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"Why don't we change bankruptcy law for all firms so that bonds automatically get converted into equity when the firm defaults"

As a practical matter, lots of firms, especially small and medium sized firms, don't have bondholders. They have bank loans or lines of credit. Supposing default for these types of firms implies that the business was not viable or profitable, would banks be willing to accept an equity in a failed firm in the the event of a default? I doubt it. They want to liquidate, get their money, and move on.

Patrick: good point. It wouldn't work in the case of bank loans anyway, because it would create a worse moral hazard problem in the opposite direction. Even, or especially if, the firm were solvent and profitable, the bank would want to call the loan, so the ownership would be transferred from the original owner to the bank, if the owner couldn't immediately repay the loan.

But otherwise, if the firm had greater value liquidated than continuing in business, it should be liquidated.

Nick - I think because Banks have a greater societal value - ie we do not always rush to prop up auto makers or high tech firms, but we will always rush to prop up banks.

"People take bigger risks when driving if they know the insurance company will pay part or all of the costs of an accident."

Do you? I don't. May seem like nitpicking, but I think these things matter.

To me, a key element of Dickson's (well thought out) proposal is that it keeps the resolution mechanism internal to the bank, rather than a tax created bailout fund which would be perceived as an external mechanism. An external mechanism might lead to banks feeling it is OK (morally) to fall back on a bailout, since after all, they paid for it, similar to the oft-quoted example (from Freakonomics maybe, I don't recall) of how charging a fine for parents picking up their children late from daycare led to more late pickups rather than fewer by replacing a moral incentive with a(n) (inadequate) financial one.

The other benefit of course is that it creates an automatic, less political and therefore hopefully less uncertain and faster acting response to bank problems than the tax would.

I am becoming increasingly worried by Canada's stance on international financial reform. The country has already been obstructing climate change talks, now it appears that it wants to obstruct a second important international policy effort.

You point out many legitimate reasons to question the proposed initiative, but I'm not sure the Conservatives are aiming for a better deal so much as killing it. This would be consistent with their history of skepticism towards international agreements and their alignment with the American right. Of course Canada always has the argument that it kept its house in order last time around...

Related note: check out Interfluidity's take on the difficulty of evaluating bank capital in the modern world: http://www.interfluidity.com/v2/716.html

Chris B: Agreed. But converting bonds into "Embedded Contingent Capital" looks like it would reduce the real resource costs of bankrupcty, as well as being a lot simpler. No judges and lawyers.

Declan: I always drive perfectly, of course! That's one of those questions that's very hard to ask about one's self.

I like your Freakonomics daycare point (that's where I read it too, I think). "Hey, we've been paying that tax all these years, so let's take some risks, and if we fail we deserve to get bailed out, because we've paid for it, dammit! No shame. Let's get our money's worth."

(By the way, that is the one argument that worries me about the Negative Income Tax.)

Guillame: Yes, that's great post by Steve Randy Waldman. (I loved his "Schrodinger's bank" metaphor!) It would be good to hear his thoughts on the Julie Dixon proposal.

In the U.S., banks already pay a tax to the FDIC. The tax is based both on the quantity of assets held as well as the risk profile of the assets. This funds the FDIC so that banks pay for each other's bailouts of depositors. The FDIC determines the rate.

The problem was that the FDIC didn't bother to collect any fees for almost a decade before this crisis, deeming the deposit guarantee fund to be fully capitalized.

Moreover, in the U.S., there is already resolution power -- the comptroller of the currency for national banks, and state agencies for state banks. These agents have the power to seize banks and place them into receivership -- what the FDIC does. Once in receivership, the assets of the failed bank are sold off to other banks, the bondholders get the residual (typically nothing), and the equity holders get nothing. Depositors are guaranteed. Counterparties are guaranteed. All this can be done over a weekend for most banks. In many cases, the bank opens the next morning with a different sign above its door, but sometimes the branches are closed too -- it depends on whether the purchasing bank wants the branches and tellers, or whether it just wants the loan portfolio and deposits. No bankruptcy proceeding is required -- this is an administrative, not a judicial, proceeding.

Just as with FDIC insurance, the problem is that the prompt corrective action laws are ignored for powerful banks -- e.g. Citigroup remains the walking dead, while the little bank in Utah is promptly closed.

Perhaps Canada doesn't have the power to place banks into receivership, and doesn't collect deposit insurance fees? If it does, then why would adding a second resolution layer help, if the first two are not used?

