How Solid Are Canada's Big Banks?

Originally posted at Sprott Money March 22, 2017

The World Economic Forum consistently ranks Canada's banks among the world's safest. Competent regulators have overseen stress tests, tightened lending standards and delinquency rates are low. Demographics are good and the country's diversified economy is backed by a treasure of oil, wood, gold and other natural resources.

So the experts say.

Institutional investors, relying on the work of Jeremy Rudin, Canada's chief bank regulator, agree. In fact, Canadian financials accounted for 35.5% of the market capitalization of the benchmark exchange (NBF February).

However this façade hides major uncertainties. Key concerns stand out, which if unaddressed, could spark solvency and liquidity issues in one or more of Canada's Big Six banks.

The fragilities can be seen in an IMF report, which calculated that Canada's financial sector accounted for a stunning 500% of GDP in 2012. Today, the assets of the Big Six banks alone are more than double the size of the country's economy.

Each (RBC, CIBC, Scotiabank, BMO, TD and National Bank) have been designated "systemically important," which in turn, due to sheer size and interconnectedness, suggests that they are almost certainly "too big to fail." That means the collapse of any one Big Bank would threaten to trigger systemic implosion.

More ominously, if Canada's financial system, arguably the world's best, is riddled with pores, what does that say about the US, the UK, and Japan? Let alone Italy and Spain?

Yet signs of fragility are everywhere. Consider:

Complacency Following "Secret" $114 Billion Bailout

A quick review of key metrics suggests Canada's banking sector, which, on the surface, having largely escaped the 2008 financial crisis, has thus learned little from it.

As David Macdonald demonstrated in a paper for the Canadian Center for Policy Alternatives, Canada's Big Banks benefited from nearly $114 billion in cash, liquidity, and other bailout help from both local and US sources following the financial crisis.

"Three of Canada's banks - CIBC, BMO, and Scotiabank - were at some point under water," Macdonald writes. "With government support exceeding the value of the company."

Sadly, details were largely kept secret, Macdonald says, hidden in footnotes and legalese, where even the term "bailout" was shunned. Reforms that could have strengthened the system were thus avoided and the Canadian public remains largely unaware of the dangers.

(A Canadian Bankers Association spokesperson denied that any Canadian bank was bailed out or was in danger of failing, but conceded that the Canada Mortgage Housing Corporation ("Canada's Fannie Mae") bought up $69 billion worth of assets and that the Bank of Canada advanced additional liquidity funding).

"Canada's Fannie Mae" Piles On Risk Amidst Residential Real Estate Bubble

In March, the Economist magazine calculated that Canadian residential housing is 112% overvalued relative to rents and 46% overvalued relative to incomes. Even Canadian bank economists, enablers of previous excesses, now describe average Toronto prices, which surged 23% last year to CAD $727,000, as a bubble.

Canadian banks have lent into much of the excesses and "Canada's Fannie Mae" (the CMHC) has guaranteed more than $500 billion in mortgages; almost as much as the US GSEs did relative to GDP prior to the 2008 crisis.

Canadian Banks Have Never Seen A Major Real Estate Implosion

Because Canadian real estate prices never collapsed during the 2008 financial crisis to the degree they did in the US and the UK (let alone Japan), regulators, investors and analysts are totally unprepared for any such eventuality.

As noted above, there are no indications that any Canadian regulatory body such as OSFI or any financial institution has had a Japan style scenario gamed out by independent risk experts. This even though some Canadian demographic trends, particularly with regards to workforce aging and retirements for the coming decade are roughly similar to what Japan's were, at the peak of its bubble.

Canadians Are In Record Debt

Worse, Canadians are in debt up to their eyeballs. According to Statistics Canada the ratio of household credit market debt (this excludes government, financial and business debts) reached a record 166.9% of disposable income in the third quarter of 2016. That was up from 166.4% in the second quarter.

Inflated asset prices currently keep those debts under the rug. However asset price levels are temporary; debts linger.

