Conference Report

IWFSAS 2017: Financial Systems Diversity, Financial Stability and Sustainable Development

Dates: 24-25 august 2017

Venue: HEC Montreal

The International Research Center on Cooperative Finance (IRCCF) of HEC Montreal, the Peter B. Gustavson School of Business, the Department of Economics and the European Union Centre of Excellence (EUCE) of the University of Victoria organised in Montreal, Quebec, on August 24-25, 2017 the second edition of the International Workshop on Financial System Architecture and Stability (IWFSAS).

The IWFSAS aims at providing a forum for academic researchers and policy makers to discuss issues related to the structure and design of financial systems and their impact on growth and financial stability, both nationally and globally.

The 2017 workshop has gathered around thirty academic researchers and experts from Canada, the United States and Europe on the topic of “Financial Systems: Diversity, Stability and Sustainable Development”.

The topic was covered in six sessions:

1. Predicting financial distress and macro-prudential policy
2. Financial institutions and systemic Risk
3.  role of bank capital and culture in financial system architecture
4. Diversity, sustainability and social responsibility in banking
5. Contagion, stability and Too-Big-To-Fail banks
6. Beyond banks: markets and other financial institutions

Keynote address on the Role of Bank Capital and Culture in Financial System Architecture (August 24, 2:00-3:15 pm)

Anjan Thakor was the keynote speaker at IWFSAS 2017.

His address focused on the role played by bank capital and culture for economic stability and growth. To this end, he first presented a model of warehouse banking. The combination of deposit-taking and warehousing with lending creates funding liquidity through the issuance of private money. The model departs from the existing literature that focuses on risk-averse depositors seeking consumption insurance. He highlighted the empirical evidence on higher bank capital and increased efficiency in their roles of screening customers for loans in the originate-to-distribute (OTD) model of securitization. The interplay with bank culture, defined as a “set of explicit and implicit contracts that determine resource allocation processes and employee behavior”, is then spelled out. Higher capital tilts the culture towards safety whereas the link is reversed for higher bailout probability. Hence, bank culture complements capital in fostering financial stability and economic growth.

Panel on Financial Systems Diversity and Stability: Regulatory Challenges

A panel session open to the public was held at 2:00 pm on August 25 on the topic “Financial Systems Diversity And Stability: What Regulatory Challenges?”. Rym Ayadi, Professor and director of the IRCCF, HEC Montreal, moderated the discussions.

Following is the composition of this panel of four experts:

• Edward KANE, Professor of Finance, Carroll School of Management, Boston College and Research Associate of the National Bureau of Economic Research
• Harald BENINK, Professor of Banking and Finance, University of Tilburg; Senior research associate at the Financial Markets Group, London School of Economics (LSE), and Chairman of the European Shadow Financial Regulatory Committee
• Gouro SALL-DIAGNE, Principal Director of the Supervision of Deposit-taking Institutions, Autorité des Marchés Financiers of Québec
• Alain LEPROHON, Vice President Finance, Desjardins Group

In his introductory remarks, Edward Kane presented some estimations of the standalone default probabilities of the eleven weakest financial institutions operating in the United States, according to the 2016 Comprehensive Capital Analysis Review. The probabilities are relatively high and highly correlated. Among these are five European “zombie” megabanks. He argued that the Federal Reserve’s rescue of foreign banks in 2008 and its continued support post crisis, through currency swaps and interest paid on deposits of foreign banks, have allowed individual-country regulators to expand their safety net at the expense of American taxpayers. These unacknowledged implicit guarantees, often well perceived by the market, are preventing a wave of insolvencies in Europe. The zombie megabanks phenomenon came about by a culture of pursuing tail risks. By not focusing on manager level behavior, banking reforms post-financial crisis failed to address the issue of risk culture in banking. This shortcoming indicates that governments have fallen prey to regulatory capture by the industry.