I think the problem is that our current tools are not used, due to political realities, rather than a defect in the tools.

And I believe the reason why our tools are not used is because we have given banks artificially low (below-market) funding costs vis-a-vis the funding costs enjoyed by the rest of the private sector. Anytime you do that -- the political realities are such that the privileged group becomes extremely powerful. It may not happen in a year, but it will eventually happen. Eventually they become the most powerful group, and start regulating everyone else, instead of the other way around.

You can try to compensate by adding one or more layers of regulation, but the banks will escape those layers -- nothing can constrain someone who has permanently cheaper access to funds. Any attempts to try to "do better" by creating more tools, yet continuing the policy of providing banks with below-market funding costs, will result in the same lack of enforcement and the same outcomes. And banks get below market funding costs because the economists believe that funding costs are exogenous, and can therefore be set to whatever they want, with no repercussions other than a simplistic inflation/unemployment trade-off.

RSJ: I don't know if CDIC (our equivalent to FDIC) still collects fees. Does anyone? But its purpose is to cover depositors (not all banks' creditors), and up to a limit. IIRC, it hasn't been used since the mid-1980's, and then only in a handful of cases(?) in history. It is very difficult to know what premiums to charge, and how big a capital fund it needs, when the insured-against events are very big but very rare.

But the purpose of the proposal is not to deal with the banks you would put into receivership (though if it kept some of them going profitably that would be a bonus). Its purpose is to act as an alternative to the bailout, for the ones the government would bail out. And for that, it looks better to me.

I think we are forgetting that Canadian banks receive a large part of their funding from CMHC, not just from stock and bond holders. This plan does nothing to address the moral hazard due to those billions. Or am I missing something?

asp: I suppose that CMHC insurance does create a moral hazard. But there is an insurance premium for that insurance, so no argument there for a bank tax. Whether that premium is high enough is a separate question (it's not obviously too low in my opinion). Whether CMHC keeps adequate reserves is another question (I worry about that more). Whether CMHC is monitoring the sorts of mortgages it insures closely enough to keep the moral hazard problem under control is another question (I dunno).

But Julie Dixon's proposal, and the bank tax, weren't really designed to deal with CMHC insurance anyway.

I was thinking more of NHA MBS' and the special auctions that the PMO ordered during the recession.

re: FDIC fees, I agree that it is hard to see before the fact, but the nice thing about a running fund is that it can be in deficit, allowing those fees to pay off the black swan events after the fact -- they do not need to anticipate them perfectly.

The thing about receivership is that it does what you want. It's effectively an administrative bankruptcy proceeding in which there is a lot of leeway. It could be used to convert bond holder claims into warrants, which is exactly what you want with the "contingent capital".

In other words, we already have all the tools, or close enough equivalents to the tools being proposed now. That should give people pause as to why it would make a big difference to tweak the tools.

re: CMHC insurance. It just occurred to me that the banks don't pay for that insurance, but they do receive the benefit. Nice work if you can get it! :-)

It seems to me that the most important thing is not avoiding future government interventions when financial institutions get into trouble. It's defining what happens to the people who get them there.

We need a system that ensures that managers who wreck financial institutions do not get to continue managing them, and do not ride off into the sunset with a huge retirement package either. Surely it is possible to set compensation rules that ensure these things. A few ideas:

1. Limits on money compensation.

2. To attract talent, institutions could offer compensation in the use of assets such as housing, cars, etc., that remain property of the bank and that will be taken away if it fails.

3. Retirement savings for executives could be required to be in the form of bank shares that cannot be sold until a certain time after leaving.

We need to change the incentives for managers. Then, if a bank fails, the government should take it over, kick out the managers, invest what is necessary to return it to health, and sell off again. All this should be spelled out ahead of time so that managers know just what happens to them personally if their company ever gets into trouble.

I don't really see how Julie Dickson's proposal is better than just increasing capital requirements. It seems to have the potential to set off a chain reaction much like what happened with the credit default swaps, which were also supposed to reduce risk.

asp: remember lesson #1 from tax incidence theory: it doesn't matter whether you place the tax on buyer or seller, it's elasticity of demand and supply that determines the incidence. Same with an insurance premium. It's the *market* for high loan/value ratio mortgages that pays the CMHC premium *and* gets the payouts.

