Break the thermometer and you will not have a fever

- Financial markets are forcing governments to respond more quickly and correct their gravest mistakes. The politicians do not like it a bit. So why not to try to blame rich speculators - prof. Reuven Brenner comments on the attemps to curb speculation before the G20 summit in Toronto.

Obserwator Finansowy: The Canadian government is the most vocal opponent of the introduction of an international tax on banks. Why?

Reuven Brenner: The Canadian government has opposed the introduction of tax on banks because there are many other regulations that impose constrains on banks and which are similar to tax. In the current debate on financial reform, there is an argument that Canadians escaped the banking crisis so other countries should emulate their banking regulations elsewhere. True,, Canadian banks remained profitable even in the fourth quarter of 2008, are well capitalized, they have no problems in raising additional capital from private sources and no large Canadian bank required public support. The problem is that you cannot really isolate banking from other taxes, regulations, institutions – those concerning mortgages in particular. Canada’s success is not only due to banking regulation, but many other laws and circumstances that contributed to this result.

What are these circumstances and laws?

– In Canada there was no political pressure similar to the US to promote homeownership. We do not have Fannie Mae, Freddie Mac to promote „affordable housing”, we do not have a law that forced banks to lend money to less reliable borrowers. Mortgage interest is not tax-deductible as it is in the United States. In the U.S., down-payment is required at 3 percent., Canada you have to pay additional insurance you have not got 20 percent of equity.

– Also, in the United States mortgages, and many other major credits are non-recourse loans. This means that when a borrower cannot repay the loan, the bank can only seize the collateral and that is it. So if the value of the property falls below the amount of debt, the borrower can simply walk away and the bank comes to own the property. In Canada, mortgages are recourse, which means that the bank can satisfy its claims from other sources including incomes and other assets of the debtor. This is a huge difference, which makes banking activities much less risky in our country.

– Canada has one regulator of the financial market. And that may actually be a lesson to be learned for the countries where financial supervision is carried out by numerous, poorly communicating institutions.

– Canadian regulations did not prohibit the marketing of securities based on assets such as CDOs. A few years before the crisis, Canadian banks did have in their portfolios a lot of such securities. But about 6 years ago, Canadian banks have begun to get rid of them, on the advice and insight of Ed Clarke, president of Toronto-Dominion Bank, who said: „These instruments have become too complicated. If I can not hold it for my mother in law, it also can not hold it for my clients.’ But it needed lots of guts to stand up during those exuberant times to do this.

Why Canadian bankers behaved as reasonable while American did not?

First, it is reasonable in retrospect: if interest rates stayed as low as they were then, we probably would not have had the crisis. And many held such expectations. Second, the answer again is associated with specific features of the Canadian banking market. In Canada, there are a total of five large banks which are pretty much protected by the state. Foreign banks can not open a branch here unless they take deposits of 150 thousand dollars. Thus in the retail segment there is a little competition. So there is the five CEOs who might watch one the other regularly and with relative ease. How were other banking CEOs convinced to emulated Clarke – I do not know.

Perhaps more important was that the Canadian banks were less leveraged?

Indeed, Canadian banks had an average of $ 18 in assets per dollar of equity, while the commercial banks in the U.S. had 26 and investment banks 40. But you can easily go bankrupt even with leverage 18:1 if you do not conduct a reasonable credit policy. And here lies the difference. The circumstances that I mentioned have made the Canadian banks to not have the incentive to go in the direction American counterparts went. American banks became machines operating on the principle origine-and-distribute. Canadian banks held loans on their balance sheets, and carefully examined the creditworthiness of customers. The top management in US banks were marketers, whereas in Canada they stayed bankers, requiring due diligence. The US counterparts outsourced due diligence to rating agencies – without proper consideration.

And what to you think of a tax on banks, an idea France and Germany will seek to introduce at the upcoming G20 summit in Toronto?

At the beginning you need to ask yourself the question – what does it mean that tax will be levied on the bank. Who exactly will pay this tax? Will it be the shareholders? If so, it will be even more expensive for the banks to raise capital, which they need now. If the costs of tax will be passed on to customers in the form of higher charges? Even now the banks have a bad image among customers and the imposition of a tax could exacerbate the political problem on the line between the public opinion and the banks. Journalists often present it this way – the banks have a bad reputation, so impose a tax on them. But hardly anyone pays notice that tax will be paid by those who are least mobile. Nor is it clear whether the money from the tax would get into a special fund to cover some extraordinary losses or simply go to the budget where it will be wasted. I believe that a tax on banks does not solve any problem.

Today France and Germany was joined by the United Kingdom, which also intends to introduce a tax on banks. Will they succeed together to push its position on the G20 forum?

Even taking into account the political backlash against the banks, which in the U.S. and Europe, is sometimes justified, I do not think that all countries will agree to this proposal. I think that in this case sober minds will prevail. Move by Cameron’s government, in my opinion, is rather political symbol than a real change in the banking sector: the British tax is minuscule, so bankers from the City will not be induced to leave abroad.

May G20 summit produce something that would move regulation of financial markets in the right direction?

No (laughs). Please tell me when was the last summit of the G20 has made a sensible decision? There are so many things on agenda from finance to environment to name it. How can anyone believe that politicians talking one with the other for 2 days would come up with anything serious? If you ever were member on Board you know that boards on companies become ineffective if you have more than 8 – max 10 members. And they focus on few issues. These meetings are PR to suggests that politicians are doing something. But do not confuse activity with any achievement.

So, yes, it is important to meet and discuss, but unless there is reasonable solutions already well prepared, which then only require signatures – it’s all for nothing. Take a recent example. Merkel and Sarkozy want to push for constraining speculation. I believe that what is proposed German Chancellor and French President is pretty silly – and all the historical evidence contradicts their statements. They seem both either stuck with prejudices from the past, or are ignorant of the past – or, my guess – they play the blame game, and diver attention from the real issues. European politicians have not complained about the speculation when the euro rose to 1.5 dollar. They are eager to take the credit when this happened. But when euro or any other currency is falling it is because government policy is worse than elsewhere – then suddenly it is the bad speculators …. But ask yourself: Who can put an end to stupid policies, to government statistical lies as in Greece? Votes? Democracy? That take quite a while, and meanwhile the mistakes compound. Financial markets force governments to react more quickly and correct their grave mistakes. And politicians do not like this one bit. So why not blame rich speculators? And subsidize academics to write treatises about speculation being bad, and rely on their „research” to justify their actions?

This story is repeated over and over for thousands of years: remember the Bible’s condemnation of usury? The current discussion on the limitations of speculation is nothing new, and almost word by word we hear arguments against the finance raised since the dawn of the civilization – that there is no real contribution to the economy, that is does not produce anything, that it destabilizes the situation. I considered these arguments in my last book „A World Of A Chance” (written much before this crisis) and where the facts and sequence of events suggest that the truth lies elsewhere. Financial markets generate prices, for example, related to the probability of insolvency (as the CDSs do). These prices, exchange rates, etc. say a lot about policies pursued. Politicians do not like to see these markets and prices as they make clear how they not lead but mislead their countries.

 

Reuven Brenner holds Repap Chair at Desautels Faculty of Management, McGill University. He is the author of among others “Force of Finance: The Triumph of Capital Markets” and “A World of Chance”.


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