Public Servants Protecting Your Money

Head Table Guests

J. Mark O’Regan, FCA, Toronto Office Managing Partner, Greater Toronto Area Regional Managing Partner, Ernst & Young and a Director, The Canadian Club of Toronto; William Brock, Vice-Chairman, Toronto Dominion Bank; The Most Rev. Edward Scott, Archbishop, Former Primate of Canada and Priest-in-Charge, St. Clement’s Anglican Church; Fred Kasravi, Chairman, Ontabia Business Development Corp.; Spencer Lanthier, Chairman, KPMG; Roger D. Wilson, Q.C., Partner, Fasken Campbell Godfrey; Grant Reuber, Chairman, Canadian Deposit Insurance Corporation; Diana Chant, C.A., Partner, Price Waterhouse and Treasurer, The Empire Club of Canada; W. Edmund Clark, President and CEO, Canada Trust; Dominic D’Alessandro; Gerry Phillips, Chairman Price Waterhouse; and Herbert Phillipps Jr., President, The Canadian Club of Toronto.

Introduction by John Campion

Nathan Rothschild’s Box of Gold

On the 14th of December, 1825, tall men in long-tailed pink coats and scarlet waistcoats shuttled the usual large number of people across marble floors in London. The people moved, as was their daily custom, with cloistered calm, in the five massive halls designed by Sir John Sonne. The most powerful and august financial institution in the world was operating its daily routine from its four-acre site on Threadneedle Street.

On this very day, when elsewhere in the world, radical colonels had tried to overthrow the Tsar of Russia, the Bank of England stood as a powerful symbol of British economic stability and a powerful precursor to world trade dominance brought on by the Industrial Revolution and the victory at Waterloo.

But this symbol of permanence in world commerce was anything but in a usual state of activity. Like the political affairs in Russia, the Bank was under intense pressure that threatened its very existence.

On December 16th, the whole British Cabinet, under Prime Minister Lord Liverpool, had met to discuss the economic crisis brought on by a wave of financial euphoria, driven by the ever-popular slogan of governments and private investors alike–spend, spend, spend.

Local speculation had been driven to a frenzy of financial dementia encouraged by Latin American investments in mines, railroads, canals and other development. Inca gold and its influence on the public imagination had captured the public passion.

Those associated with the accumulation of wealth were instilled, as usual, with superhuman intelligence. The public madness mesmerized new investors into the bull market of 1824. Crowd psychology and human greed had converted sober individuals into a mass movement of starry-eyed speculators against which, as Schiller has said, "The very gods themselves contend in vain."

In the face of the market collapse, the Bank was facing an unprecedented run on its reserves as the public and the country banks demanded gold for paper. In the banks’ vast storerooms, officials ransacked reserve boxes for gold. By December 17th, the Bank was completely drained except for 100,000 gold Sovereigns. Not since the Bank had been founded by William the Third in 1694 to finance his French wars had it stood on the brink of financial ruin and British and world trade with it.

Quite by accident, Bank officials stumbled upon a huge, unmarked chest thought to contain paper bonds. Upon opening, 1.5 pounds million in gold Sovereigns were discovered. By December 20th, these too were gone and the Bank was down to 60,000 gold Sovereigns.

But by this time, Nathan Rothchilds, showing the value and power of private banks, had literally got his hands on 200,000 more gold Sovereigns and had 25 couriers ranging all over Europe to buy more.

Thus, the Bank and its credit were saved. Economic depression of a world-wide, deep, lasting and great historic significance followed. Key financial houses across Europe failed. The shortage and recall of credit produced a huge industrial crisis. Workers rioted in the streets. No Latin American government was able to raise loans until 1850. The Latin American Independence Movement fell from high expectation for good to petty destructive wars.

Countless individuals, institutions and groups suffered loss of wealth, decline in salaries, increased work hours and the abolishment of ancient holidays. Economists’ reputations were ruined and political reputations were shattered.

