Canadian banking outlook downgraded over ‘bail-in’ move, adding to recent financial stability concerns

By Guest Contributor
July 17, 2014

By Daniel Seleanu, Compliance Complete

TORONTO, July 17, 2014 (Thomson Reuters Accelus) -  In yet another worrying sign for Canada’s financial sector, Moody’s Investors Service has lowered its outlook for the Canadian banking system from “stable” to “negative” over uncertainty about government willingness to bail out banks during a crisis. It follows a pair of recent warnings issued by the Bank of Canada (BOC) and the Bank for International Settlements (BIS), both of which highlighted the growing risk of stress posed by runaway consumer debt and property prices.

 

Moody’s negative outlook reflected the rating agency’s pessimism over Canada’s plan to implement a “bail-in” regime that would avoid taxpayer-funded bank bailouts by shifting some of the burden to bondholders. It would allow banks to convert some of their debt into to equity during a crisis.

“The accelerating global trend of governments to share the burden of bank resolutions with senior bondholders could reduce the predictability of government support in bank failure scenarios,” Moody’s Senior Vice President David Beattie said in a statement. He added that the ratings for most Canadian banks were buttressed by the agency’s “very high expectation of support” from the government.

“Our assumption has always been that the Canadian government would be very willing to support the major Canadian banks in the interest of economic stability and ensuring that the payment system operates correctly under times of stress,” Beattie told Thomson Reuters. “It’s clear their intentions have changed.”

This is the second Moody’s downgrade in response to the bail-in proposal. In June, the agency adopted a negative outlook on senior debt and uninsured deposits at Canada’s largest banks. “The government’s intentions are clear, and if a legislative framework permitting bail-in can be implemented, it will likely be negative for creditors,” Beattie said at the time.

In both cases, however, Moody’s also raised broader concerns for Canada’s financial system, including risky bank behaviour, high levels of household debt, and overvalued property markets. In its most recent statement, Moody’s observed that Canadian banks were pursuing profits in “riskier businesses and geographies,” which it said represented a growing risk to systemic stability.

“Moody’s also notes that while the potential for external shocks to the Canadian economy has receded, high household indebtedness and elevated housing prices remain key risks to banking system stability in Canada.”

Other recent warnings

Echoing the rating agency’s apprehension over debt and property price inflation, the Bank of Canada (BOC) and the Bank for International Settlements (BIS), which monitors systemic risk globally, recently issued their own warnings.

In its latest Financial System Review (FSR) (PDF), the BOC warned that while Canada’s financial system was stable overall, it remained vulnerable to several risks that could trigger a disorderly real estate correction resulting in severe banking instability. The FSR described four key risks to Canada’s financial system, all of which ultimately relate to housing:

    • Rapidly declining home prices prompted by a large macro-economic shock. The BOC said this scenario represents an elevated risk with a low probability of occurring, but stressed that it would cause a severe impact.

 

    • A sharp increase in long-term interest rates, likely resulting from an overshoot in US rates. This scenario represents a moderate risk, with moderately severe potential impact, and a low probability of occurring, the BOC said.

 

    • Stress emanating from China and other emerging market economies that could be triggered by a severe financial disruption in China, associated reversal of Chinese economic growth, and the subsequent, widespread impact on global economic and financial systems. The BOC said this scenario carried elevated risk, moderate probability, and moderately severe potential impact.

 

    • Financial stress from Europe, with global consequences, possibly caused by market concern over banking sector health or a sudden economic shock related to geopolitical tensions in Ukraine and Russia. The BOC said this scenario carried elevated risk, moderate probability, and moderately severe potential impact.

Additionally, the BIS, which coordinates central bank policies internationally, reported recently that Canada’s financial system was showing “early warning indicators” of a potential future banking crisis. It noted that Canadian property price inflation and credit growth were accelerating beyond historical norms and reaching levels only seen in large emerging markets. An extended period of enthusiastic lending and property price appreciation has left Canadian banks vulnerable to borrower defaults triggered by higher interest rates and/or economic downturns and sudden market corrections, the BIS explained.

“Early warning indicators in a number of countries are sending worrying signals,” the report said. Countries that were less affected by the 2008 financial crisis—namely Canada, Australia, and the Nordic countries—are currently in the late stages of strong financial booms, “making them vulnerable to a balance sheet recession and, in some cases, serious financial distress”.

What happened?

The growing threat to Canada’s financial system originated prior to the 2008 global financial crisis. According to the BIS, the macroeconomic side-effects of the post-crisis global recession had actually interrupted a “pronounced financial cycle” in Canada, even as its banks largely avoided significant distress.

The counter-cyclical impact was short-lived, however, because while worse-hit countries underwent a painful deleveraging process, Canadian households continued to borrow money. Combined with strong commodity price growth over recent years, the continued credit expansion and related housing surge have prompted a return to the boom phase of the cycle, the report explained.

Despite the recent cluster of warnings, Canada’s financial system remains considered well-regulated and stable, as demonstrated by its strong performance during the global crisis. Moody’s, even while voicing displeasure with the government’s impending bail-in policy, stressed that its assessment of individual Canadian banks remained unchanged and Canada’s continued to be “one of the highest-rated banking systems in the world”.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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