Tougher bank liquidity rules will boost Canada’s economy, Bank of Canada says

Tougher capital and liquidity requirements for banks would reduce the frequency and severity of any future global financial crises and the threat they would pose to Canada’s economy, according to a Bank of Canada report.

The benefits of revised requirements would far outweigh the short-term costs that banks would likely pass along to consumers as they adjust to the changes, the central bank said in a report released Wednesday.

G20 leaders agreed to a loose proposal at a June meeting in Toronto, and a summit in Seoul, South Korea, in November is expected to produce timelines for requiring banks to back up their more risky products such as mortgages with a pool of cash or solid investments.

“The bank calculates the potential benefit from a reduced incidence of crises to be approximately half a trillion dollars,” it said in the report titled “Strengthening International Capital and Liquidity Standards.”

There will likely be some costs to consumers as banks seek to pass on the costs of higher capital and lending requirements through higher lending rates or restricting credit – and that will eat up some of the projected gains.

But the report suggested that over time the net benefit to Canada would amount to $200 billion, or about 13 per cent of the country’s gross domestic product, based on conservative estimates of the cost of financial crises.

About two-thirds of the benefits would come from a reduction of risk to foreign rather than domestic financial crises, as the probability of a crisis originating in Canada is already much lower.

Although Canadian banks remained relatively healthy during the recession, the country felt reverberations of the crisis and is set to become more exposed as the world’s economies become more interconnected, the central bank warned.

Canada was buffeted by financial shocks from abroad and couldn’t escape the spillover effects of the global downturn, Bank of Canada governor Mark Carney said in a statement from Ottawa.

The country’s economic output fell by more than three per cent during the crisis and more than 400,000 people lost their jobs.

“The recent global financial crisis left a legacy of damaged economies, failed financial institutions, lost jobs, and higher fiscal deficits. Canada was not immune,” Carney said.

“It is thus clearly in Canada’s interest to work with other countries to develop stronger international capital and liquidity standards. This will improve the robustness of our own banking system, and contribute to the promotion of global financial stability.”

The new standards are part of a broader package of international financial reforms introduced in the wake of the 2008-2009 recession, when it became clear that the global banking system didn’t have enough capital and liquidity, and many banks could not withstand the economic shock without public sector support, the Bank report said.

The central bank study was released on the same day as two international reports on the subject drew similar conclusions _ the costs associated with implementing new rules would be far less than the international banking community has claimed and will be outweighed by long term gains.

The Bank of Canada report found that every two percentage point increase in the level of bank capital required decreases the likelihood of a global financial crisis by 2.9 percentage points and by 0.8 percentage points in Canada, resulting in a 1.1 per cent boost to Canada’s annual GDP.

Meanwhile, that same capital increase will cause Canada’s annual GDP to decline 0.3 per cent, as economic output falls due to the effect of tighter lending on consumer spending_ resulting in a net 0.8 per cent boost to Canada’s annual GDP.

The cost of higher bank capital will lead to higher lending spreads, as banks are forced to keep more money on hand rather than dole it out to borrowers. The Bank calculated that with every percentage point increase in bank capital requirements, lending spreads would increase by about 14 basis points.

However, it says a longer transition period would help to mitigate some of those risks.

The report projected central banks around the world would have to pursue lower interest rates to help cushion the effects of the tighter rules.

Most Canadian banks appear to be well-placed to met the new international standards since they carry a large portfolio of residential mortgages that can be easily converted to mortgage backed securities, which qualify as eligible liquid assets under the new rules, the Bank said.

The report acknowledged, however, that there is significant uncertainty in both its study and the two international studies that made similar conclusions, as predicting the financial sector’s impact on market cycles is still an emerging field.