors known to affect the neutral rate of interest globally and domestically. From this perspective, fears that policy stances are increasingly diverging across advanced economies and that this divergence may have adverse consequences for the international financial system may be overblown.

Hmm..

How Neoliberal Thinkers Spawned Monsters They Never Imagined

November 28, 2019

Interesting interview of Wendy Brown who has written a book on the topic:

Lynn Parramore: To many people, neoliberalism is about economic agendas. But your book explores what you describe as the moral aspect of the neoliberal project. Why is this significant?

Wendy Brown: Most critical engagement with neoliberalism focuses on economic policy – deregulation, privatization, regressive taxation, union busting and the extreme inequality and instability these generate. However, there is another aspect to neoliberalism, apparent both in its intellectual foundations and its actual roll-out, that mirrors these moves in the sphere of traditional morality. All the early schools of neoliberalism (Chicago, Austrian, Freiburg, Virginia) affirmed markets and the importance of states supporting without intervening in them.

But they also all affirmed the importance of traditional morality (centered in the patriarchal family and private property) and the importance of states supporting without intervening in it. They all supported expanding its reach from the private into the civic sphere and rolling back social justice previsions that conflict with it. Neoliberalism thus aims to de-regulate the social sphere in a way that parallels the de-regulation of markets.

Concretely this means challenging, in the name of freedom, not only regulatory and redistributive economic policy but policies aimed at gender, sexual and racial equality. It means legitimating assertions of personal freedom against equality mandates (and when corporations are identified as persons, they too are empowered to assert such freedom). Because neoliberalism has everywhere carried this moral project in addition to its economic one, and because it has everywhere opposed freedom to state imposed social justice or social protection of the vulnerable, the meaning of liberalism has been fundamentally altered in the past four decades.

That’s how it is possible to be simultaneously libertarian, ethnonationalist and patriarchal today: The right’s contemporary attack on “social justice warriors” is straight out of Hayek.

All human constructs have serious limitations…

Europe needs its “own open development bank” to push its global agenda

November 27, 2019

Everyone needs a bank these days. That too in this digital era where people are questioning the role banks will play in future.

In this piece. Eric Berglof of EBRD argues for a development bank to push Europe’s global agenda:

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Why Financial Markets’ (yet another) new exuberance is irrational

November 27, 2019

Nouriel Roubini in this proj synd piece:

Owing to a recent easing of both Sino-American tensions and monetary policies, many investors seem to be betting on another era of expansion for the global economy. But they would do well to remember that the fundamental risks to growth remain, and are actually getting worse.

….

The disconnect between financial markets and the real economy is becoming more pronounced. Investors are happily focusing on the attenuation of some short-term tail risks, and on central banks’ return to monetary-policy easing. But the fundamental risks to the global economy remain. In fact, from a medium-term perspective, they are actually getting worse.

But who cares as long as the music is on…

The onward march towards an old-style command economy..

November 26, 2019

V. Anantha Nageswaran in this piece points how shortselling is being banned in quite a few parts of the world:

Elizabeth Warren, Bernie Sanders and James Corbyn must be fancying their chances in the forthcoming elections in their respective countries. Never mind that former US President Barack Obama cautioned against the Democratic Party turning too far left. Even if they heed his advice, the world’s capitalists and regulators seem united in turning voters and candidates leftwards.

I just saw a story (Return Of Short-Selling Bans: Market Protection Or “War Against Truth”?, 19 November 2019) put out by Reuters that Turkey has banned short-selling. Korea might do so, and so could Europe if Brexit creates market turbulence. Europe had resorted to banning short-selling between 2008 and 2012 as it battled the fallout of the global crisis and then the Greek crisis. Global economies, advanced and developing, now ride on asset prices. As leverage ratios have risen relentlessly both in the public and private sectors, the only way governments can prevent the unravelling of balance sheets is to place all policy tools at the service of underpinning asset prices.

The logic is clear. However, the question is whether its costs would exceed the benefits, and whether it would postpone real price discovery to a later date—only for it to manifest itself more uncontrollably than now.

The more things change, the more they remain the same!

Does the Lack of Financial Stability Impair the Transmission of Monetary Policy?

November 25, 2019

Viral Acharya, Björn Imbierowicz, Sascha Steffen and Daniel Teichmann in this new NBER paper:

We investigate the transmission of central bank liquidity to bank deposits and loan spreads in Europe over the period from January 2006 to June 2010. We find evidence consistent with an impaired transmission channel due to bank risk. Central bank liquidity does not translate into lower loan spreads for high-risk banks for maturities beyond one year, even as it lowers deposit spreads for both high-risk and low-risk banks. This adversely affects the balance sheets of high-risk bank borrowers, leading to lower payouts, capital expenditures and employment. Overall, our results suggest that banks’ capital constraints at the time of an easing of monetary policy pose a challenge to the effectiveness of the bank-lending channel and the central bank’s lender-of-last-resort function.

 

Canada’s banking system and its resilience

November 22, 2019

Canada has a long history of financial/banking stability compared to most other nations.

In this recent speech, Carolina Wilkins, DG at Bank of Canada  points how the system will remain stable despite the worst possible adverse shocks:

Canadian banks are part of a global banking system that is more solid than it was a decade ago. Globally active banks are holding over US$2 trillion more capital than they were at the beginning of 2011, when the phase-in of the post-crisis reforms began. This translates to a 7-percentage point increase in their Tier 1 capital ratio.11  The leverage limits and new liquidity regulations also make these banks more resilient.12

Canada has implemented new measures to further strengthen our banking system. For example, Canada’s prudential regulator, the Office of the Superintendent of Financial Institutions (OSFI), increased the required amount of capital that Canada’s big banks have to hold to protect themselves against financial-system vulnerabilities. Canada introduced a bail-in regime to ensure that investors—not taxpayers—would take the brunt of the financial burden in the unlikely event that a big bank were to fail. Also, OSFI asked many smaller, single-business-line banks to reduce their reliance on short-term brokered funding, which can be flightier in stressful situations.

The Bank of Canada, along with OSFI, evaluates these safeguards by conducting stress tests on the major banks. Given that the idea is to plan for the worst, it’s important to study extreme scenarios. The most recent test was in the context of the International Monetary Fund (IMF)’s Financial System Stability Assessment of Canada, published in June.13 

The scenario used was worse than anything seen in Canada in recent decades. There’s a recession that lasts two years, the unemployment rate increases by 6 percentage points, and house prices fall by 40 percent.14 Clearly this would be very difficult for people if it were to materialize. That said, this test found that our banks could withstand even this kind of severe, system-wide shock. This says to me that efforts to increase resilience in the banking system have been worthwhile, because they would help prevent a bad situation from becoming even worse.

Hmm…


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