Financialization and the Financial Crisis

Eric Pineault is the designated hitter on the topic of financialization but I thought I might make a small contribution to get the discussion rolling.

I’ve been reading Galbraith’s The Predator State see a review here — and it got me to thinking just how little our federal government — and governments elsewhere — has done to radically change our financial system in a way that would minimize the chances of a re-occurence of the current crisis.   If anything, the policy response thus far seems designed to dial us back to the summer of 2008 and beyond, to unstuck the securitization markets so that everyone can go back to not caring about debt.

What do I mean? Consider the federal government’s –  and the private sector’s — major credit crisis policy initiatives:

1.  Since last spring, the central bank accepts a wide range of collateral in exchange for short-term liquidity (PRAs), including Asset-Backed Commercial Paper  (ABCP) and other esoteric derivative instruments.  These efforts all, effectively, legitimize these financial products and the underlying philosophy behind them;

2.  The government has introduced two major programs aimed at restarting the securitization markets, namely backstopping the ABCP restructuring and the $12 billion Canadian Secured Credit Facility (CSCF) for the auto leasing sector.

3.  Canada’s august accounting body has put in place accounting changes that allow banks to defer painful writedowns of their bad debts;

4. The $125 billion insured mortgage purchase program (IMPP) has been set up with no quid-pro quo from the banks — no demand that they limit dividend payments, no demand that executives take a pay cut, nothing. Oh, I know. It’s “not a bailout” but an enlightened investment on the part of the federal government that insured the mortgages anyway (if it’s such a good idea, why don’t we do it all the time?).  Sure, but that view evades the crucial point, which is that the federal government stepped in because it had to.  Moreover, the policy has major benefits for the banking sector — swapping mortgages for government debt also makes their risk-adjusted capital ratios look much better (some good news here in that the banks are starting to rely much less on IMPP).

Now I’m not necessarily saying that any of these policy responses is wrongheaded. I’m not sure I would have done anything different.  What I would do different, however, is try to frame them — or at least begin the process of framing them — in a longer-term discussion about how to avoid this mess in the future.  That means, giving serious thought to restructuring at least three major areas of policy:

1. Taxation policy: As Galbraith rightly points out, the broad policy approach in the last 20 or 30 years has been to shift taxation away from investment income — capital gains and dividends (hello TFSA) — towards consumption (hello GST — although clearly, Harper has played somewhat against trend in lowering the GST).   One of the consequences has been an explosion in dividend payouts, share buybacks and a decline in investment spending (see any of Jim Stanford’s pieces a year or two ago on the lack of investment spending by Canada’s business class) which has driven stock market prices up (and now down).  The other resulting consequence has been a boom in investment culture — the idea that everyone can get rich by just putting their money and faith in the stock market — see point 3 below;

2. Banking: Is it wise to even have securitization markets — unheard of just 20 years ago — and if we want them, how should we regulate them to ensure they don’t go kaboom in the future?  Not a word on this has been ushered thus far by the government despite the fact that this is clearly the locus of the current crisis;

3. Income policy and social responsibility: Partly as a consequence of the points made in (1) above, there’s been a broad shift towards putting the individual at the centre of his or her own economic future (retirement) rather than thinking about the issue from a collective perspective (income security programs).  A related effect has been the tendency for our economic elites to push the largely pointless and ineffective  “economic or financial literacy” agenda.


  • What were/are the errors in Canadian policy?

    It seems a bit of a stretch to say “The US adopted different policies than Canada, and the US banking sector imploded while the Canadian banking sector did not” and the conclude “Therefore, Canada must revisit its policies.”


  • I’ve wrestled with this question myself and my feeling is that Canadian policy is guilty by association: while we’ve certainly lagged the U.S. in the extent and depth of financial shinanagans, we were certainly heading down the same path.

    The Globe ran a nice investigative piece (for example) last weekend on our own little noticed subprime mortgage problem. They had to work hard to make the case because the data weren’t really there to enable an easy discussion of the problem. Nonexistent data, however, do not equal nonexistent problem. We in Canada lack the depth of the data they have in the United States. That seems like one good place to start if we want to avoid the problem in the future.

    Even more to the point, Canada is a small, open economy dependent on trade and international capital flows. We’ve hitched our wagon to that horse and that means, extending the metaphor, we need to anticipate as much as possible where that horse will take us and regulate as a consequence.

