Keeping the Genie in the Bottle: Grading the Regulation of Canadian Financial Institutions

Abstract

The Canadian financial sector made it through the recent global credit crisis in better shape than most. Still the government undertook extraordinary measures to support the soundness of Canadian financial institutions. Fortunately, Canadians learned the lessons of the world banking crisis at lower cost than others. They may not be so lucky the next time. Canada’s approach to regulation includes many features that have been effective in insulating its financial sector from major shocks. Its principles-based approach has proven more adaptable to emerging financial innovations than the rules-based approaches as adopted in the U.S. By favouring permission over prohibition, it has allowed beneficial financial innovations to thrive, while leaving regulators able to step in when innovations appear harmful to the stability of the system. On the whole, Canada’s regulatory approach is, put simply, simpler and reduces the costs of compliance and enforcement. Significantly, it has remained immune from the toxic political influences that overshadow U.S. regulation. None of this guarantees that the Canadian approach to regulation is fail-proof. The Canadian financial sector has a few large banks – some with assets ranging up to 50% of GDP – who could be categorized as “too big to fail.” Deposit insurance rates remain low and insurer’s reserves are not sufficient to shield the Canadian public from the costs of institutional failure. Despite the good job in fostering a stable environment, Canadian regulators must still face a number of issues. Each financial crisis is different and future crises are always over the horizon. Success in avoiding the brunt of the last crisis does not guarantee that Canadian financial institutions will escape unscathed from the next one. Also, fast paced innovation puts regulators in a continual game of catch-up. The rapid growth of shadow banks and over-the-counter derivatives contributed to the last crisis and the issues they raise have yet to be resolved. Finally, the success of international efforts to reverse “too big to fail” by allowing troubled financial institutions to fail safely cannot be assured. It requires authorities to close failing institutions promptly but history suggests that delay may appeal to regulators. They may hope that an institution, if given time, can recover. They may also fear fuelling a financial crisis by repeating the distress unleashed by the failures in the last crisis. With no chance for a trial run, regulators may be forced to bailout failing institutions in the heat of a crisis. To prevent such an outcome, regulators must strengthen measures to ensure that major institutions are too safe to fail.