And so, in this first modern world-wide financial crash, it is possible to experience all the oft-repeated indicia of financial euphoria and depression. The value of institutional stability in crisis periods was illustrated and remains unchallenged to this day.

The maintenance of long-term institutional financial stability in Canada is the responsibility of the Superintendent of Financial Institutions. We have little doubt about the significance of John Palmer’s job as Superintendent of Financial Institutions for Canada.

Mr. Palmer is a Fellow of both the Ontario and British Columbia Institutes of Chartered Accountants. In his role in private accounting, he specialized in tax, assisted two successive federal Ministers of National Revenue and served clients in both the private and public sectors in such areas as financial services, real estate, transportation and communications.

He served on the panel of senior advisors to the Auditor General of Canada and as a Governor of the Canadian Comprehensive Auditing Foundation. Mr. Palmer is involved in charitable and community organisations, including the United Way of Greater Toronto and the Canadian Stage Company. It is with great pleasure that I ask you to welcome Mr. Palmer to our joint Clubs.

John Palmer

Thank you very much, John. If I wasn’t apprehensive before about my responsibilities, I certainly am after that introduction. In looking around, I’m really quite impressed with the number of people here today. This is my first public address since my appointment as Superintendent last September. I’ve addressed smaller groups on an in-camera basis and I have had to testify before parliamentary committees, which certainly wasn’t voluntary, but this is the first large-scale speaking engagement that I’ve accepted. I’ve been reluctant to accept engagements before this because, as a newly appointed Superintendent, I thought it might be useful to learn something about the job before I talked to others. So I decided somewhat arbitrarily not to accept public engagements for the first six months, and I’ve remained faithful to that decision. Someone who approached me a few months ago to give an address said, when I turned him down, "Palmer, it’s time you came out of the closet. You can’t hide forever." Well, today I may not be coming out of the closet, but I do have a few things to tell you.

In the course of a recent ski trip to the United States I had occasion to visit an American doctor. Before he would see me I had to fill out a form requiring information on my bank account, my major credit cards and my occupation. When it came to occupation I filled in "public servant." When I got in to see the doctor, and I actually got in to see him very quickly once they had established my ability to pay, he looked at the application form. "Boy," he said, "’public servant’–that’s the world’s greatest oxymoron." There are a few other things I’d like to tell you about this experience with the American medical system, but I’ll save that for another time.

But I do want to stress that for me the term "public servant" is not an oxymoron. It has real meaning, and that’s one of the reasons I took the job that I was offered. I hope to show you that in the office I have the honour to head, often referred to by the acronym OSPE, the concept of service to the public is alive and well. To do this, I’m first going to give a brief overview of Canada’s financial system, because we have quite a broad audience here, and then explain the role that OSPE plays within that system. I’ll also talk about some of the challenges facing OSPE and some of the changes that are underway to enable OSPE to respond better to those challenges.

First, let me try to position OSPE within the financial system. When I refer to the financial system, I’m talking about the following entities: schedule I and schedule II banks, all federally chartered; trust companies, both federally and provincially chartered; federal and provincial life insurance companies; federal and provincial property and casualty insurance companies; and of course investment dealers, credit unions, pension funds and mutual funds.

OSPE’s primary responsibility is to supervise federal financial institutions. That comprises all of the banks and those trust companies, life insurance companies and property and casualty companies which are federally chartered. OSPE also supervises pension funds which are established under federal jurisdiction. There are 1,100 of these. In addition, OSPE contracts with certain of the provinces to carry out supervisory functions with respect to provincially chartered life and property and casualty insurance companies. OSPE does not have direct responsibility for the supervision of investment dealers or credit unions, although it does have responsibility for a number of credit union centrals.

As you can see, OSPE is not the only regulator of financial institutions in Canada. The provinces have regulatory responsibilities similar to those of OSPE within their jurisdictions, and there are also securities commissions in several of the provinces.

This short tour of the horizon would not be complete without mentioning the Canadian Deposit Insurance Corporation, or CDIC, headed up by my friend Dr. Reuber here. CDIC provides a deposit insurance to both federally and provincially chartered deposit-taking institutions, including both banks and trust companies. CDIC is not a regulator, but it does have some functions which complement those of the federal and provincial regulators of deposit-taking institutions.

