Risk and Regulation in the New Financial Marketplace

Ronald Goodall

For many years I have been very fond of mystery novels. I had difficulty laying down a book by Sir Arthur Conan Doyle, Agatha Christie or P.D. James until I found out "who did it." In fact in recent months I regret to say that I have spurned Canadian culture on Sunday night - one of the few nights I watch television-to immerse myself in British culture broadcast by an American television station. I watch the adventures of Agatha Christie's Miss Marple.

In the past few years I have found myself becoming addicted to another kind of mystery novel. I have become absorbed in the documented unravelling of financial transactions. The book Public Money, Private Greed by Terence Corcoran and Laura Reid detailed the drama of the Greymac, Seaway and Crown Trust affairs. The probing of the failure of the Albertabased Commercial and Northland banks produced the Estey Report. In recent weeks, breakfast has taken a little longer as I attempted to follow the daily reports in The Globe and Mail on the review of the affairs of the Principal Group. However, I speculate that if our speaker today has the time, a multitude of controls could be designed to prevent the recurrence of problems peculiar to financial transactions and my reading would be limited again to the meandering of Sherlock Holmes and Hercule Poirot!

Michael Mackenzie received an arts degree from the University of Toronto in 1948 and an M.B.A. from Harvard in 1955. He became a chartered accountant in 1953 and was elected a Fellow of the Institute of Chartered Accountants of Ontario in 1965. In his career with the accounting firm of Clarkson Gordon, Mr. Mackenzie has held numerous responsibilities in auditing, consulting and taxation for a wide range of public and private-sector clients. In more recent years he has serviced several chartered banks, a mortgage loan company, a lease financing company, stockbrokers and the Bank of Canada. He has held consulting assignments in the area of financial analysis, planning and accounting matters for federal and provincial government agencies and other clients. He has served as an expert witness on accounting matters in a number of court actions and public regulatory hearings. Mr. Mackenzie served as member on the audit policy committee, the management committee and the accounting policy committee of Clarkson Gordon as well as being partner in charge of services to the banking industry.

He has been active with community organizations in Toronto and in Montreal, such as the Art Gallery of Ontario, the Montreal Museum of Fine Arts, the Hincks Treatment Centre, the Toronto Free Theatre and the Canadian Institute on Public Affairs.

In February 1987, Mr. Mackenzie embarked upon a second career and was appointed Inspector-General of Banks. The Financial Post told us that Mr. Mackenzie "will be the midwife for Canada's transition to one-stop financial conglomerates" and quoted our speaker as having "to learn to think like an actuary as well." This quotation, of course, immediately reminded me of all the misinformed stories of accountants, such as, what is the difference between an accountant and an actuary? The answer is that the accountant has personality!

Ladies and gentlemen, please welcome Michael Mackenzie, Superintendent of Financial Institutions, Canada, who will address us on "Risk and Regulation in the New Financial Marketplace."

Michael Mackenzie

Ladies and gentlemen, it is a great honour for me to have the opportunity to address The Empire Club of Toronto. I propose to share with you today some of my thoughts about the prudential supervision of financial institutions in Canada and the role of our office. This is of special significance since it was one year ago that I ceased to be a private citizen with the announcement that I had been chosen for my present role.

I am lucky because I accepted the government's invitation to become a senior regulator of financial institutions at a point in time when everyone knows that a great deal is happening and significant future changes are in the wind in Canada and other parts of the world. These events are providing a climate where there is a general recognition at government levels, in financial markets, and in the public generally that the country needs strong and active supervision of its financial institutions. Throughout my remarks today I will be talking about the major elements of these events and changes and how they can be expected to influence the work that we will be doing.

Obviously, some of the unhappy and costly events of the last several years in Canada and elsewhere have helped to set the stage. I do not propose to describe these events, details of which are likely known to most of you, other than to point out two main lessons.

