23 October 2008

Ottawa to Guarantee Interbank Lending

The Globe and Mail, Kevin Carmichael, 23 October 2008

Canada's government has pledged to temporarily guarantee banks' medium and longer term borrowing in a bid to keep pace with the multi-billion dollar financial rescues offered by other countries over the past couple of weeks.

Finance Minister Jim Flaherty said Thursday that he will establish the Canadian Lenders Assurance Facility, which will offer financial institutions insurance on any debt they issue with terms greater than three months.

“We are being proactive,” Mr. Flaherty said at a news conference. “I've had the concern expressed directly to me, and certainly through our officials, that this potential downside could become a reality and it could happen fairly quickly.”

Canada's decision to offer a backstop for interbank lending comes almost two weeks after it signed a pledge by Group of Seven nations to work together to restore confidence in the global financial system. At least a dozen other countries have already offered some form of backstop for the wholesale debt market, including the United States, Australia and most recently Sweden.

The worry in Ottawa was that all these rescue packages would make it more difficult for Canada's banks to secure money abroad. While there's little evidence that this is happening now, the risk is that international lenders will opt to do business with counterparties that are backed by their government's treasuries. That could force Canadian banks to offer higher yields, an extra cost that would eventually be absorbed by consumers and businesses.

“This is a proactive step,” Mr. Flaherty told reporters. “There is this concern that our institutions could be disadvantaged competitively.”

Canada's government has had to do less than other nations to salvage the financial system because the countries banks are relatively sound. Institutions such as Royal Bank of Canada largely avoided the frenzy for the now toxic assets linked to U.S. subprime mortgage market, and stronger regulations forced banks to keep plenty of cash in reserve.

Mr. Flaherty repeated Thursday that Canada's banks are “sound.”

The government didn't attach a cost to the program. With international credit markets calmer, there's a chance the program won't be used. At the same time, if conditions worsen, the government could potentially be responsible for billions of dollars worth of loans.

When asked to further define Canada's potential liability, Mr. Flaherty said “zero to a lot.”

Canada's response to the credit crisis is modest compared with programs in the U.S. and Europe, where governments have used billions of taxpayers' funds to take stakes in financial institutions and guarantee all deposits.

Mr. Flaherty suggested Thursday that he feels he's done enough for now, saying Canada's banks are well capitalized and that he's satisfied with Canada's current guarantee on deposits of up to $100,000.

Bank of Canada governor Mark Carney endorsed Mr. Flaherty's insurance plan, calling the program “sensible.”

Mr. Carney, who spoke at a separate press conference in Ottawa, also backed Mr. Flaherty's assertion that no further measures are needed to support Canada's banks at this time.

Taking a question on whether Canada should buy stakes in banks, Mr. Carney said the reason countries such as the U.S. are injecting liquidity into their banks is to bring capital ratios up to Canadian standards. “We're already at the finish line,” Mr. Carney said.

Two weeks ago, Mr. Flaherty set up a program that will allow Canadian financial institutions to swap up to $25-billion of mortgages in return for cash to bolster their balance sheets.

The insurance program will start early next month, and remain in place until April 30, 2009. All federally regulated deposit-taking institutions are eligible to apply for insurance on each issuance of debt with terms longer than three months.

The backstop will come at a cost. The base fee will by 1.35 per cent on each request, with a surcharge of an extra quarter point for institutions with a credit rating of A- or above. Financial institutions with a lower credit rating will have to pay a surcharge of a half point.

The Canadian Bankers Association said it welcomed the move.

“Canada's banks are well capitalized and financially sound, with or without this federal government loan insurance,” said its head, Nancy Hughes Anthony.

“Governments around the world have guaranteed loans between banks and our federal government has recognized that, without a similar move in Canada, our strong banks could find it more difficult to compete for loans on the international market, which ultimately could affect borrowing for consumers and businesses.”
Financial Post, Paul Vieira & Eoin Callan, 23 October 2008

Jim Flaherty, the Finance Minister, went to some length on Thursday to let people know the borrowing guarantee Ottawa would provide to banks was "temporary." He also emphasized the insurance was available on "commercial terms."

As presented, the federal plan appeared measured and cautious -- two trademarks this federal Conservative government likes people to think is part of its DNA.

But perhaps it also had the earmarks of a Finance Minister not entirely sold on the concept. Sources close to the banking sector suggest Mr. Flaherty didn't feel it was necessary to provide a guarantee in the "Canadian context," given the strength of the financial system and improving credit conditions in the country.

"He didn't feel the urgency to move," said one person familiar with the talks between bank executives and the Finance Minister's office.

Canadian chartered banks had pushed Ottawa for some form of government-backed guarantee since Oct. 13, when Washington signaled it was taking this step. Banks were confident they could compete when it was only European governments that had made the commitment, but were concerned about getting elbowed out of North American borrowing markets once U.S. banks had this assurance.

As it happened, Mr. Flaherty became a reluctant convert. That was just fine with some economic observers, who say the Minister delivered a reasonable response to the banks' call.

"It was worth taking that little bit of extra time to craft something this elegant," William Robson, president of the C.D. Howe Institute, said yesterday of Ottawa's backstop plan.

Details of Mr. Flaherty's guarantee plan were unveiled on Thursday. The guarantee comes in the form of a temporary insurance program, the Canadian Lenders Assurance Facility, which federally regulated lenders can tap. The insurance will be available on wholesale term borrowing, such as interbank lending, and the scheme expires six months after it kicks in, expected some time in November.

Mr. Flaherty said the take up on insurance could range from "zero to a lot," without clarifying what "a lot" meant. Government documents, however, suggest the maximum amount of insurance available is equivalent to 20% of bank deposits as of Oct. 1.

"There may not be any take up ... because the insurance is on commercial terms," Mr. Flaherty said. Those terms are an insurance premium of 1.35%, plus an additional charge of a minimum 25 basis points, based on the debt's investment grade.

"The banks will have to reflect on whether or not they want to use it because there's a significant cost to it to protect Canadian taxpayers."

Initial response was lukewarm. Bank executives told the Financial Post the premium being charged meant they would balk at using the facility. Further, they were not able to pledge that the move would benefit consumers.

A former Department of Finance official said Mr. Flaherty and his officials likely struggled on what to charge as a premium.

"If the pricing is too attractive [to banks], then it could amount to additional contingent liabilities finding their way onto the government's books," the official said.

The Canadian plan is modeled somewhat on the British scheme, although not as strict. But is not nearly as generous as the blanket guarantee Washington has offered, observers say.

Mr. Robson said he particularly likes the exit plan laid out in Ottawa's insurance scheme.

"I like this way of going about it because it is relatively easy to do, and then when the crisis is over you can take it away again."

Other countries, like the United States, that have issued similar guarantees on borrowing "are going to find it difficult -– even if the crisis abates –- to undo some of what they have done," he said.