The financial sectors that OSPE supervises are strong and well capitalised by almost any standard. They also include world-class institutions by any measure including size, range of products and competitiveness. For example, five Canadian banks rank in the top 100 internationally by assets. Most Canadian banks have capital which significantly exceeds standards set by the bank for international settlements or by the BIS. As of October of last year, the big six banks had an average risk-base capital ratio of 9.83 per cent compared to a BIS standard of eight per cent. On a capital-to-assets basis Canadian banks have capital representing about seven per cent of their assets. For Canadian property and casualty companies the ratio is about nine per cent and for Canadian life insurance companies the ratio is just above nine per cent.

Canadian financial institutions have long been active internationally. The big six banks have more than 25 per cent of their assets invested abroad. The Canadian life insurance companies are even more active internationally, with 53 per cent of their assets invested abroad and 51 per cent of their policy obligations falling to people outside Canada. In some ways, the life insurance industry may represent one of Canada’s greatest international success stories, notwithstanding recent failures.

Let me give you a short history of OSPE. It was formed in 1987 by merging two federal government agencies, the Department of Insurance and the Office of the Inspector General of Banks. The objective in creating OSPE was to strengthen the overall level of supervision over financial institutions and to recognise the growing integration within the financial sector by empowering one federal agency to supervise the different types of federally incorporated financial institutions and their various activities. A remarkable amount was accomplished under OSPE’s first Superintendent, whom I succeeded last year. A good team of people was built up using staff from the Department of Insurance and the Office of the Inspector

General of Banks. Also, many new people were hired, most of them from financial institutions in the accounting profession.

A philosophy of supervision was developed which reflects the traditions of the predecessor agencies, and which responded to the recommendations of the royal commission (which investigated the failure of the two Western banks). This philosophy of supervision combines the best elements of the U.K. and U.S. approaches to supervision. The U.K. approach emphasises largely offsite monitoring of financial data, while the American approach is based on very intensive on-site examinations. The Canadian approach utilises the two techniques, relying on both the monitoring of data and on periodic examinations which are less intensive and detailed than the American equivalent. Unlike that of the Americans, the Canadian supervisory approach also places heavy reliance on the work of the external auditors, which we think adds value and reduces duplication of efforts and costs. My attitude to that is changing a lot.

Following from OSPE’s philosophy of regulation, detailed methodologies were developed. This was done using OSPE resources, but with a good deal of help from financial institutions and from the auditing profession.

But while my predecessor and his colleagues were labouring hard to build an organisation and develop a supervisory approach, the financial world was not standing still and waiting for all this to happen. Indeed OSPE found that the goal posts were moving rapidly. Within the financial sector there were both rapid integration and diversification. Examples of integration were the bank’s acquisition of investment dealers, trust companies, mutual fund groups and more recently insurance companies. We also saw insurance companies acquiring trust companies and diversifying their product mix, including their segregated fund portfolios, which most of us think of as mutual funds. Diversification included expansion in the capital markets area, more new derivative products and a rapid growth in fee-based activities.

While the financial sector was changing, the country went through the deepest economic downturn since the 1930s and OSPE was faced with an extraordinary challenge. The extent of that challenge can be seen by considering the number of financial institutions supervised by OSPE which failed or otherwise closed their doors during and immediately after the recession. How many of these financial institutions can you name? A few high-profile names like Standard Trust, Central Guarantee Trust or perhaps Sovereign Life might come to mind. I doubt that you would be able to name many others, partly because most of them were smaller and partly because they went out of business quietly by merger, take-over or simply by closing their doors and running off their obligations. And there were many of these. On the basis of 1994 data, OSPE’s records indicate that the following number of federal financial institutions went out of business after 1989. There were 15 schedule II banks, 17 trust and loan companies, 33 life insurance companies and 74 property and casualty insurance companies, for a total of 139 institutions. These figures do not include companies like Royal Trust and Montreal Trust, which retained their identity but were taken over by other institutions.

