The credit crunch has set its share of dubious precedents, not least of which is the U.S. government-engineered bailout of a troubled brokerage firm, New York-based Bear Stearns & Co. Inc. Canadian regulators remain confident that a similar situation couldn’t happen here, but the episode raises some fundamental questions for policy-makers to ponder.

The Bear Stearns bailout was unusual for a number of reasons, but what precipitated the crisis at the firm appears to be very ordinary. The firm was essentially the victim of the classic cause of bank failures — a “run on the bank.” As its sources of liquidity very quickly dried up, the business quickly became insolvent.

What makes this situation unusual is that it happened at an investment bank rather than at a traditional deposit-taking institution. But what is truly novel is the reason U.S. officials stepped in and helped arrange J.P. Morgan Chase & Co. Inc. ’s acquisition of Bear Stearns.

In testimony before the U.S. Senate committee on banking, housing and urban affairs, Federal Reserve Board chairman Ben Bernanke said that the Fed had decided to intervene and help save Bear Stearns because the firm was so deeply entwined in the U.S. financial system that to let it fail could have severely damaged the entire system and, ultimately, the economy.

“Normally, the market sorts out which companies survive and which fail, and that is as it should be,” Bernanke told the committee. “However, the issues raised here extended well beyond the fate of one company.”

Bernanke noted that Bear Stearns was an important player in a number of markets. “The sudden failure of Bear Stearns probably would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence,” he said. “Given the exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain.”

Policy-makers were also worried that the pain would have spread well beyond the financial system, further harming the economy. To avoid that possibility, government officials felt compelled to prevent Bear Stearns from falling into bankruptcy. But officials did so using a process that seems somewhat murky and poorly understood.

As a result, the Fed and the U.S. Treasury have been accused of injecting moral hazard into the U.S. financial system. By bailing out Bear Stearns, it is argued, they are implicitly providing a guarantee for other investment banks, which are lightly regulated. Government officials are thereby inviting these firms to take undue risks in that they know they can enjoy the rewards of that risk-taking while a catastrophic failure would probably fall on the shoulders of the government and, ultimately, the taxpayers.

Defenders of the Fed’s decision have refuted this suggestion, pointing out that Bear Stearns shareholders took a severe hit, even after J.P. Morgan agreed to raise the price it is paying for the firm from a mere $2 a share to $10 a share. And many of Bear Stearns’ employees suffered greatly from the firm’s collapse. It’s unlikely that any firm would intentionally invite that much risk, the defenders insist.

Regardless of whether the bailout has increased moral hazard in the U.S. investment banking business, it has injected a new doctrine into the world of prudential regulation: that a firm can be considered “too integrated to fail.”

It has often been argued that banks can get “too big to fail.” Should an individual bank represent a very large chunk of the local market, the government may feel obliged to prevent a failure that would affect a large number of consumers and businesses. That’s one of the reasons for opposing bank mergers in an already sparsely populated banking market such as Canada’s.

But the notion that a firm could be too deeply insinuated into important financial markets to be allowed to fail is a new concept, and it raises important considerations for policy-makers who have to worry about financial firms’ solvency.

For example, if the circumstances in which the government would probably step in to prevent a failure has expanded, does the regulatory oversight required to prevent a failure have to increase as well? Are counterparty risks being given sufficient attention? Does the speed, and the source, of Bear Stearns’ fall alter regulators’ evaluation of banks’ vulnerabilities? And if banks are to be prevented from getting too big to fail, shouldn’t they also be prevented from getting too interconnected to fail?

@page_break@To Glorianne Stromberg, a long-time financial services industry observer and former regulator in Toronto, the lesson in all of this for governments, regulators and central bankers is that there are major gaps in our regulatory oversight system.

“The way business is done, what business is done and who is doing it have far exceeded the financial system for which our regulatory process was designed,” Stromberg warns. “The four pillars of financial services regulation have been vapourized, leaving large segments unregulated or unsupervised — both functionally and prudentially.”

Yet Canada’s federal prudential regulator, the Office of the Super-intendent of Financial Institutions, maintains that the Bear Stearns episode has not, by itself, changed OSFI’s thinking on bank risk.

“We have a robust framework for making risk assessments,” says Rod Giles, manager of communications and public relations with OSFI in Ottawa. “The events surrounding Bear Stearns has not caused us to change our approach.”

Giles points out that OSFI has been working to improve its ability to identify risks as part of an overall effort to stay on top of the evolving risk environment. “One of the initiatives flowing out of that was the creation of an emerging risk committee,” he says. “We are also adding resources to our supervision sector and have increased our consultations with the private sector.”

These initiatives were underway before the Bear Stearns collapse, Giles adds.

Doug Hyndman, chairman of the B.C. Securities Commission in Vancouver, suggests that there is little likelihood of a similar failure in Canada. “I suppose there are always lessons from that type of event,” he observes. “But our big Canadian dealers don’t have anything like the principal trading exposure that Bear Stearns had, and, therefore, aren’t as vulnerable to that kind of ‘run’.”

Whether or not a Bear Stearns-like collapse is likely to happen here, in any dealer insolvency, the primary concern for the regulators that are closest to Canadian dealers is the ongoing safety of client funds.

“Our job is not to ensure that no member fails,” says Paul Bourque, senior vice president of member regulation at the Investment Dealers Association of Canada in Toronto, “but rather to ensure that, if any member does fail, all the client cash and securities are available for distribution to the clients.”

He adds that given the industry contingency fund (see page 22), IDA rules and bankruptcy legislation, it is “extremely unlikely that any client would lose cash or securities in the event of a dealer insolvency of any size.”

Of course, the situation in Canada is quite different from that in the U.S. and many other markets because the biggest investment dealers in Canada are owned by much larger financial institutions. The expectation is that their parent banks would backstop the dealers should they face a real liquidity crisis.

However, the promise of parental support or government salvation is not something on which a contingency fund can afford to rely. Rozanne Reszel, CEO of the Canadian Investor Protection Fund in Toronto, says that, although the CIPF expects that if one of the large bank-owned dealers ran into trouble, “there could well be other compensation funds involved on behalf of related regulated companies and possibly government agencies, but we can’t unilaterally reduce our assessment of risk in CIPF-member firms.”

This past year, the CIPF reviewed the adequacy of its assets to cover possible claim. As outlined in its soon to be released annual report, the CIPF finally concluded that, to keep pace with recent increases in client net equity, it was necessary to take out a $100-million insurance policy.

“This improves our ability to respond to multiple event occurrences,” Reszel says, “should they arise.”

The CIPF is in the midst of implementing a risk-based assessment model, designed to reward firms that have adopted good controls and governance practices.

Nevertheless, the collapse of a large firm, or even a parent bank, is not beyond the realm of possibility. The Bear Stearns episode shows that even the largest financial institutions aren’t immune to the sorts of funding crises that can cripple a bank. And in the Canadian market, the systemic pressure would probably be even greater because of the level of bank concentration. As a recent research report published by the Bank of England points out, all else being equal, more concentrated banking markets “are prone to larger systemic risk.”

Indeed, if a failure of that magnitude did happen, Bourque notes, it would become a systemic issue, which would then fall under the oversight of the federal banking and provincial securities regulators.

The BCSC’s Hyndman indicates that securities regulators are in regular contact with the Bank of Canada and other federal authorities that have primarily responsibly for financial system stability, “We share information,” he says, “and act in concert when necessary.”

Canada might not be a likely source of the next Bear Stearns, but domestic policy-makers can surely learn some lessons from that exceptional episode. IE