RSJ: good question. Dunno. Hope someone who understands banks better than me can give an informed answer. It *might* be that *pre-commitment* to a particular resolution has benefits that differ from the actual application of that resolution. If bondholders and shareholders know in advance that that is what will happen, it may change prices and incentives. Or it might be that the potential capital cushion of bonds just isn't big enough at present.

OT: Tax Incidence & CMHC Insurance. Ok, I went and read up on tax incidence but did not come across the idea that the *market* receives all the benefits. I don't know if the banks or if people buying houses with low down payments are less elastic in this case, but it appears that it is not always a wash.

Anyway, insurance is kind of a side issue to the topic, which is the moral hazard we create for Canadian banks via CMHC MBAs. Is it significant?

"re: CMHC insurance. It just occurred to me that the banks don't pay for that insurance, but they do receive the benefit. Nice work if you can get it! :-)"

Nick's answer is better. My 2 cents: the default risk lies with the buyer and the buyer pays the premium, and lives in the house, and get's sued if they default. It may not be entirely correct, but this is the way I think of it: the gov't made a policy decision: "Want more high loan/value ratio purchases for otherwise qualified buyers". The banks said "That's nice. Why should we play ball?". The result is CMHC.

In my opinion Dickson's proposal has little actual benefit for Canada and is mainly way to show Canada is being constructive on the international stage for several reasons. First Canadian banks don't tend to issue that much in bonds on the wholesale market to begin with compared to US banks. The primary buyers of bank debt in Canada are money market funds and bond mutual funds which are going to socked by the HST on their management fees come July 1st which in combination with low interest rates will probably put a few out of business shrinking the market for wholesale bank bonds vs core deposits even more. Also as money market funds get socked by the HST and several new regulatory changes by the OSC the market for non bank "shadow" financing will dry up even more allowing to chartered banks to increase their deposit margins. Corporate tax rates are lower and going even lower in Canada vs the US lessening the tax penalty for banks to finance with equity vs debt(This is an even bigger issue in countries such as Hong Kong and Singapore with even lower corporate rates than Canada). Canadian banks don't have holding companies like US banks subject to regular bankruptcy procedure instead in Canada the top level corporate entity is the actual CDIC insured chartered bank which would fall completely within the CDIC resolution procedure. In the US the FDIC can resolve banks but not bank holding companies which is where most financial company assets exist. While this is a subject for another post I think there is a great opportunity for Canada to become a Hong Kong style financial center right across the border from an increasingly left leaning United States.

The following is perhaps one of the best blog posts I have seen on the current banking crisis.


One of things I feel that is often forgotten in Canada is how much common heritage we have with places such as Australia, Hong Kong, New Zealand, and Singapore. In an area such as banking the original founders of the major Canadian, Australian, and Hong Kong banks were in some cases even related to each other.

One of the few books I have found that discusses at all the common heritage of Canada, Australia, and Hong Kong.

I'd second Tim's recommendation of John Hempton (Bronte Capital)'s arguments in favour of a less competitive banking sector. It's a viewpoint I share.

RSJ: "Perhaps Canada doesn't have the power to place banks into receivership"

Yes it does, OSFI has effectively unlimited powers with respect to banks.

"why would adding a second resolution layer help, if the first two are not used?"

See my earlier comments with respect to the proposed layer being internal rather than external, and 'mechanical/automatic' rather than 'political/negotiable'

"I think the problem is that our current tools are not used, due to political realities, rather than a defect in the tools."

If a tool is not used due to political realities, that *is* a defect in the tools.

"And I believe the reason why our tools are not used is because we have given banks artificially low (below-market) funding costs vis-a-vis the funding costs enjoyed by the rest of the private sector. Anytime you do that -- the political realities are such that the privileged group becomes extremely powerful. It may not happen in a year, but it will eventually happen. Eventually they become the most powerful group, and start regulating everyone else, instead of the other way around."

Canada's had 5 big banks for over 100 years, since before the country even existed, and yet just a few years back they were denied a simple operation (merging) that would have been granted almost any other industry. How long must we wait before the banks control the government?

"You can try to compensate by adding one or more layers of regulation, but the banks will escape those layers"

Banks will only try to escape those layers if they are driven to do so by competition - this brings us back to John Hempton's arguments against a competitive banking sector (see the link in Tim's comment).

I guess I'm wondering why it's axiomatic that banks and the financial sector will periodically fail catastrophically, and thus we need to find a way to deal with that?

