Bringing the roles of central banks and financial institutions
Barbara G. Stymiest
Chief Operating Officer
RBC Financial Group
International Economic Forum of the Americas
June 9, 2008
Good morning, ladies and gentlemen. It is a pleasure to be
with you here today.
We've been living through the credit crunch for more than
10 months now. And for about 9 of those months, many of us
in the banking realm have been asked to comment on the beginnings,
evolution and potential end to this turmoil.
I do not purport to offer you the definitive word here today,
as more analysis will have to occur before there is a complete
picture of what happened, what went wrong and what was done
What I do want the room to consider is my belief that we're
at a delicate juncture. We're at a point in time when people
are starting to reflect and make significant decisions about
their roles in this new environment and they need to do this
The question posed today is the roles of central banks and
financial institutions in managing the repercussions of previous
crises and their respective roles in preventing the crises
My answer, as I will outline, is that although we each have
different stakeholders, financial institutions, central banks
and regulators have a shared responsibility. Our actions and
reactions to events occur in very separate and distinct spheres,
but we do not have mutually exclusive responsibilities; they
are symbiotic, shared interests.
But before we get to roles, please allow me the opportunity
to step back and walk you through the past 10 months of the
I'm speaking to you today as both a witness and a participant.
As Canada's largest financial institution, and the largest
capital markets player in the country, as well as the fifth
largest financial institution in North America and one of
the world's top 20 banks, it was inevitable that we would
be a part of this story.
The story of the credit crunch really began with the bursting
of the last bubble. In the aftermath of the dot-com crash,
and the seismic shock created by the tragic events of September
11th, borrowing became remarkably cheap - in the United States
and in many countries around the world.
This was also a time when the global financial system was
flush with liquidity and had a seemingly insatiable demand
for financial assets. That demand found its focal point in
the U.S., which by 2005-06 was absorbing a remarkable 60%
of global capital flows, from Europe and Asia as well as the
recycling of petro-dollars from the Middle East.
The U.S. markets, where rules-based regulation had over a
long period of time fostered market participants' compliance
with the letter, though perhaps not the spirit, of the law,
offered more inefficiencies to take advantage of than other
markets, such as Canada.
These inefficiencies are rooted deep in the American past,
in the forging some 80 years ago of restrictions against nationwide
banking. The McFadden Act created a core banking system that
was fragmented and insufficiently diversified - a system dominated
by small- to mid-sized lenders, many with under-developed
risk management and treasury operations with a funding model
heavily reliant upon securitization rather than the model
favoured by most other countries: matched funding via retail
and commercial deposits.
The securitization model empowered a fragmented banking system
to get loans off the books and onto the market as a way of
freeing up capital for further loan origination.
Over time, this movement away from classic deposit funding
further exposed the U.S. banking system to the fault lines
underlying the capital markets.
In the low-interest-rate dawn of this current decade, mortgage
lenders saw what they thought was a sure thing - an untapped
market of consumers who now could better afford to take on
The growth in mortgages accelerated. Housing prices rose.
With banks keen to move assets off their balance sheets -
and investment banks eager to assist - financial products
grew more sophisticated. The demand for high-yield products
gave rise to new types of structured vehicles (like CDOs)
which found their way to markets and investors through unregulated
channels. Mortgage brokers found even more credit-challenged
consumers to take on new loans or perhaps lowered their standards,
as the rewards were too rich to ignore. Some people have called
this the moral hazard.
Competition pushed mortgage rates to artificially low levels.
Securitized products were being released into a world where
there was no natural counterpoint to ensure that lending standards
were respected. Traditional checks and balances were eroded.
This financial alchemy in which the sum of securitized parts
was greater than the whole began to insinuate itself into
the markets - magically satisfying the demands of many originators
to remove "undesirable" poorly documented sub-prime
assets off their balance sheets while supplying the investor
with a "highly rated" security.
For their part, many banks believed that spreading risk to
the four corners of America and around the globe inoculated
them against the risk of a catastrophic collapse in the securitization
market. And many policy makers believed this too.
In this "originate to distribute" model, the accounting
income that would have been recognized over the life of loans
was substantially booked as up front fee income. And the residual
interests of the originators, the money centre banks and investment
banks, were subject to complex marking-to-model practices,
based on what we now recognize as faulty assumptions.
As an aside, the originate-to-distribute model has many benefits.
Investors get more products to choose from that match their
risk tolerance. Borrowers benefit from wider access to funds
and cheaper rates. And originators get improved capital efficiency
and increased funding options. In the months ahead, doubtless
this model will be challenged, but these points are crucial
to a full evaluation.
Many believed ratings agencies would act as de facto regulators,
watchdogs by proxy. But the rating agencies were poorly equipped
to serve that function, at least as it pertains to the complex
investment vehicles at the root of subprime. Moreover, observable
signs of increasing delinquencies came late and could not
easily be interpreted in terms of expected losses.
As with all bubbles, we see now that it was based on folly
and fantasy - on the fanciful notion that home values could
only rise, or alternatively, not fall dramatically, that safety
and security in the financial markets could be assured simply
by appearing to distribute risk more broadly.