Wolves Are In Charge Of The Hen House

Another dangerous sign stems from the fact that all key stakeholders that facilitated the 2008 bubbles and ensuing crisis escaped unnoticed. That means the wolves remain in charge of the hen house.

For example, as Macdonald notes in his paper, Gordon Nixon, CEO of RBC, Canada's largest bank during the crisis, took in CAD $9.6 million in compensation in 2008, and $12.1 million in 2009.

Canadian bank CEOs and directors now figure that they'll be bailed out and collect their bonuses, no matter what risks they take.

Bank CEOs aren't alone in escaping blame for running the system into the ground in 2008. Most Canadians wouldn't recognize David Dodge either. However, as governor of the Bank of Canada, he fostered the easy-money policies which facilitated the debt and asset bubbles that led to the ensuing troubles.

OSFI: Financial Sector "Group Think" Stress Tests

Another key threat to Canada's financial system relates to the "group think" that pervades top officials, which leads them to err simultaneously.

This is evident in the stress tests that various regulators (the IMF, OSFI, the BOC) have conducted or overseen on the big banks, which remain riddled with holes.

Shorn of business cycle theorists, the stress tests only considered scenarios based on Canada's history dating back to the 1980s. This despite the fact that eight years of unconventional monetary policy suggests that there are high risks that Western economics are in the midst of a 1930s-style liquidity trap.

As if that were not enough, the stress tests only considered Canadian economic performance. But the first question a doctor will ask is what ailments there are in your family history. Canada's family (the G-7) includes Japan. An obvious stress test scenario would have looked at Japanese metrics during the past two decades.

Worse, regulators allowed the banks themselves to conduct the key bottom-up stress testing, rather than outsourcing the job to independent consultants. That's like asking a drunk to check the inventory list in the wine closet to make sure everything is still there. Finally, the stress tests appear to have omitted any probability of freezing up of key counterparties, as occurred with AIG during the 2008 crisis. What would happen if there was a 1% default in the notional value of the $1 quadrillion global derivatives market? (a $10 trillion loss) We don't know.

The fact that bureaucrats who looked away during the buildup to the 2008 financial crisis weren't reprimanded will have major implications going forward. That's because Jeremy Rudin, head of OSFI, the organization most closely charged with overseeing Big Bank stability, was one of those bureaucrats.

Rudin's story is instructive because it mirrors that of almost all key Canadian financial sector regulatory officials.

Rudin (according to his official biography) spent the pre-2008 crisis years in increasing positions of responsibility in Canada's finance ministry, which culminated in an assistant deputy minister posting. As insiders know, ADM is a crucial position, which gave Rudin, if he did his job well, better access to information and contacts than even his bosses had.

Yet during his years at the heart of the action, Rubin either saw no unusual risks building up, or he reported none.

(This on its own is stunning as there were clear warnings, well in advance, to anyone who was paying attention, from a slew of prognosticators (ranging from Robert Prechter, to Ian Gordon, Peter Schiff, Douglas Noland, Henry Liu and many others) of severe impending risks).

In either case, the chances that Mr. Rudin would identify systemic risks in Canada's financial system if they existed today, or would forcefully report them to the public in a way they understood, are slim.

Worse, OSFI junior officials likely would not either.

In fact, no Canadian regulatory official is allowed to speak to the press without prior approval from the top. The career of any insider who forcefully publicly expressed doubts about sector solvency, liquidity, or risk concerns would essentially be over.

(OSFI spokesperson declined to comment on Mr. Rudin's record prior to joining the organization).

Canadian Bank Accounting Structures Are Lax, Complex And Opaque

Almost unnoticed during the 2008 financial crisis, was that Big Four audit firms all happily signed the financial statements of global big banks, including those in Canada, which only months later proved to be insolvent.