Harald Benink echoed those warning, by advising to learn the right lessons from the 2008 financial crisis. He stated that there is strong empirical evidence that higher capital standards are beneficial for financial stability and economic growth. The credibility of the European resolution regime is compromised by its institutional and constitutional complexities that have not shielded the implementation from apparent political considerations relating to burden sharing in case of recapitalization. The current regime should improve the predictability of bail-in priority rules for creditors by its consistent application. While nonperforming loans are at record levels, identification of losses during Asset Quality Reviews and stress test exercises in recent years seem to benefit from supervisory discretion, evidenced by large divergences on capital shortfall between supervisors and markets. Moreover, many loopholes create a supervisory grey zone allowing the Single Resolution Board to avoid resolving a credit institution when a member state, by invoking the need to preserve financial stability, is providing some forms of financial support to this institution.

The remarks of Gouro Sall-Diagne were related to Canada, in particular Quebec. In the Quebec financial regulatory system, the Autorité des Marchés Financiers (AMF) plays a leading role in the supervision nonbank financial institutions, including the Desjardins group, and the protection of consumers. Concerning capital adequacy, the AMF adapts Basel requirement to its supervised institutions. To that end, it issues guidelines regarding capital adequacy, liquidity adequacy, sound and prudent management practices and sound commercial practices. Diversity is accounted for by tailoring rules to the complexity and size of the institutions. The AMF is also the resolution authority of its supervised financial institutions. Besides, Mrs Diagne highlighted their collaboration with the other provincial and federal supervisory agencies as well as the AMF contribution at the international level of standard setting. In conclusion, she added that, as supervisor, the AMF looks beyond the trend of the moment or the most recent crisis.

In turn, Alain Leprohon started his comments by presenting his organization, the Desjardins group, which is a pillar of diversity in the Canadian financial system. It is the largest financial cooperative in Canada, with assets totaling more than 270 billion. He noted that, in this IPad decade, how people do banking has changed. The Desjardins business model has to evolve to that reality, which implied increased investment in technology to catch up with new competitors like Fintechs, Google payment and Apple pay. Another challenge is how to keep geographical presence from becoming a weakness for Desjardins and how to speed up change in the democratic governance structure. Besides, a challenge which is not unique to Desjardins but applies to other Canadian banks as well, is increased regulation, particularly since Desjardins’ designation by the AMF as a domestic Systematically Important Financial Institution (SIFI). As a consequence, Desjardins has to prepare for a bail-in mechanism in a particularly creative way by emitting a financial instrument that fits its cooperative model.

After the introductory comments, the ensuing debate essentially covered three topics: link between capital requirements and macroeconomic conditions, possible consolidations in the Canadian banking sector to create megabanks, resolution mechanisms for Canadian banks and cooperatives.

As regards capital requirements, some participants raised the issue of the possibility excessive forbearance in Europe, which can have serious macroeconomic consequences including the risk of a lost decade similar to what Japan experienced in the 1990s. Concerning bank mergers in Canada, they are discouraged by the regulation which gives a veto power to the Minister of Finance. This plays to the advantage of Canada because megabanks get politically powerful and can held hostage the economy. Finally, large Canadian banks are still awaiting final rules from the Canadian Deposit Insurance Corporation (CDIC) to be issued, in order to draft their resolution plans. For the case of the Desjardins, the AMF is looking forward to updating the Quebec law on financial cooperatives before the end of 2017, including provisions for the resolution plan of the group.

A conclusive speech was delivered by Patrick Déry, superintendent, solvency, at the Autorité des Marchés Financiers.

According to Mr Déry, diversity is a reality in the Canadian and Quebec financial sectors owing to the modulation of the legal framework to some traditions of the provinces and territories. This leads to a diversity of regulatory solutions and approaches in order to reach similar goals. A few challenges have to be overcome. First, the flip side of financial stability is that staff in safety net agencies lack experience in managing bank resolution. The second challenge is to reach an appropriate level of collaboration between the federal and provincial players of the safety net, in order to achieve operational agility and optimal crisis prevention. A third challenge pertains to the diversity of business models, which compels the regulator to adapt means to create a level playing field in the markets. An illustration is the cooperative and mutualist models, the democratic governance of which has to comply with international standards, similarly to privately and publicly-owned financial institutions. Finally, with its international contribution, the AMF contributes to research and drafting leading to new standards and guidance. This helps build and update the operational capacity of the AMF and better prepares the industry for the transition to new standards.