When I look at the shenanigans that went on to create the crisis, whether it was Lehman, or Magnetar, or GS, or the subprime fiasco (ninja loans etc)... ALL of it was behaviour that, had you asked ANY regulator (or even mildly well informed citizen) whether the activity should continue would have said "Nein!". Without the pervasive. blatant stupidity and fraud, I really don't think the fall 2008/winter 2009 melt down would have been more than a run of the mill recession.

It seems to me that, in a modern monetary and banking system, in a stable democracy there is absolutely, positively NO excuse for a large depository institution to fail unless it either is profoundly stupid or criminal on a massive scale.

If we look at the history of the big US investment bank (most now listed among the TBTF), they weathered 1873, 1893, 1907, WWI, 1920-21, The Great Depression, and WWII very well. Much better than many regular banks despite the fact that they took more risks. In fact, they saved our bacon in 1907!

If investment banks can manage this kind of record over 100 years and more, then it seems to me very wrong to take as given that banks will fail, will wreak the economy, and we need to plan for it.

So the implicit question (which I'll make explicit) is : what changed? Why are big investment banks like GS now blowing-up and why are commercial banks - which stopped periodically wrecking the economy circa 1938 until the mid to late 1970's - suddenly now public enemy #1?

FWIW, my own sense is that regulation is a big part of it, but the big investment banks where never that heavily regulated, and they've gone from saving our butts circa 1907, to Government Sachs circa 2010. Why?

Yes, the CDIC still collects fees. You can find their last annual report (2008-09) at


Page 3 reports Premium income in the 08-09 fiscal year as $92 million. As of end March 2009, they had $800 million in "Provision for insurance losses" and $1,760 million in available financial assets to protect $512,000 in deposits.

Oh....and they had 97 permanent employees.

One wonders what they do all day. It has an air of the Maytag repairman.

Asp: CMHC insurance. It just occurred to me that the banks don't pay for that insurance, but they do receive the benefit. Nice work if you can get it! :-)
Actually, it's home buyers who pay for that insurance, and homebuyers who get the benefit (through much lower interest rates on CDIC insured mortgages".

An additional comment I'll make to muddy the waters further is that both Hong Kong and Canada have traditionally have had something very close to unregulated equity/stock markets alongside staid uncompetitive commercial banks whereas in the US a large part of the post 1930s regulatory consensus was the need for highly regulated stock exchanges above all else. Interestingly several books I have read about the 1960s stock market boom in the US such as Go-Go Years describe the Toronto Stock Exchange(this was back when there was a real exchange floor) as almost a Las Vegas style casino in the middle of staid Bay Street during what was then a huge mining boom in Canada with all sorts of fairly shady operators compared to the SEC regulated New York Stock Exchange. I suspect the fictional portrail of Hong Kong in James Clavell's Noble House is also pretty accurate according to other accounts I have heard of 1960s Hong Kong.

Even more recently Canada still doesn't have a national securities regulator and the provinces leave much of the day to day regulation of the securities market to the industry controlled IIROC. Many of the companies listed on the TSX Venture Exchange(basically the old Calgary Stock Exchange) would never even get near an SEC regulated exchange in the US. One argument I could see in favor of this policy is that loosely regulated stock markets give companies a financing alternative to the staid banks with less economic risk due to the non defaulting nature of equity of course this doesn't negate the problem of absolute fraud such as in Bre-X. Also the problem of the 1929 crash was not so much the crash itself as that commercial banks had lent heavily on margin to individuals to buy stock and were exposed to a drop in collateral value.

a little off topic but ...

Nick, you might want to check out Bill Mitchell's latest.


Some bits of it.

"In this blog – The origins of the economic crisis – I argued that the roots of the crisis were in part to be found in the way in which the neo-liberal policy agenda (the attacks on unions etc) allowed a major divergence between productivity growth and real wages growth to occur from around the mid-1980s (the date depends which country you are talking about)."

"What happened to the gap between labour productivity and real wages? The gap represents profits and shows that during the neo-liberal years there was a dramatic redistribution of national income towards capital. The Federal government (aided and abetted by the state governments) helped this process in a number of ways: privatisation; outsourcing; pernicious welfare-to-work and industrial relations legislation; the National Competition Policy to name just a few of the ways. The next graph depicts the summary of this gap – the wage share – and shows how far it has fallen over the last two decades."