The first is that they underline the need for a much higher level of professionalism on the part of all those involved in the management and supervision of financial institutions than we have had. This professionalism must take as one of its key elements the fact that the owners, managers, auditors and advisers of deposit-taking institutions recognize fiduciary responsibilities that are different from those of normal commercial undertakings. All of us involved with these institutions share the task of assuring that these responsibilities are recognized and are being met.

The second lesson may not be so obvious. It is now clear to me that one of the most significant fallouts of the various hearings and commissions dealing with these failures is the international attention they focused on the management and regulation of financial markets in Canada. A lot of these observers did not like some of the things they saw. The Canadian reputation for soundness and competence has suffered in New York, London, Zurich, Tokyo and other centres at a time when more and more financial business is being conducted on an international scale. This is not good news.

The fact that there have been some recent calamities has kept these doubts and questions very much alive. In addition there are now some international concerns about federalprovincial fragmentation - even balkanization - of the regulatory process in Canada.

A short while ago an old friend who is an experienced reporter in Washington gave me some sound advice about public speaking based on his many years of watching public officials in action. It is this. Public officials who develop no more than three basic messages and stick to them, win. Those who scatter their messages, lose. Therefore, he said, develop the messages, package them and repackage them, surround them with funny stories, run the risk of boring yourself and your audiences, but stay with them. So here goes.

Message one. There is high and increasing system risk in financial markets these days and the chances of trouble and accidents are high. The stakes are high. The pressures on financial institutions operating in Canada over my term of office will be intense and some of today's winners will turn into tomorrow's losers.

Message two. The core of regulation and the key to the prevention of trouble is effective and professional selfgovernance and self-regulation of our financial institutions.

Message three. In light of all this, our office is now designing and implementing supervisory and regulatory programs that are pro-active. One of the things we have learned from past failures is that it is difficult to deal effectively with institutions already deeply in trouble. There is a wide difference between the world of real time and the world of hindsight.

Before talking about my three messages in more detail, I should like to say a word about our mandate and mission. Clearly our core mandate is the protection and well-being of the public. Our task is to work to ensure the public's confidence in the safety and security of the institutions with which it does business and to which it entrusts its savings in the form of deposits, insurance policies and pension funds as well as the insurance protection over its assets. To these, I now have to add the protection of the public as investors in securities which will be done in collaboration with existing provincial securities regulators and in a way that recognizes that investor protection is primarily the mandate of the securities commissions.

Our overriding concern is with the ability of each federally regulated institution to meet all its obligations as they fall due. That is, the prime motivation of the actions we take is our prudential concern for the liquidity and solvency of each institution. This is based on the premise that public trust and confidence in the safety of financial institutions is overwhelmingly important to a sound economy.

A related concern is that access to the system is in fact free and open. That is, that no individuals or corporations have, because of ownership links, preferred access.

A safe financial services industry is one where its members are competently and honestly run and are profitable. While our concern is with the whole, a good deal of regulatory activity must focus on each institution separately since the system as a whole is the sum of its parts.

I should now like to talk a bit about what I have come to call "system risk." By this I mean, the general conditions in the economic financial and market environment that if not managed well can lead to trouble. In my view, system risk is high and increasing these days.

First, we have now enjoyed over five years of economic recovery in North America. The recent turmoil in the stock markets is said to be occurring in large part because of fears that the period of recovery is nearing its end. I am not an economist in the business of making official forecasts. But I have a gut feeling that boom times though still with us today may be running out and that the environment for our financial institutions over the next several years may not be as benign as it has been - and this will create stresses. One indication of this is the impact of the break in the stock market on the ability of our financial institutions to raise new capital over the foreseeable future.

Financial institutions, particularly banks, have had great difficulty adjusting to noninflationary times. As far as I can see, these adjustments have now taken place. There are, however, some signs that inflationary pressures are beginning to build again. Fears about inflation and interest rate increases are clearly influencing the current stock market. Significant increases in interest rates in the near future would likely have seriously damaging impacts on our financial institutions.