The last ten months have proved many wrong, and it has been
a costly and, in some cases, humiliating lesson. Disappearance
of markets and sharply increased doubts about valuations both
of structured products and the underlying assets are continuing
to affect the credit markets. Although some markets are starting
to function again, there is still a long way to go. The securitization
market, in particular, remains mostly frozen. Banks are relying
on the short end of the curve for much of their funding, which
has been facilitated by the influxes of liquidity provided
by the central banks, but challenges remain in the mid- to
longer end. While concerns over the fundamental solvency of
financial institutions have largely abated, what we're now
faced with is a mismatch of supply and demand in bank funding
that continues to affect banks in material ways.
As I said a few moments ago the banks were very active in
using the securitization market to move assets off their balance
sheets but, concurrently, they were also forced to drive volumes
and balances to maintain their profitability in a low interest
rate environment, with narrow spreads. In many cases, this
growth in assets exceeded the growth rate in relationship
deposits thus driving higher levels of external borrowing
at a much higher cost. This trend is clearly not sustainable.
There is now significant pressure on banks to deleverage
their balance sheets, especially when you consider the banking
system has had a significant increase in leverage caused by
the net reduction in capital bases (losses of $380B
exceed capital raises of $257B), as well as some banks being
forced to buy-back assets from securitized vehicles which
This story is not yet at an end. The excess liquidity that
drove the subprime market has disappeared and its absence
has affected many other financial instruments. We have seen
failures of single names like Northern Rock and Bear Stearns
and some bank CEOs are being relieved of their duties (like
Citi, UBS, Merrill and very recently Wachovia). We still have
yet to fully understand the impact of this credit disruption
on the banking system and the follow on effects on the general
economy. More specifically, what the impact will be on the
consumer as the economy slows and this deleveraging continues.
Today, all parties are considering the question of what a
post-recovery environment will really look like. In the meantime,
bank treasurers, such as ours, are being rewarded for having
established well diversified programs for access to term funding
Beyond the funding issue, it's safe to say that banks have
entered into a more cautious phase defined by increased transparency,
a measure of internal austerity and reduced exposure to, and
improved monitoring of, risk.
Let me emphasize: neither government nor industry should
be expected to hold people's hands on every major financial
We need to remind ourselves of the old-fashioned principles
and basic fundamentals that have made our industry such an
enduring and successful feature of the global finance landscape.
In the coming months and years, as a recovery takes hold,
financial institutions defined by long-term business strategies,
strong balance sheets and especially by disciplined risk management
principles will be rewarded.
Some of you may know that UBS recently published a Shareholder
Report on its write-downs which has been well read across
the industry. Despite the incongruity between its write-downs
and its principles, it made clear that, "
management is accountable for, and is expected to manage,
all risks arising from their business and function and to
ensure that risk and profit objectives are balanced. The identification
of business risks associated with a business strategy is the
responsibility of the business Senior Management."
I mentioned earlier that we at RBC were a part of this story
and while we are not happy with the size of our write-downs,
they are, relatively speaking, modest compared to many other
To what do we credit this reality? It's very simple: good
business strategy, clear accountabilities for risk-return
tradeoffs and sound risk management. I believe that this is
the defining narrative in this story. The landscape for financial
institutions has changed dramatically from the days when we
were simple lenders and deposit takers. Those financial institutions
that managed this transition to their risk profile well are
set to handle the crises of the future, as their risk and
control infrastructure is better prepared to keep pace with
business growth. Where businesses forge ahead with innovation,
a well-managed risk infrastructure will quickly close the
gaps between old and new.
RBC's ability to manage risk well is a core competency, and
is supported by a strong risk management culture and an effective
risk management approach to business innovation.
The tone is set at the top to ensure that the principles,
policies, processes, authorities and limits appropriate to
the type and nature of RBC's businesses are in place to support
effective enterprise-wide risk management framework.
Collaboration between the businesses and with our control
functions is a key component of RBC's enterprise wide risk
management. RBC has a structured approach to defining the
amount and type of risk we are able and willing to take as
It starts with identifying regulatory constraints that limit
our ability to accept risk. This helps us define our risk
capacity, which is the maximum amount of risk we can accept.
Knowing our risk capacity, we then establish and regularly
confirm a set of self-imposed constraints and drivers where
we have chosen to limit or otherwise influence the amount
of risk we undertake. This is our risk appetite.
Risk appetite is then translated into risk limits that guide
our businesses in their risk taking activity. Continuous measurement
and monitoring is used to confirm that our risk profile -
the actual exposure as compared to our established risk limits
and tolerances - remains within our risk appetite.
This means that we have a consistent discipline across the
enterprise to manage risk. The details need to be tailored
to specific situations, and for new innovations, but the fundamental
structure is the same.
Some institutions chose not to participate in certain markets.
They managed their risk to near-zero. But there was no reward.
Other institutions participated actively in new markets, but
didn't close the gap between reward and sound risk management.
And yet others, like RBC, participated in these markets and
adapted their risk management practices to close the innovation
Striking the right balance between risk management and business
innovation is a delicate affair, but ultimately our shareholders
benefit when we get it right.
