Recession, regulation weighing on banks

However, Canadian bankers diverge from their global peers in ranking regulatory risk higher on their list of concerns; in fact, Canadian bankers say, the bur-den of implementing the raft of new global regulations will be onerous.

The Banking Banana Skins 2012 report on a survey conducted by the London-based Centre for Study of Financial Innovation in association with PwC was released in late January. The report ranks what bankers, sector regulators and informed observers had said were their top 30 concerns for 2012. More than 700 banking insiders in 58 countries were surveyed, including 41 executives in Canada.

Both Canadian and international banking leaders had ranked macroeconomic risks as the top concern, as well as access to liquidity, the availability of capital and the potential of taking deeper than expected credit losses among their respective top five concerns.

The survey responses speak to bankers’ general worry regarding recent global economic uncertainty, including the ongoing sovereign-debt crisis in Europe, anemic growth rates among developed economies and the possibility of a slowdown in emerging economies.

“If there is a return to recession,” the report says, “it is very likely that [some global] banks will suffer severe credit losses, and that more of them will fail or have to be nationalized.”

Clearly, Canadian banks are in a much stronger position than some of their global counterparts, with ready access to more than adequate levels of capital and a track record of posting strong returns, quarter after quarter.

“A lot of that has to do with the Canadian banks’ profitable domestic operations,” says Michael King, assistant professor with the Richard Ivey School of Business at the University of Western Ontario in London, Ont., “their focus on traditional lending and relatively low exposure to complicated and highly leveraged business lines.”

Nevertheless, if the global economy should fall into recession, there almost certainly would be knock-on negative effects on the Canadian economy.

There are economic worries at home as well, with many Canadian consumers now carrying a high degree (by historical standards) of household debt relative to income. As a result of consumers’ efforts to reduce that debt, there could be a reduction in consumer borrowing. That situation would probably accelerate, accompanied by an increase in defaults, in the event of a recession. As a result, Canadian banks’ earnings would be affected.

“I think domestic risks are more pressing concerns to Canadian banks than exposure to Europe or other parts of the world,” King says, “because Canadian banks are heavily exposed to Canadian households.”

The fact that Canadian bankers ranked regulation as a greater risk (third overall) compared with their global counterparts (sixth), Kazarian suggests, speaks primarily to the concern of Canadian banks about the cost and complexity of implementing new global regulatory regimes.

Not only must Canadian banks prepare themselves in anticipation of the implementation of the so-called Basel III banking regulations, which begin to come into effect next year, but Canadian banks also will have to deal with whatever separate banking regulatory regimes are ultimately established in key foreign countries.

“There are thousands and thousands of pages of U.S. and British regulations,” Kazarian says, “that are going to have some impact on the Canadian banks that do business in these jurisdictions.”

Finally, Canadian banks will have to adjust to any changes that Canada’s Office of the Superintendent of Financial Institutions finds necessary to make in light of new global regulatory realities, including the possibility of OSFI requiring domestic banks to hold an additional buffer of capital above the minimum thresholds mandated by Basel III.

According to a February investor report by John Aiken, vice president of global research, Canadian financials, with Barclays Capital, a division of Britain Barclays Bank PLC, in Toronto: “At present, we believe investors should brace for an incremental 1%-1.5% cushion required by the regulator, given the systemic importance of the large Schedule 1 banks to the Canadian economy.”

The Canadian banking sector has readily acknowledged the merits of a strong regulatory system for the Canadian banks and, thus, the domestic economy overall. However, it has sounded the alarm regarding the negative implications of overregulation, which, it says, will create an unnecessary administrative burden.

“What is being required of Canada’s banks is the biggest regulatory implementation exercise that they have ever been through,” Terry Campbell, president and CEO of the Toronto-based Cana-dian Bankers Association, said to the standing Senate committee on banking, trade and commerce in December. “This is stretching systems and resources to the limit and beyond, and not just as a near-term necessity but at a steady run rate. This is a real challenge for the system — particularly for smaller institutions — and we must take care to ensure that the sheer volume and complexity of the new rules do not become a new ‘regulatory risk’ in and of [themselves].”

The concern with overregulation, the CBA argues, is that banks could be so overwhelmed with new regulatory requirements that the sector fails to identify other potential risks in a timely manner.

Nevertheless, many experts in the banking sector argue that the global push toward stronger, more robust banking regulations is an understandable consequence of the world’s near-miss with global catastrophe during the financial crisis of 2008. The greatly increased global emphasis on financial stability is simply the new reality to which the world’s banks will have to adjust.

“These regulations are designed to make the banks more stable and the economy less volatile,” King says. “We have to accept that lower profitability for the banks may be a trade-off for having a less risky financial system.” IE