There are a number of major potentially dangerous economic discrepancies and imbalances in current conditions. One hears a lot about U.S. trade and budget deficits these days. The consumer economies of North America are doing well; the producing economies, although improving in some respect, are not as healthy. While there have been signs of significant real economy and investment improvements in Canada in recent months, the levels of new investment in producing assets and technology are too low. There is also evidence that income and wealth gaps between different regions and classes of people in Canada are wide and getting wider. In the modern world, this always leads to trouble. In our country, it may be one of the factors underlying the hostile and political environment for financial institutions, itself a risk factor.

Our economy is characterized by a tremendous growth in sophistication and innovation in financial markets that bears little relation to underlying commercial and industrial activity. There seems to be a lot of financial and real estate speculation, corporate takeover activity and asset trading for short-term gains. The enormous growth of foreign exchange trading is not related to fundamental economics; I am told that only 5 to 10 per cent of forex contracts now are trade related.

The financial innovations of the past several years have been developed under favourable market conditions. No one knows how they will withstand economic shock and less-than-benign conditions. The impact of new markettraded products in bear markets is not known. It is interesting to note that the two recently issued post-mortems on the October 19 market break in the U.S. have pointed fingers to the destabilizing roles of new products and socalled computerized insurance programs. Many of these innovations include new financial products designed to be used for hedging purposes. Everyone knows that unless there are a lot of speculators around, many of these products cannot be used to hedge - and a lot of speculators in a market both adds to and reduces risk. What worries me even more is that while hedging spreads or transfers risk around, it does not reduce the underlying transaction or position risk. And since all the players may not fully understand the risks they are giving up or acquiring, and there is a new dimension of transactions risk associated with these instruments, the development of new hedging techniques will reduce risks for some players but actually increase risks in the system taken as a whole.

There seems to have been an exponential growth in the volume and value of large financial transactions - in Eurocurrency markets, bond trading, foreign exchange, commercial paper. The dollar flows through the New York clearing system - and Canadian banks are active participants-about $1.5 trillion each day. The volumes of swaps are enormous. If you couple this with the immensely powerful data processing and communications technologies, without which many of these markets could not exist, the risks of accidents are frightening. The necessary control systems go far beyond anything we used to know. Fortunately, the systems that have been developed are very impressive - but they are not fail-safe.

Debt loads are heavy. In Canada we see many corporations and most families with improving balance sheets although there is still too much private-sector debt around. More recently, there has been a significant increase in consumer debt; particularly mortgages. Governments, mainly in Canada, the U.S. and the LDCs, are trying to cope with debt burdens that are - or likely will become - virtually unmanageable.

The banks' LDC debt problem in particular continues to be serious and its overhang on the markets is ominous. As you know, it occupied a good deal of my time last summer and continues to do so. The situation has not improved, the possibilities of payment suspensions and moratoria are increasing, and no one sees a stable solution.

I believe, however, that the international commercial banking system is now much better insulated against serious problems coming from this quarter than it was a few years ago.

Financial markets have become more international and very much more competitive. The pricing of an increasing number of banking and securities transactions is under intense pressure and does not adequately compensate for the risks being taken. Competition is fierce-both internationally and domestically, and is increasing. The plain fact is that there is an oversupply of financial institutions into the market. The risk factors associated with competition will increase as institutions take advantage of deregulation to move into other financial services. The most obvious example is banks moving into the securities business where the cultures and risk characteristics are so different. I think these risks are manageable - but it will take hard work and constant attention.

