Ann Kaplan is President and CEO of iFinance Canada.
Last week marked the 10th anniversary of the stock-market highs of 2007, ahead of the disastrous 2008 financial crisis and the big-bank bailouts. The U.S. government spent billions of taxpayer dollars to bail out the banks, as failure would have likely caused a worldwide depression.
Canada took a soft hit from the collapse, thanks largely to our rigorous bank regulations. Unlike European and North American banks, which were on the verge of bankruptcy in 2008, Canadian banks required no such help or extraordinary intervention by the Bank of Canada.
While Canada's bank regulations are sufficient to withstand a storm, what of our shadow-banking sector, which operates largely unregulated? These are the companies that work in the shadows of the banks and often get their financing from the big banks. As someone who oversees one of Canada's largest non-bank, unsecured consumer-lending companies, I can tell you that this industry needs more oversight and transparency.
Specifically, we need to establish a voluntary compliance framework that would facilitate transparency among companies in the shadow-banking sector, including investment banks, money-market funds and the securities markets. This would be different from regulations, which could turn off the taps and would have a big impact on access to financing and, thus, spending. Such access was integral after the financial crisis and led to new and innovative outlets for capital-raising as bank lending became unavailable. Regulations would kill such innovation.
It's important to understand the difference between banks and shadow banks, which can include hedge funds, pension funds and secured investment vehicles. Shadow banks do not accept deposits and are not subject to regulations such as those that protect taxpayers' savings deposited into bank accounts. We in the shadow-banking sector have more flexibility in providing innovative financial-lending instruments.
Our industry has grown and evolved tremendously in the aftermath of 2008. According to some reports, the worldwide shadow-banking industry totalled approximately $60-trillion (U.S.) in 2011. According to the Bank of Canada, the size of the shadow-banking sector in Canada is about 40 per cent of the traditional banking sector. That's a significant chunk of the economy.
By not being regulated, we are able to take on a higher risk in lending money. This risk, though, is generally offset with reserves and covenants that satisfy the partnering institutions and prevent the transfer of risk to borrowers. The downside with non-regulation is the rise of ill-defined terms, ill-defined requirements and a lack of consistency in how each product and/or company is viewed – giving way to wiggle room and leeway to omissions that can and will cause upset when a crisis happens.
I have long lobbied for more transparency and confirmation of conformity through an official set of standards for non-bank lenders. Such standards for the shadow-bank system would provide best practices and require companies to disclose any areas of non-compliance.
As a member of the shadow-banking subcommittee of the G20Y, I submitted recommendations that were adopted earlier this year in a report by the Financial Stability Board (FSB), which co-ordinates financial regulation for the Group of 20 economies. This work by the FSB is a step in the right direction. But there are many steps. The first step is an understanding of the need for oversight, something about which both the FSB and Bank of Canada seem to be in agreement.
Various sectors need to work together to develop a voluntary framework that has the common goal of providing clarity, consistent definitions and terminology. While there are many models that could be adopted, accounting firms should oversee audits of shadow-bank institutions. The voluntary framework might be more of a checklist that would be implemented at the discretion of the lender, such as a regulated bank.
Completing the checklist could perhaps become part of the standard requirement by banks before lending to shadow banks.
A lot can be underwritten in the numerous categories that fall under the umbrella of shadow banking. Shadow banks are a large part of the financial world, yet they exist without the same oversight of banks and with less clarity to investors and borrowers. It's time to shine the light on the shadows.