Nothing was said, because most Canadians, even seasoned investors and analysts, have little knowledge of the technical accounting standards that govern the banks. That's not surprising, because Chartered Professional Accountants of Canada, the body that regulates the profession, keeps key information about those standards and how their audits are conducted behind a paywall. This makes it particularly difficult for the public to monitor its performance.

(A CPA Canada spokesperson declined to comment regarding the cost of a hard copy of one of its handbooks, referring questions to its online store, but said that to maintain regular, timely access to the changes would cost $145 a year ($1,450 for ten years + tax)).

Auditors Can't Be Sued For Incompetence

Furthermore, as Al Rosen of Accountability Research tirelessly points out, Canadian auditors essentially can't be sued for incompetence. Their focus is thus naturally on maximizing audit fees and drumming up ancillary revenues from their clients; while presumably doing as little actual verification work as possible.

As such, there is a strong temptation to overlook fraud, error or incompetence.

New IFRS 9 Standards May Be Worse Than Previous Rules

New IFRS 9 accounting standards, which are currently being implemented throughout the Canadian financial sector, to address deficiencies identified in the wake of the 2008 financial crisis, appear to be more of the same.

In fact in some key areas, notably the flexibility the new rules give managers to value loan impairments, the regulations are dangerous. Because these days accountants often use flexibility to make things look better than they really are.

Worse, because IFRS 9 rules give the appearance of addressing the issue of misstatements, while not actually doing so, they will almost certainly do more harm than good.

The reasonable investor can draw only one conclusion: bank financial statements are highly unreliable at best. And if they were wrong, no one would tell you.

Regulatory Silos, Amidst Complexity And Opacity

The biggest and most worrying challenge is that Canadian financial sector stakeholders have erected a variety of complex regulatory and information bodies; but none has clear overall authority and power to maintain system stability.

All have evolved into solid silos, which have little clue what the other organizations are doing. For example it is unclear whether economists at the Bank of Canada have internal access to the skills needed to comprehend a 200-page bank financial statement or to analyze a derivatives book.

The upshot is that likely not one Canadian financial regulator in a 100 can provide a decent global-macro assessment of system stability. Obvious steps, proposed by outsiders have been ignored, or deemed superfluous.

(Eg. A Glass-Steagall style break-up of the big banks, cleaning up Canada's auditing industry, running regular stress tests conducted by independent consultants, using Japan-style scenarios, banning derivatives trading or tightening system credit).

Regulatory Rentiers

One way to understand why regulatory safeguards are so faulty, is to assess bank auditors and regulators the same way they look at banks: as interest groups, whose main goal is to extract rents, fees, jobs and promotions from the system.

The key interest of the regulators in such a scenario, would be to foster maximum growth among the financial institutions they feed on. Surprisingly, judging from the aftermath of the previous financial crisis, regulators might well benefit from a recurrence, particularly if the institutions were once again bailed out with taxpayer funds.

OSFI, CMHC, the BOC, ratings agencies and the CPA Canada, are perennially engaged in power grabs, for more staff, budgets and bigger salaries.

A new financial crisis, would enable them to point the finger at each other, and to demand more laws, regulations and bigger budgets, to set things right. They'd likely get much of what they ask for.

In short, none have any interest in rocking the boat.

To a man, their risk experts missed the boat during the 2008 financial crisis.

None, based on research done for this article, will sound the whistle, before the next one occurs.

That said, the seasoned investor faces challenges. Just because a crisis is inevitable by no means implies that it is imminent.

The overwhelming support that Canada's big banks get from regulators, auditors, rating agencies and analysts (including those outside the country), suggests that an investor's base case scenario would give them the benefit of the doubt, and to set aside a blogger's meanderings.

Maybe Canadian banks are among the world's best.

Maybe the financial system would remain stable if one went under.

Nevertheless, there is plenty of room for doubt.

Furthermore, the evident risks in the Canadian financial system, suggest that a decent review of those in other G-7 nations is clearly in order.

It also suggests that there a good case for hedging one's investment bets ... and preparing for the worst.