Closer to home, there are three structural risk factors specific to financial services. One is the problem of gaps and conflicts between federal and provincial regulation and supervision. This, I believe, is manageable as we focus together on specific issues of mutual concern. Our relationships and ability to deal with our provincial colleagues as issues arise are developing. We and they are well aware of the danger of people being able to structure their affairs to avoid the jurisdiction of most severity. We should all be concerned with the dangers of balkanization of the regulation of this industry. The second factor is a depositor insurance regime without coinsurance. This, for all its merits, removes essential market disciplines from exercising their control over many deposit-taking institutions. With reasonably secure, although often costly, sources of funds, a number of institutions have been driven to take on high-risk assets in order to earn quick returns to build capital. The only way to manage this is to substitute regulatory discipline for the market. Thirdly, we are seeing the rise of financial conglomerates; some with commercial connections, others without. While this development can properly be viewed as having the potential for adding to financial strength and stability in the system, I think it is clear that it also adds to risk. There are some dangers, for example, intrinsic to "one-stop" financial shopping. Take all these factors together coupled with the fact that in today's world bad news travels fast, and I think you will agree that I have taken on a very high-risk job.

The first line of defence in this environment lies in selfgovernance and self-regulation. This, in our judgment, is the key to a safe system. This may seem obvious. Yet, at various levels - the government, including both politicians and civil servants; the industry itself, both management and directors; the accountants and lawyers advising institutions - I do not believe this concept is well understood or even in some cases accepted.

What I mean by self-regulation encompasses the following: Competent and honest management that accepts the fact that its fiduciary responsibilities are just as important as its entrepreneurial responsibilities and devotes itself to the safety and prosperity of the institution being managed without being distracted by outside interests.

Boards of directors that are actively concerned with sound governance and that understand their fiduciary responsibilities. This assessment of the importance of directors' roles is reflected in the draft trust and loan company legislation published before Christmas.

Sound management practices including good financial and internal controls and audit functions. In a world facing the kinds of risks I have already described, this calls for systems embodying a degree of sophistication going far beyond what we used to know. At the same time, it requires an increased ability to stand back from transactions to assess their impact - and this is becoming very difficult. Sound and very conservative asset valuation and accounting practices, particularly those related to revenue recognition rules.

Adequately capitalized operations and good liquidity management. In this context, each financial institution that is a member of a corporate group should be itself adequately financed and independently managed. Business conditions are very strong right now and so it is a good time for institutions to increase reserves, build capital, and improve liquidity.

Competent work by external auditors, and reliance on their audit reports by directors and by our office.

Tight controls over related party transactions and insistence that they all be at market prices and terms. Last - and most important - good profitability so that shocks can be taken if need be and access to new capital is possible.

I have no hesitation in saying that an industry will be able to assure safety for depositors and policyholders as well as investors only if it is profitable.

Institutions that are well managed and governed according to the precepts just outlined should be able to weather turbulent conditions. It is, of course, not too difficult to display many of the appearances of good management when things are going well. But history tells us that when the environment becomes difficult, good managements come under pressure and management quality often deteriorates. The classic moves are from apparently good conservative management to cosmetic management to desperation management. The quality of management is the essential ingredient in a strong financial system. Poor management is the key factor in virtually all failures and near failures.

The opening up of new markets and new competition under deregulation will separate the strong and the weak - the well managed and the poorly managed. In other markets where there has been deregulation, there have been winners and losers. I doubt if Canadian financial services deregulation will prove to be the exception to this rule.

It is mainly because of these perceptions about the importance of management - and the need to know how it is handling adversity - that we are becoming more pro-active in our approaches.

The key to this is the development of direct relationships with boards of directors, usually through their audit committees. All the applicable legislation that I am familiar with states that the basic job of directors is to manage. It seems to us, therefore, that a good, direct relationship between the regulator and boards of directors is very important. If established when things are going well, this relationship should increase the chances of preventing trouble from getting out of control when things go badly. We have started this program of direct contacts with bank boards and have also started to meet with trust company and life insurance boards. So far, this initiative has been well received and the meetings have been anything but superficial. Real issues are covered.

I should note at this stage that, in doing this, we are not trying to manage any institution.