Turning from risk management at financial institutions to
the domains of the central banks and regulators.
The Bank of Canada, as our nation's central bank, has five
main areas of responsibility, one of which, monetary policy,
has a direct influence on the general economy. The setting
of overnight interest rates, the targets for inflation and
the provision of liquidity all contribute to the smooth and
efficient operation of the financial system.
Financial institutions earn returns for their shareholders
and are dependent on the overall health of the economy. Banks
need consumers to be confident in the economy in order to
spend; similarly, we need business to borrow, spend and invest
in order to get returns to the economy in a greater order
of magnitude. Furthermore, capital markets businesses earn
returns by serving clients who are issuers and investors by
facilitating capital raisings, both traditional debt and equity
as well as structured products to meet the complex needs of
their clients. To play this role, capital markets players
must be able to originate, distribute and trade and this can
only be done in well functioning, liquid markets.
All of this to say that central banks and financial institutions
have a shared interest in the operation of the markets. Our
interests are aligned.
Central banks have been very effective players through this
most recent period. Their focus on injecting liquidity into
the financial system has helped ease the strain on markets.
The Bank of Canada, as lender of last resort, has called for
an increased range of instruments to use as collateral. These
calls should be heeded, in fact, the House of Commons may
be voting on this matter late today.
Where it concerns regulation, we need to consider - and in
my view largely resist - calls for increased regulation, a
clamour that is in full throat among some politicians and
certain economists. Some demand a worldwide regulatory architecture,
arguing that global finance cannot rely on a patchwork of
domestic oversight. Others seek a more rigid and demanding
national system of regulation.
It must be said right up front that the financial system is
fundamentally sound. But, like any system, it is vulnerable
to excesses. In this instance, excesses in the housing market,
the originate-to-distribute model and leverage all played
a part in allowing this most recent bubble to inflate.
Given that the system is sound, any reform should be targeted
at the excesses, rather than broadly across the system. What's
more, gazing into the rearview mirror to establish new rules
for going-forward is a perilous proposition. Humans have a
very natural inclination to never want to make the exact same
mistake again. The risk is that by over-reacting to one particular
set of circumstances, we set the stage for a whole new set
of problems in the next cycle.
To over-regulate risks creating a shadow market to which
markets shift to avoid overly burdensome rules. To under-react
risks losing the confidence of investors. Striking the right
balance is the key to the success.
I believe we must be guided by the recent words of Sir John
Bond, the former Chairman of HSBC, who said: "Sensible
regulation is fine, but not all regulation is sensible."
In terms of the United States, it appears that the time is
ripe for a de novo review of the regulatory framework
- in particular, a change in structure away from the
fragmentation in the marketplace. This is not a recommendation
to simply add new regulations onto the existing structure.
The vagaries of a banking system with many smaller participants
relying heavily on a market-based system of funding could
be mitigated by an evolution to fewer nationwide banks backed
by FDIC charters - and therefore not be as affected by the
whims and fluctuations of capital markets. Meanwhile, the
volatility inherent in the operations of the monoline mortgage
lenders could be diminished by absorbing more of them into
the banking fold.
Does this scenario sound familiar? It should. It's Canada's.
Increased regulation has the charm of appearing to be a quick
fix. But the truth is that where this crisis is concerned
- a broad crisis over many countries and asset classes - there
is no quick fix. And this will not be the last crisis we face.
One of the lessons that reverberates from recent events is
that more and continuous communication between home and host
banking regulators is essential in a globalized world. Dialogue
promotes better compliance and heightens efficiency. In an
environment where corporate overhead and public regulatory
expenditures are continually under scrutiny, collaboration
among regulators will contribute to more streamlined and effective
compliance regimes. This will bring us closer to the shared
goal of a more efficient and sounder international financial
system with more protection for consumers and investors.
As a result, the notion of some sort of global regulatory
regime seems a non-starter in practical terms, leaving alone
any merits of its theoretical underpinnings. It makes more
sense to focus on existing and successful examples of international
co-operation, such as the Financial Stability Forum, a body
whose creation was spearheaded in large part by our former
Prime Minister, Paul Martin. Their recent recommendations
in respect of risk management, valuations and disclosure as
well as recommendations to strengthen prudential oversight
and the authorities' responsiveness to risks are critical.
But even these recommendations must be examined in consultation
with all parties. Our experience over the past ten months
bears this out. We should be cautious about moving ahead precipitously
with any type of prescriptive regulatory response that may
be disruptive, overreaching and ultimately unnecessary down
the road. And from the perspective of Canada, we need to be
particularly careful considering that we have one of the best
financial services sectors in the world.
The crucial thing to take away from what happened is not
simply that bubbles happen and are damaging - it's that the
global markets in the modern era are highly resilient and
that the complex interdependence between various markets is
not transparent and contagion fallout is a risk that needs
to be managed. This demands a co-ordinated response by the
various central banks. Although this is arguably the most
severe crisis we have ever experienced, we will make it through,
as we have made it through others. And over the long term,
the ability to defend against the impact of such crises can
be improved by the banks themselves, as well as by the policymakers
and regulators. We all share the same interests and responsibilities.