    In pragmatic terms, what does that mean? Consider that Germany outlawed the practice of securitization — its banking system could not package loan assets and dump them on others. For whatever reason, however, German policymakers neglected to also ban purchases of foreign securitized assets by their banking system. Guess what? German banks were some of the hardest hit by the crisis because they loaded up on these (mostly) U.S.-originated assets.

    Does the fact that the crisis originated somewhere else mean German policymakers should do nothing or are absolved from all responsibility for what happened there? No. The policy solution here seems fairly clear — i.e., tighten up rules on ownership of foreign securitized products.

    Same thing with events here in Canada, where we suffered our own made-in-Canada crisis (yes, triggered by events in the U.S.) in the form of the ABCP meltdown (for example), the consequences of which were dramatic policy action by the BoC. We could do like Germany and ban the issue and/or purchase of securitization products. Or we could impose accounting rules that make them less palatable. Or we could limit the issue of securitization products to only a small, highly liquid portion, of bank assets. Or we could be working, through the BIS, to more aggressively regulate them on a global scale. And so on. The point is these things need to be on the table. Policymakers need to be discussing them at the same time that they try to put out the fire.

  • The Canadian government is actually very active around the financial re-regulation agenda. Tiff Macklem – Associate Deputy from Finance – co chaired the first working group of the G-20 which is about to report to the G-20 and Canada was also represented on that key group by David Longworth from the Bank. We haven’t seen the report yet and I suspect it will fall well short of what I would see as the correct agenda (see the TUAC paper I have posted before.) At the same time, it will go well well beyond doing nothing and will endorse regulation of the shadow banking system, limits on leverage, much greater transparency re the nature and trading of derivatives, and greater international oversight of domestic regulators. The Canadian position – publicly expressed in an op ed by Flaherty in the Financila Times in November – is that good regulation on these lines begins at home — and it is a bit hard to fault Canada given higher than Basel capital requirements which were effectively applied to all systemically important institutions. Canada will resist doing anything about financial sector compensation.

  • Hi Andrew,
    Thanks for the comment — I was hoping to get a discussion going in part because frankly, I’ve been surprised at how little in the way of concrete action or talk we’ve seen despite all the hand-waving about the need to re-regulate (and the trumpeting of the “Canadian way”). Certainly, none of the policy measures that I’m familiar with and which have been announced thus far point in that direction (btw — Krugman posted a blistering editorial yesterday making roughly the same point that I tried to make here, i.e,. that policymakers seems determined to dial us back to 2006.)

    That said, I confess I wasn’t aware of Canada’s efforts on the international scale – at least not in the detail you have put forward – but based on what you’ve written, I still can’t say they inspire me with great hope. Macklem and Longworth are hardly radicals and radicals are what we need right now (what is the old aphorism? … the trick is to be as radical as reality itself). Moreover, I’m not sure that “more transparency” for example — the solution to all our problems for years now it seems — is going to do much of anything. More regulation of shadow banking sounds good but the devil is in the details of course. I’ll believe it when I see it. Greater international oversight over domestic regulators leaves me cold because (a) it’s largely unaccountable and (b) international institutions (IMF, OECD) helped spread the gospel of fiscal and monetary policy orthodoxy over the last 30 years. Maybe the BASEL standards are one example of a good international rule but then again, it seems to me they could actually encourage more securitization by increasing the incentives to move assets off the book to keep those ratios in line with standards. That said, in principle, I’m not opposed to international oversight on financial issues, it’s just that we’ve seen precious little evidence so far that it takes us in a progressive direction.

    As for the position taken by our politicians (almost all political stripes), I can’t say that trumpeting of the “Canadian advantage” on financial matters does anything for me. Just a little while ago, we were hearing from many of the same about how uncompetitive our financial services sector had become and how great the need was for more risk taking and mergers (see, for example, the expert panel which produced the “Compete to Win” report and advocated the lifting of de facto prohibitions on bank, insurance co. and other mergers). It’s a bit rich to pat ourselves on the back when we were angling to do the same as everyone else. I think we got lucky, mostly.

    More substantially, however, I think there’s the bigger question of the long-term historical process of financialization and related policies which have (for example) (a) shifted the taxation burden from investment income to consumption; (b) increasingly made individuals responsible for managing risk that could be better managed collectively; (c) compelled pension funds (the CPPIB springs to mind) to play the market game in the name of chasing returns rather than pursue some other policy objective; and so on. To my knowledge, Canada has hardly been a boy scout in resisting these tendencies which, arguably, are as much to blame for the current mess as anything else.

