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Labour + Industry

Your Bank's Not as Safe as You Think

And the next crash is waiting to happen. First in an occasional series.

Nick Fillmore 4 Dec

Nick Fillmore is a freelance journalist who worked in many areas with the CBC over nearly 30 years. He is a former member of This Magazine's editorial board and was publisher of the 4th Estate, an independent weekly in Nova Scotia, during the 1970s. Fillmore was also founder of the Canadian Association of Journalists. Email Fillmore or visit his blog.

[Editor’s note: Canada's economy has been feeling almost festive lately. Not so long ago it was very different, as the world weathered an economic crisis brought on mainly by misconduct in the financial industry. Do better times mean the banks have learned their lessons? Not hardly, veteran investigative journalist Nick Fillmore finds, in a series of hard-hitting reports running twice a week for three weeks, starting today on The Tyee.]

If Canada's banking regulations are not substantially toughened by the time the next global financial crisis hits -- yes, there will be another crisis -- our Big Five banks may very well find themselves in serious trouble. Again.

The public is almost entirely unaware that our banking system could go into a tailspin with just a couple of wrong moves or some bad luck. And when the next serious setback occurs, we could end up suffering even more than in 2008-10.

Throughout the Great Recession, Finance Minister Jim Flaherty and the financial community managed to keep secret the fact that our largest banks were in financial difficulty. Had people known the reality, they might have wanted their money back.

In fact, all of Canada's five big banks (BMO, CIBC, Toronto-Dominion, Scotiabank, and the Royal Bank of Canada) faced serious financial problems in 2008, the Canadian Centre for Policy Alternatives (CCPA) found.

Our banks held far too many toxic United States sub-prime mortgages, the same mortgages that sank the U.S. economy. For a while, some of our Big Five were close to not being able to pay their debts.

All totalled, the five wrote down losses of $16.17 billion during the financial crisis, much of it due to losses on near-worthless bundled mortgages. What ensured the banks' survival was massive relief, worth $114 billion, from three sources: the Central Mortgage and Housing Corporation, the U.S. Federal Reserve and the Bank of Canada.

As the Big Five banks were receiving billions of dollars in support, some of their executives were the highest paid in North America. Gordon Nixon of the Royal Bank and Ed Clark of the Toronto Dominion received about C$10.4 million each. That topped even the US$9.6-million salary and bonus awarded to Goldman Sachs Group CEO and Chairman Lloyd Blankfein.

The governing Conservatives had their own reason for wanting to keep the banking crisis secret: 2008 was also a federal election year. Unaware of the crisis, Canadians re-elected a minority Conservative government. Had voters known the extent of the financial crisis, there might have been a different outcome.

This is the fifth anniversary of the 2008 crash and the financial community and the Harper government have not done enough to make our system crash-proof.

Canadian banks remain extremely vulnerable for several reasons. For one, they are making loans and investments valued in the billions of dollars without holding enough in reserve funds should disaster strike. Secondly, many of our banks' activities are intertwined with the same U.S. and European financial institutions that are still gambling and taking risks as they did during the period leading up to the collapse. If a foreign bank crashes or a European government goes broke, the reverberations will reach Canada.

Not (nearly) as strong as they look

"Despite what is commonly understood," writes Chris Ferreira, who runs the website Economic Reason, "the Canadian banking system is not as strong and resilient as most people might assume. If Canadian banks are so strong, why did they need to be rescued in 2008?"

Our financial system is fragile enough that it could equally suffer a shock from within: A collapse of housing values or stress on the economy because of high personal debt.

Globally, while many of the big banks that survived are in better shape than they were in 2008, many are still in dangerous territory. They refuse to adhere to new government regulations, they take more risks than ever, and some even engage in dangerous, potentially illegal activities. I'll report more on that later in the series.

Unfortunately, most people tend to throw their hands up in frustration when the topic of banks and bank profits comes up. The general public has no idea what the banks are up to.

Both are dangerous, because the pro-business Conservative government does not police the banking system very well. Mainstream media, instead of holding the financial sector to account, suck up to the wealthy businessmen who buy advertising and generally call the shots in the country.

If we are to avoid even more serious problems, public interest groups need to monitor the financial sector rigorously, and when people are unhappy with their bank -- a common occurrence -- they need to complain to their MP.

Another financial crash would be devastating for Canada and particularly devastating for those at the bottom of the economic ladder. The Great Recession cost every Canadian an average of $12,000. While the job market has recovered, net employment fell by 362,500 jobs between October 2008 and May 2009.

Why did the Big Five come so close to the brink?

Looking back, people might wonder how Canada's top five banks, with assets running into trillions of dollars, could nearly collapse with losses of only $16.17 billion.

It's simple. The banks failed to have enough hard-cash reserve assets on hand to cover their losses when things started going south.

This points to a fundamental flaw in the banking system.

Most people believe that banks loan out no more than the amount of money they have in their vault. Not so.

Canadian banks, and banks in most countries, keep only a fraction of the money on hand that they loan out or invest. The difference is the bank's "leverage," with the amount of cash on hand being loaned or invested out -- leveraged -- typically many times.

Based on the calmer times of a few years ago, banks assume they will not have any major setbacks. But the Canadian banks were not as "safe" going into the recession as we were led to believe.