I have been extremely encouraged by the levels of cooperation we have received so far from executives of banks, trust companies, and insurance companies. We are receiving excellent support from the legal and accounting professions. I sense that people do not at all object to the concepts of regulation that I have been talking about and want to help.

One reason for this, I am happy to say, is that the former Department of Insurance and Office of the Inspector General of Banks have been perceived by industry participants as professional and competent. Bob Hammond, who is at the head table today, enjoys a first-class reputation in financial circles as a tough but fair and sensible regulator.

There are now a few other pro-active initiatives that I want to touch on. The first is the question of control over the accounting rules and the way these are developed in the financial services industry. As far as banks are concerned, our office is not yet ready to turn the making of these rules over to the accounting profession. One reason for this is that it is our office's responsibility to wrestle with the problem of how to handle accounting for country risk debt exposures. This is a problem which has so far been beyond the capability of the accounting profession anywhere in the world to deal with.

At this point I might note that the Canadian loan loss accounting system for banks with its requirement to spread loan losses over five years has served the banking industry well even though it is not loved by accountants. In my view, it has produced generally better and more visible results in periods of heavy loan losses than have the U.S. and U.K. accounting systems.

This power to direct the accounting rules has been critical in helping our banks revalue these exposures to levels that are in line with market realities in a clear and visible way. I note that the new legislation proposes that trust company financial statements follow the CICA Handbook rules, "except as otherwise prescribed" by our office.

We are, however, collaborating with the profession in the development of appropriate accounting rules including those for fee income and certain other financing transactions peculiar to lending institutions. Our office has participated in the CICA Task Force that has developed a new guideline on accounting for loan fee income. We will also be taking a leadership role in developing procedures for handling off balance sheet risks and appropriate risk-weighted approaches in the measurement of capital. We are working with both actuaries and accountants on changing methodologies used in setting insurance reserves. These are major projects.

At this point, I wish to reiterate something said earlier. The experience of the last five years or more in Canada and the U.S. illustrates the dangers of financial institutions following what might be called aggressive valuation and accounting procedures. In a regime where deposits are fully insured, the insurer and the regulator working with the insurer have a duty to ensure that insured institutions follow very conservative accounting. Accounting rules need to be developed with the depositor and policyholder as well as the shareholder in mind. This principle, it seems, is accepted in the life insurance business. It is a dimension not necessarily compatible with the CICA focus on shareholders and investors.

I should also note that the accounting issues assume an unusual importance for financial institutions because of leverage. Deposit-taking firms operate with capital or borrowing bases of around 5 to 6 per cent of total assets. It does not take a very large error in accounting or valuation of assets to destroy this base.

The accounting rules should be generally applied in as uniform a way as possible to all players across the system. As we all know, however, the application of accounting rules is not mechanical; it is often necessary to use judgment.

It is, in my opinion, important that each time an auditor examines a set of financial statements, he stands back from the numbers and the particular accounting and valuation practices used to ask if, taken in the aggregate, they make sense. It is entirely possible that, on an item-by-item basis, one can justify each accounting treatment, but taken as a whole, the result does not yield a fair presentation of financial condition. Our office expects that reporting auditors will do this standing back and take appropriate action as necessary. It is even more important that senior management who prepare financial statements and directors who approve them take the same approach. This is the prime subject covered in our directors' meetings.

A word now about our relationships with external auditors. I have no doubt that we want to continue the practice of relying on audited financial statements as important regulatory documents. In the case of banks, this is explicit. In the case of trust and insurance companies, it is implicit in the sense that the statements are accepted and then adjusted by us to arrive at borrowing bases and insurance reserves. Auditors are, in fact, already involved with the regulatory financial statements of trust companies and insurance companies.