Despite the many closures, in the great majority of cases depositors, policy holders and creditors were not unduly affected. In some cases, of course, they were very much affected and the losses in dollars were substantial, but in most cases the capital of the institutions was sufficient to absorb the losses on closure.

It’s important to note that this consolidation occurred during a traumatic time for Canada. During this period the country went through a deep recession and experienced a virtual collapse of commercial real estate. For a variety of reasons financial institutions were heavily exposed to commercial real estate, and many of them experienced substantial losses. But notwithstanding the trauma and the failures, most of the remaining financial institutions were covered well and the financial sector is now generally in good shape. And it’s worth noting that during this same period 40 new federal financial institutions started up.

What are OSPE’s responsibilities vis-a-vis these financial institution failures and closures? There are some who believe that OSPE’s role is to prevent failures. If that were the case, OSPE failed miserably over the course of the recession. OSPE’s role has never in fact been formally spelled out, but that situation is now about to be clarified. The Department of Finance issued a policy paper last February proposing a number of changes to legislation affecting financial institutions. These changes will include an amendment to provide OSPE with a specific mandate. This mandate makes it clear that OSPE’s primary role is to protect the rights of depositors, policy holders and ordinary creditors of financial institutions. The mandate also makes it clear that, while regulation and supervision by OSPE may reduce the risk that financial institutions will fail, OSPE cannot prevent failures. That’s the responsibility of boards of directors of financial institutions. This mandate, while still at the proposal stage, is entirely consistent with the role that OSPE has been attempting to carry out since it was created in 1987.

When I appeared before the Senate banking committee in October some people seemed horrified when I said that there would continue to be failures of financial institutions. We still seem to have a view in Canada that financial institutions should not be allowed to fail, and that if they do, somehow it is the government’s and probably OSPE’s fault if a federal financial institution is concerned. In my view that kind of attitude is unrealistic and probably unwise. The essence of our free enterprise system is innovation, experimentation, and a drive to provide better services and better products. The companies that do this well succeed, grow bigger, and become more profitable. The companies that do not succeed whither and die. This is fundamental to our economic system and, while no one likes the pain created by the death or restructuring of companies, no one has yet discovered a better system.

Within the economic system generally, there has been a remarkable turnover in the roster of companies that provide our goods and services. You only have to look at the Financial Post 500 listing today and ask yourself how many of those companies were on the top 500 lists 20 years ago–remarkably few. If we want a financial system that is creative and innovative, one that is constantly providing new and better services to customers, we have to allow the laws of economics to work there too. Some financial institutions will tend to succeed at the expense of others. Others which are not as resourceful, not as well-managed, and which do not respond to changes in the marketplace as effectively, will need to reorganise, restructure or even go out of business.

While I believe that this process should (within limits) be allowed to work within the financial sector, it is reasonable for us to ask that the competitive struggles of financial institutions be carefully monitored, so that when death becomes a possibility someone looks out for the rights of depositors, policy holders and creditors. And for federal financial institutions, that’s part of OSPE’s task.

How does OSPE go about carrying out its role of protecting depositors, policy holders and creditors? Conceptually, there are four ways in which OSPE could protect the rights of these groups whose money is the lifeblood of our financial system. First, it could restrict the activities of financial institutions so as to limit their capacity to get into trouble. Second, it could ensure that financial institutions are adequately capitalised so that there is an effective cushion against losses experienced by financial institutions which take excessive risks. Third, it could try to ensure that there is appropriate market discipline so that consumers withdraw their business if financial institutions engage in excessively risky behaviour. And finally, OSPE could intervene in the affairs of individual financial institutions when they appear to be getting into difficulty. In fact OSPE uses all four elements in carrying out its role, but with particular emphasis on ensuring that institutions are adequately capitalised and intervening directly into the affairs of financial institutions when they run into problems.