"Canadian banks were actually significantly more leveraged -- and therefore more risky -- than well-run American commercial banks," wrote Peter Boone and Simon Johnson, two widely-read U.S. analysts. "For example JP Morgan was 13 times leveraged at the end of 2008, and Wells Fargo was 11 times leveraged. Canada's five largest banks averaged 19 times leveraged, with the largest bank, Royal Bank of Canada, 23 times leveraged."

In the U.S., banks are required to have cash assets valued at 10 per cent of their total investments and loans on hand, in case they have to cope with unforeseen losses. That wasn't enough, as more than 120 U.S. banks, big and small, collapsed or had to be rescued.

Meanwhile, Canadian banks are required to hold only seven per cent of their outstanding debt in backup cash or cash equivalents. That will rise for Canada's top banks to eight per cent by 2016 -- still not enough to protect them during a severe crisis.

Despite the big scare, no Canadian bank collapsed during the recession. However, between 1980 and 1996, a total of 41 Canadian banks, trust companies and mortgage corporations have failed.

"Common wisdom in Canada has been that our banks have sufficient capital", said Jem Berkes, a business consultant who follows developments in the financial community religiously. "Using their new improved measures -- likely to be adopted by regulators in coming years -- Canadian banks actually have some of the poorest capital levels in the world and that's a cause for great concern. It suggests that our banks do not have enough capital to weather global storms."

A minimum 20 per cent rule

The backup cash-equivalent equity kept on hand should be about 20 or 30 per cent of a bank's financial obligations, Neil Barofsky said in an interview with Bloomberg TV. Barofsky should know. He was the special inspector general overseeing the Troubled Assets Relief Program (TARP), America's principle bail-out instrument, from late 2008 until March 2011.

The risks, after all, are real. "I don't see how anyone could say the financial system is stable," writes independent U.S. analyst Greg Hunter. "The next collapse will make the 2008 meltdown look like a day at the beach."

Bank executives nonetheless oppose the idea of having high reserves. They say it would restrict them from making their full potential profit on the funds held in reserve. I would say the safety of our entire economic system is more important than a few more millions in profit for big banks.

Banks facing the greatest risks are those holding stacks of derivatives and similarly dangerous instruments for huge-money gambling. (More on them in a later report.) In addition, if banks have assets that become heavily overvalued, such as those U.S. junk mortgages, they can end up with serious losses.

Economist Jim Stanford says Canada's big banks continue to needlessly make themselves vulnerable. "They have used [their] power poorly," writes Stanford. "Jolting the economy with on-again-off-again surges of credit rather than the steady supply we need. Every bank that does this is inherently vulnerable, even Canadian banks, since no bank has money in the vault to pay its depositors if they all show up demanding cash."

Who's money is it in the bank?

If there were a big financial crash, would ordinary people and small investors be able to get their money back?

In normal times, banks have no problem refunding cash to their depositors on a reasonable request. But technically, when people deposit money into a bank they are turning over their property to that institution in return for a debt claim. The money is no longer theirs: it belongs to the bank. They become an unsecured creditor holding an IOU.

This means that banks can legally refuse to return someone's money on the spot, at least until the conditions of their agreement (that fine print when you open an account) have been completed.

Shockwaves went around the world in March 2013 when the main bank in Cyprus not only refused to give people back their money, but actually began seizing money from the accounts of people with fairly large savings to pay its own debts.

Given the uncertain future of the world financial sector, it's unclear whether ordinary Canadians will be able to get their money back in the event of a severe financial collapse. We should never say, "It can't happen here."

Big investors and corporations that belong to the Canadian Investors Protection Fund (CIPF) have their bank holdings guaranteed up to $1 million. But widows who live in Scarborough don't have that luxury.*

In the event of a crash, the Canadian government might take the same action that the Cyprus bank took, one already being planned by other governments. People would be allowed to keep, say, up to the $100,000 of the money they have in a bank. Some portion of anything more might be handed over to the banks to help balance their books. Finance Minister Jim Flaherty says he won't, but it's impossible to be sure.

The backup to the backup is empty

When someone asks whether their deposited money is safe, the government and the banks quickly point out that the Canadian Deposit Insurance Corporation (CDIC) insures funds in several categories of bank deposit for up to $100,000 per person. (See sidebar for insured deposits.)

The CDIC, we're assured, will be there for people if there are losses due to a financial crisis, a housing crash, a credit crunch among already overburdened Canadians or just a general decline in the economy.

The CIDC's math makes that hard to credit. The corporation claims to be ready to back up $604 billion in deposits. For this gargantuan task it has in assets only $2.2 billion -- a minuscule 0.36 per cent of the total potential claim, points out analyst Chris Ferreira. The CDIC has power to borrow only another $19 billion, although Parliament could authorize additional borrowing.

Of course, if the economy really hits the wall, there will be a run on assets everywhere to cover huge debts. There might not be enough to go round.

Until now, the big banks have been encouraged to operating in a risky manner because they've been able to count on the federal government appropriating taxpayers' money to bail them out. In future, the banks may be expected to solve their own financial problems. That may be bad news for account holders if the banks come after depositors for the cash to settle their debts.

Tomorrow in this series: How banks make money from thin air, and control governments through debts and cozy relationships.

*This paragraph added Dec. 5 at 4 p.m. as a clarification.  [Tyee]

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