The Bank of Canada Shouldn't Reduce Rates to Protect Banks
The Bank of Canada shouldn't reduce interest rates, using quantitative easing (QE), to protect banks against their poor business decisions and failed risk management.
The financial crisis of 2008 highlighted the importance of responsible risk management practices for banks. In the aftermath of the crisis, regulators around the world introduced a range of measures to:
stop the contagion of bank failure after the Lehmann Brothers debacle.
ensure that banks are better equipped to weather future shocks.
However, some critics argue that these measures are too generous to the banks and overly prescriptive.
Too generous because rates were lowered to prevent mortgage defaults, which would have caused many banks to fail. This effectively saved bank investors (owners) from taking losses in the years following the crisis. This rewarded bank investors for taking on too much risk before the property bubble and penalized people with savings because savings accounts and bond investments (safe investments) had very low investment returns. This then forced people to move their retirement investments into riskier assets.
Too prescriptive because regulators began to tell banks what they should do to manage their risk. This gave investors the impression that any financial institution compliant with the regulator was effectively lower risk.
Unfortunately, cookie-cutter regulatory instructions do not adequately address all of the known risks and yet-to-be-discovered risks in the banking sector. The Silicon Valley Bank (SVB) collapse illustrates this. SVB was caught-out because they placed a bet that interest rates would not rise significantly and depositors would not make significant withdrawals.
SVB failed for similar reasons to banks in the early 20th century. We could argue that management was negligent, misjudged the risk, the shareholders (board of directors) didn’t challenge management’s rose-tinted risk management, or that the regulator should have caught the problem sooner.
The ultimate responsibility lies with management and the board of directors. Regulators are the third line of defence, and they are dependent on information provided by management.
The Fed was right to protect depositors, to prevent contagion, and they are right to allow the bank to fail.
However, they should not intervene in the markets to artificially lower rates for all banks, to protect a minority of banks for their poor risk management.
This approach incentivizes risk-taking by protecting poorly managed banks and penalizes banks with lower risk profiles. Critics suggest that the best approach is to allow banks to take losses and to offer help any banks in trouble, but at a punitive price.
There are several reasons why this approach makes sense. First, if banks know that they will be bailed out by the central bank, they are more likely to take risks that they might not otherwise take. This creates a moral hazard problem, where banks are incentivized to engage in risky behaviour because they know they will be protected from losses.
Second, if the central bank does bail out banks, it creates a perception among investors that there is no downside risk in banking investments. This can lead to a situation where investors pour money into higher-risk and higher-return banks, penalizing well-run banks and rewarding the banks that push risk boundaries.
Finally, if the central bank protects banks from losses, it may discourage them from taking responsibility for their own risk management practices. This can create a situation where banks continue to engage in risky behaviour, knowing they will be protected by the central bank.
Regulators have an important role to play in ensuring that banks are adhering to best practices when it comes to risk management. However, regulators should be focused on encouraging responsible behaviour, rather than protecting banks from the consequences of their own actions.
Investors also have a role to play in promoting responsible risk management practices. By focusing on banks that prioritize risk management and responsible behaviour, investors can create an environment where banks are incentivized to prioritize these practices.
In conclusion, the Bank of Canada should not interfere in the bond market to protect banks against their own poor business decisions. They did this during the 2008 financial crisis, which did not prevent risk-seeking banks from poor risk management.
Instead, banks and their owners should be held accountable for their own actions and oversight, and regulators should be focused on promoting responsible behaviour. This is the best approach to creating a banking industry that is resilient, sustainable, and responsible.
If the Bank of Canada takes this course of action, then mortgage rates will likely remain high for the remainder of 2023 as the BoC battles inflation.