There are restrictions on the activities in which financial institutions can engage themselves, but these restrictions for most are pretty broad and are designed to give financial institutions the flexibility to develop new products and to remain competitive both in Canada and internationally.

OSPE’s principal focus in the area of the activities of financial institutions is to ensure that the boards of directors have adopted what are called prudent portfolio, guidelines for their institutions, and then to check that each institution is following the guidelines set by its directors. With respect to the maintenance of market discipline, it should be noted that the existence of deposit insurance has probably weakened market discipline within insured levels. However, insured levels in Canada are not particularly high, and those institutions wishing to attract deposits beyond insured levels must be able to assure potential depositors of the safety and soundness of their institutions. To assist in enhancing market discipline, the government is requiring the distribution to the public of more information about financial institutions, either by the institutions themselves or from data collected by OSPE.

As noted, OSPE’s supervisory approach places heavy emphasis on the need for adequate capitalisation. A number of tests have to be met, including required percentages for risk based capital, maximum asset-to-capital multiples and, for life insurance companies, what we call the MCCSR ratio. These are monitored carefully, and action is taken when it appears that an institution is gone or is about to go off-side.

The fourth, and perhaps the most important arrow in OSPE’s quiver is direct intervention. This has several stages. For financial institutions that are operating normally, OSPE’s involvement will include an annual on-site examination, monitoring of financial data, an annual closing meeting with management following the examination to report on OSPE’s findings, and usually a meeting with the board of directors or the audit committee of the board to report on those findings and raise any concerns that OSPE might have arising out of the examination and the monitoring process. As a financial institution encounters difficulty, such as the need for substantial write-downs a deterioration in profitability, or the erosion of capital, OSPE’s intervention becomes more active and increasingly directive. Interventions that OSPE will consider using include meetings with management and the board of directors to communicate concerns; increased monitoring; more in-depth examinations; requests for a business plan to show how the institution will remedy the problems it seems to be experiencing; a suggestion to the board that management changes may be needed; the prohibition of dividends and share redemptions; decreases in the permitted asset to capital multiple; the issuing of a compliance order requiring more capital; the assumption of direct control of the assets and operations of the institution; and finally a request for the minister’s permission to seek a winding up order for the financial institution.

The various stages in the financial decline of a financial institution, and OSPE’s likely intervention at each stage of that decline, are described in annex number II to the recent policy paper issued by the Department of Finance. This document applies to deposit-taking institutions and also shows how OSPE and CDIC work together at each stage. OSPE has issued a similar document to life insurance companies.

I’ve been talking a lot about financial institution failures, but it is important to emphasise that most Canadian financial institutions have successfully weathered the economic storms today and are financially strong. I believe that OSPE has played a constructive role in helping many of these institutions through their difficulties. One CEO of a Canadian financial institution, which experienced a severe erosion of its capital during the recession but which is now in much better shape, told me a few weeks ago that his institution simply would not have made it if it had not been for the help of OSPE. I’ve become aware of a number of other successes whose specifics I can’t tell you about. OSPE’s regulatory successes tend to be quiet ones, which is as it should be.

However I do have to acknowledge that we are not perfect. Let me give you one instance. Over the last few months I’ve been visiting senior executives of financial institutions to seek their views on how good a job OSPE is doing. Are we doing everything we could be doing? Are we missing anything? How could we improve? In the course of these visits I met with the CFO of a regional financial institution. I asked him how OSPE was doing. Happily, like most of the others I’ve talked to, he thought that OSPE was doing a pretty good job, and he acknowledged that most of OSPE’s recommendations to the company were pretty sensible.

But he went on to say that back in 1989, when the real estate boom was reaching its final days, OSPE met with the board of directors to express concern about the company’s lack of diversification. Now this indeed was a valid concern. Most of the company’s mortgages were secured by properties in its particular region, which had been highly sensitive to past economic cycles. Criticising this company’s lack of diversification, OSPE asked if the company had considered expanding into Ontario, which traditionally has been a more stable and less cyclical source of real estate investments. In this case, the company was wise enough not to follow this suggestion, thereby avoiding the heavy losses they would have experienced had they expanded their Ontario mortgage portfolio in 1989.

