Where is Finance Minister Flaherty?

Where is Finance Minister Flaherty? by Doug Peters and Arthur Donner. (from today’s Toronto Star)

 

(Doug Peters is the former Chief Economist of The Toronto-Dominion Bank and was Secretary of State (Finance) from 1993 to 1997. Arthur Donner, a Toronto economic consultant, began his career as an economist at the Federal Reserve Bank of NewYork.)

 

“The credit problems are not primarily a shortage of liquidity. They come from an excess of bad loans that have to be written off in whole or part. This is a job for management and their auditors. The Fed is not responsible for correcting bad private lending decisions.” (Lawrence Summers, Financial Times, November 25, 2007)

 

Regulators, central banks and investors are still uncertain about the full extent of the credit-induced losses that have infected financial institutions in North America and Europe. Canada’s own version of the problem, the $35 billion of frozen asset backed commercial paper, has not yet been satisfactorily solved. No one really wants to purchase these debt instruments. This is not too surprising. It is difficult to determine the price for exotic instruments that do not trade.

 

A committee led by Mr. Purdy Crawford which was set up to protect the investors holding these securities correctly sees the need for an outside pool of funds to help maintain a market for the reconstituted debt.

 

As part of the proposed solution, Canada’s chartered banks are being asked by the Bank of Canada to supply from $500-million to one billion dollars each to refinance and restart this financial fiasco, despite the fact that some of the banks were not even involved in this business.

 

There has been a massive public policy/regulatory failure on these exotic instruments not only in Canada but also in the US and Western Europe. As our quotation from Lawrence Summers highlights, it is not the job of the central bank to bail out bad and overly risky investment decisions.

 

The central bank’s job is to protect the entire financial system, to ensure that the system does not fail. In plain words, the central banks must protect bank depositors, not reward shareholders for risky or greedy behavior.

 

The Bank of Canada is taking a public lead on this file, when from our perspective the federal regulators should take the lead. Regulation of federally chartered financial institutions is the responsibility of the Ministry of Finance.

 

Finance Minister Flaherty has been curiously silent on this issue despite the gravity of the problems in the Canada’s money market. The Finance Minister appears to have left these difficult problems to the Governor of the Bank of Canada. But this is not only a central bank problem. Indeed, the principal source of the problem is lack of adequate regulation and government oversight. The lead in on this file should be the Minister of Finance, not the Governor of our central bank.

 

Insufficient regulation of the credit market has allowed a number of non-bank entities to issue short-term commercial paper to investors that failed to be sufficiently transparent. Investors bought these debt instruments without the knowledge of what assets were behind these notes. The result has been a tightening of credit throughout the whole credit system and Canadian businesses and individuals now face much more severe borrowing restrictions than would normally have been the case.

 

Canada’s banks are important conduits of monetary policy and just when conditions appear to call for an easier policy, the credit crunch has tightened up the system. This is an issue for the Canadian economy and the Canadian government must step up to the plate and protect the interest of Canadians.

 

There are two questions that the banks should be asking before they contribute any funds to such a bailout. First, they should ask how much money the government would be contributing to the bailout scheme, or whether the government would be willing to guarantee the amounts that the banks are committing. Second, they should be asking what the federal government intends to do to make sure that such a fiasco in the money market will not happen again.

 

There is an important public policy question as to what regulations are needed to prevent a recurrence of such a fiasco in the future. The asset backed securities were issued without adequate capital, without adequate margin and without a clear source of liquidity in case of need. Thus the policy role of the regulatory authority in dealing with exotic financial instruments is to ensure the adequacy of both capital and liquidity.

 

Two paths might be followed. First, the trusts that hold the assets behind these short-term debts could be compelled to be structured as federal trust companies with the required capital and regulation. Or alternatively, each trust could be required to have an unconditional guarantee on liquidity from a bank and that bank would be required to have a full amount of regulatory capital behind such guarantees.

 

Politically, Finance Minister Flaherty may have been burned by the government’s turnaround with respect to income trust issue. He seems to wants to avoid this file so as not to be politically burned twice.

 

But before this tentative agreement to rescue the asset backed commercial paper market falls apart, the Finance Minister should show that the government of Canada is concerned about this problem, is willing to both step in and take a lead position, and will take on the responsibility of correcting a faulty regulatory system.