There are some future dimensions. One that must be pursued with the profession when the legislation is passed is the auditors' role in reporting transactions or conditions that affect negatively the well-being of the institution, and in assisting us in monitoring adherence to guidelines and rules covering self-dealing and conflicts of interest. We have been talking to the profession about this and we all recognize the need to clarify responsibilities. For example, we need to determine what is meant by the word "well-being." We would, if possible, like to avoid the necessity of building up a special staff or our own to do this work. One approach could be to ask auditors to prepare for us lists of related party transactions and leave to us the judgment as to their compliance with rules. As far as trust companies are concerned, this will require them to make an examination of the trusts, estates and agencies accounts which they do not do now.

We have taken steps to set up advisory committees of auditors of banks, trust companies, life insurance and casualty insurance companies. Our meetings with these committees to date have been frank and open and have strengthened the relationship between our office and the auditors of these institutions, and we hope will improve the auditors' capacity to be independent.

Our examination policy is to take an even-handed and consistent approach in looking at each institution. It is obvious, however, that we are more cautious with any institution where there is a heavy concentration of assets in certain industries and geographical areas. Experience tells us that the most effective way an institution can manage risk is to diversify both sides of its balance sheet - its assets and its funding. Where this does not exist, we know that management and directors and we ourselves should watch out.

A related area is that of capital adequacy. There is a need to develop regulatory measures of capital that are realistic and consistent. Reality involves ways of risk weighting both assets and off-balance sheet committees and exposures. Consistency means developing compatible approaches as between different institutions and countries.

There are two immediate problems. One is to harmonize the very different approaches taken by banks and securities dealers. This is a problem that is also taking the attention of authorities in the U.S. and the U.K. who are concerned both with their own situations and international harmonization. The second is to develop common international standards. There are ongoing meetings to try to develop consistent and sensible risk-weighted standards under Bank for International Settlements initiatives. We support these initiatives since we share the view that international competition must be constrained by generally accepted and consistent prudential standards of capital. We are taking an active part in the process and these standards may well be in place in the very near future. There is mounting evidence that the cost of capital and the needs for capital have become critical factors in business strategies and pricing.

The legislation setting up our office contains new directions of compliance powers to be exercised when, to quote, "a bank (or other institution) is committing or pursuing or is about to commit or pursue any act or course of conduct that is an unsafe or unsound practice." In addition, we are being given some power to set asset values, particularly those related to real estate.

This is new territory for a regulator in Canada, and the existence of these powers presents some new problems. There is, for example, no clear definition of "unsafe or unsound practices." I can assure you that I hope we will never have to use the power but I'm afraid we will not be able to avoid doing so in some situations. We will, of course, be careful to deal with only matters that are significant and in most cases act only where we see no alternative. There are appeal provisions and you can be sure we will only proceed when we are sure of our grounds. The U.S. experience has been that the threat to use the power is often as effective as its actual use.

Finally, a word about our banking system. During the six years ended last October, the Big Six Canadian banks recorded about $20 billion of loan losses, including over $8 billion of country risk loss provisions. During the same period, they were able to continue to pay dividends, reinvest earnings and attract new capital despite these enormous losses. These banks are better capitalized today than they

were in 1982. This is a formidable accomplishment. Even after taking LDC loss provision hits, the Canadian banks generally have higher equity-to-asset ratios than do U.S. banks.

The property and casualty insurers have suffered severe losses in recent years. They have generally weathered their problems and are today in strong financial positions. In general, the trust companies and life insurers are in good shape.

In our view, Canadian institutions are in the main competently managed and are holding generally diversified assets and a diversified deposit book.

In recent years, in my observation, the management of our financial institutions has, perhaps to the chagrin of many of their more adventurous staff, been generally risk averse and, therefore, quite cautious.

I think, although many in this audience and elsewhere in Canada have strong views about the place of the major Canadian banks, trust and insurance companies in our economy, we should realize that it is important to us all that they constitute the core of a healthy financial system. Such a system is central to the well-functioning of our economy, including its ability to handle pain.

The appreciation of the audience was expressed by Diana L. Chant, Treasurer of The Club.