The moral: Regulators are human and do not have perfect foresight. If we had it we probably wouldn’t be regulators.

Well, I believe that our financial system held up well through the recession, and also believe that while OSPE can be proud of the role they played, some improvements are clearly needed. In my view, most of the necessary changes have been included in the Department of Finance policy paper. Let me summarise a few that OSPE regards as most important. First, OSPE would gain the power to request an opinion on insurance liabilities to its policy holders from an actuary who is independent of the company, when OSPE has some concerns about the institution’s own calculations. Second, it is proposed that OSPE gain some powers with respect to the appointment of directors. These powers have not yet been decided. What OSPE is in fact requesting is the right of veto over the appointment of directors of troubled financial institutions. We’re not seeking a right of veto to all directorship appointments for financial institutions, although there are some who appear to want to give us this power. Another important proposal is to create a restructuring mechanism for insurance companies in Canada, in order to facilitate solutions that fall short of liquidation. This kind of mechanism won’t be useful in every situation, but will be a valuable addition to the arsenal of remedial actions now available to regulators and protection funds. In another recommendation, the Department of Finance policy paper calls for the establishment of a policy holder protection board to continue the work of Commcorp in protecting the policy holders of life insurance companies.

Commcorp has an excellent record in responding to the failures of insurance companies which have occurred to date, and in upgrading its facilities as needs have changed. Further upgrading is needed to enhance its capacity to levy assessments on member institutions and to make it possible for Commcorp to contribute to a restructuring of a member institution before liquidation occurs. The Department of Finance proposals for accomplishing these objectives are under discussion with the life insurance industry, and I’m optimistic that these positive changes will be achieved either through the PPB or a continuing enhancement of Commcorp.

Even if these and other changes in the policy paper are implemented, many challenges will face Canada’s financial institutions and OSPE, their largest regulator. Technology is fundamentally changing the face of the financial sector. It is facilitating many new products and improving the service that financial institutions are able to offer their customers. However, it also requires massive investments, and it is creating differentiations between those financial institutions strong enough to make the necessary investments and those which will have to be content with inferior measures. Some of the new products that technology has made possible, such as derivatives and other sophisticated financial instruments, are adding complexity and risk to the financial sector.

The investments in new technology and the development of new products are driven by competition which, despite the consolidation which has already taken place in the Canadian financial sector, has never been more intense. Not only are Canadian financial institutions competing aggressively amongst themselves for shares of the markets, some of which are relatively mature and not growing, they are also facing competition from foreign financial institutions and near financial institutions, such as leasing companies and, increasingly, the major pension funds. Consolidation in the financial sector is continuing.

The larger institutions continue to expand into territories which were once the preserves of other industries. Smaller institutions continue to disappear. Regardless of future legislative changes, these trends will continue.

Environmental risks are an increasing concern for all financial institutions, which may end up holding the bag for the clean-up of contaminated sites if they don’t spot the risks well in advance. The recent earthquake in Kobe, Japan, and the huge estimated cost of repairing the damage there, has dramatised a potential threat to Canada’s property and casualty insurance industry from a major Canadian earthquake. And that earthquake is not a question of whether. It is simply a question of when.

Above all else is the volatility that pervades every aspect of economic life. In any given day, the amount of money washing around the world, seeking advantageous opportunities, is many times that needed to finance the day’s trade in goods and services. The amount of speculative money in the system, the speed with which transactions take place, the instant availability of data and the growing interdependence of all of the players on the world’s economic stage mean that unforeseen and profound changes can occur overnight.

Since the Baring’s Bank collapse, people (particularly people up in Ottawa) have frequently asked me to assure them such a thing can’t happen here. Let’s understand that the only way OSPE could make sure that that can’t happen here is to post teams of derivatives experts on a 24-hour-a-day basis in every trading room of every Canadian financial institution across Canada and around the world. And even then, something might slip past us. We can’t make sure it can’t happen here. What w