"In the past, the dilemma of capitalism was that the firms had to keep real wages growing in line with productivity to ensure that the consumptions goods produced were sold. But in the recent period, capital has found a new way to accomplish this which allowed them to suppress real wages growth and pocket increasing shares of the national income produced as profits. Along the way, this munificence also manifested as the ridiculous executive pay deals that we have read about constantly over the last decade or so.

The trick was found in the rise of “financial engineering” which pushed ever increasing debt onto the household sector. The capitalists found that they could sustain purchasing power and receive a bonus along the way in the form of interest payments. This seemed to be a much better strategy than paying higher real wages."

For debt, I am pretty sure he means currency denominated debt. Remember the discussion about apples?

"saving our butts circa 1907"

Woah, Nelly. Morgan saved his own butt, at personal cost. Usually he was able to save his own butt at someone else's cost. I think 1907 was the last straw, as the banking failures grew more severe more quickly, and led to the creation of the Federal Reserve, not long after Morgan saw that the system was getting less and less stable, and he could not count on it righting itself.

"Oh....and they had 97 permanent employees."

It sets up a nice contrast with little Bermuda-based Primus Guaranty (PRS). With a mere 47 extremely well-compensated employees, this company managed to write 13 B in Credit Default Swaps on an equity base of about 160 million dollars. I think total assets are north of 20 Billion. Because it maintains a AAA credit rating, it need not post collateral.

On the other hand, ATT, with a market cap of 150 B, 70 B of debt, and annual annual free cash flow of 15 B does not have a AAA credit rating, and would be required to post collateral if it wrote even a single credit default swap.

There, in a nutshell, is the government, financial, and non-financial sector. In the first sector you have people paid relatively little to do relatively little, in the financial sector you have people paid enormous amounts to do great harm, and in the non-financial sector you have a combination of the first two, but with telephone service as a side-effect. :P

RSJ: Fair enough ... still...

More seriously, you are talking about a business with the possibility of huge short term financial pay-offs for managers. Wall street has given itself an incentive structure in which more money is paid out in bonuses to employees than in dividends.

Moreover, there is a belief among the leadership (and economists) that on the one hand you are absolutely critical to the functioning of the economy and therefore the survival of your pro-cyclical highly levered business is a matter of national security, while on the other hand, that what you do is absolutely neutral, and is in fact an illusion.

It's true that from FDR-Bretton Woods, we didn't have any financial crises, but look at what else we had:

* 90% top marginal tax rates, taking windfall seeking off the table. CEOs made only 4-5 times as much as the average worker. Traders made less than CEOs, no matter how successful.

* Iron-clad regulation of bank size, bank products, bank fees, and bank costs -- even the rates available on savings accounts were controlled, as well as which counties the banks could operate in.

* Only vanilla investment products were allowed, and those who traded in these products could not work for banks, or have access to central bank discount lending facilities. Neither could they accept deposits -- they could only speculate with their own firm's money.

* Iron wall between broker dealers/market makers and investment banks

So the combination of these two things took away the incentives and ability of banks to engage in risky behavior. As soon as you get rid of one of these, Manhattan starts to party again.


How do any of your comments apply to Canada? What is your knowledge of the Canadian financial system from the the 1930s to today? Why wasn't there a banking crisis in Canada shortly after the Lester Pearson government(back when Ronald Reagan was still a Hollywood actor) deregulated the interest Canadian banks could pay on deposits long before the US did.

Tim, I don't know about the history of Canadian banking. Although I'm a big fan of economic history in general, and banking crises in particular, in Canada this history is a bit more boring :P

Maybe you guys are just downright incorruptible, or maybe I haven't found a good source. Any sources would be appreciated.

RSJ: I laughed out loud at this line -- it is too true!

"Moreover, there is a belief among the leadership (and economists) that on the one hand you are absolutely critical to the functioning of the economy and therefore the survival of your pro-cyclical highly levered business is a matter of national security, while on the other hand, that what you do is absolutely neutral, and is in fact an illusion."

As for Canadian banks, I would venture that the quality of regulations really does matter, and a country focused on "good governance" is just different from one focused on "life & liberty"

Is there a difference in terms of a bank's capital requirements if it sells off mortgages to CMHC through the vastly expanded Canada Mortgage Bond Program or retains these CMHC-insured mortgages on its books? In other words, does the Canada Mortgage Bond Program enable Canadian banks to free up capital?

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