    What is even more damning, however, is that Canada has long adopted a beggar-thy-neighbour trade policy, relying on exports to drive demand for our goods and services rather than domestically-led consumption either from the private sector or the government sector (hello balanced budget advocates!). These exports were of course dependent on consumption in the U.S., which in turn was dependent on the same debt-fuelled consumption binge that brought us to the edge of the precipice. Again, from this perspective, it seems a bit rich to me to say that Canada somehow gets a free ride on the crisis and needn’t change much because everything’s fine thank you very much. Someone else may have prepared the meal, but we dined at the same table and now we want to leave without taking responsibility for the mess.


  • Oh…forgot to add a thank you on the TUAC piece. I somehow missed your post back in December. Very interesting. Any idea of how much play it’s gotten?

  • I did hear recently that one of the reasons the US banks look north fro ideas on change is the secure retail revenue streams that the Canadian banks have captured from the Canadian public. Government backed and service charge Guaranteed.

    If I had the data I could better get a fix on these captive retail revenues. At a minimum they are revenues you can pretty “bank on”.

    I do agree very much with the information shortage mentioned above and a starting point would be to get a lot more information, given the fact that we have handed over quite a few billions to the sector, one would think that information would be a lot easier to access.

    No executive pay curtailment, not much in the way of regulatory changes, no talk of governance issues all because we seem to have a model banking sector.

    I do wonder though, inside the walls of the banking “inner circles”, what actually is the health of our banking sector.

    We have heard quite a few horror stories, but somehow it is all smiles when we hear about the Canadian banking sector.


  • The Globe ran a nice investigative piece (for example) last weekend on our own little noticed subprime mortgage problem. They had to work hard to make the case because the data weren’t really there to enable an easy discussion of the problem.

    Heh. As it happens, I kind of went medieval on that piece.

  • Hi Gordon,
    Point taken on the Globe piece (thanks for the link to your blog btw) but despite the hyperbole, I think it performed a valuable function of alerting the public and policy makers that the problems in the U.S. were surely but steadily moving up north (hey, Garth Turner was on to something for once!!) with little in the way of policy action to stop the spread of U.S.-style practices.

    If the take-away is simply that we need to guard against insidious policy creep, then I think the article accomplished something worthwhile (oh, and having better data would be nice too — I think we can agree that the article does a good job of outlining the challenges of tracking the numbers down and putting them in the public domain).

  • With respect to point #4 (the $125 billion) it won’t help the capital ratios much because the mortgages in question were already gov’t guaranteed (0 capital under Basel 1, minimal under Basel 2)

    It was a bailout (or at least a measure to match bailouts in other countries to preserve a level playing field) in that it provided what was effectively a very low interest rate loan (banks get the money from the mortgages now instead of waiting for the interest, in return for paying slightly higher rate of interest than the mortgage do, on average) from the government to the banks, on far better terms than they could borrow from anyone else at the time.

    Basel 1 encouraged securitization because it did not differentiate very well (or at all in many cases) between high and low risk loans, providing financial incentives to holders of good loans to sell them off to folks who wouldn’t need to keep capital against them.

    Rather than simply outlawing securitization (which would be wise, in my opinion – it’s not smart to separate the supplier of money to be lent from the risk of default any more than you have to), Basel 2 intended to make securitization un(or at least less)necessary by more carefully matching capital requirements to the risks of the loans being held.

    Having said that, securitization was only a contributing enabler to our situation which is basically just too much debt (securitization contributed to this by helping the financial system increase its leverage). If you were to include securitization in a system such that the purchasers of securitized exposures needed capital in the same manner that the banks do, you could retain securitization (but why would you want to?) while limiting the systemic risk due to overall leverage.

  • Hi all, thanks for getting this going, I’m in the midst of a very bitter labour conflict at my university between professors and the government, have ended up as one of the union organizers… so haven’t had much time for anything else in the past 3 weeks… but will wade into the discussion when things have calmed down here at UQAM.

  • Declan,
    Thanks for the comment. You’re right about the IMPP and its impact on capital ratios. It’s easy to forget that these mortgages were insured by CMHC! Good point on the bailout. Finally, on Basel 2, I’ve just come across an interesting piece by Randall Wray of the Levy Institute ( which might be worth a read (haven’t read it myself yet but it’s on the to-do list).

  • Thanks for the link Arun, an interesting read, generally a lot of foresight considering when it was written, although kind of scattered and a lot longer than necessary.

    His general point that a capital agreement like Basel 2 can only get us so far with respect to financial stability is certainly well taken.

    In some respects, the Basel agreements resemble escalating legal/police/military action in the Drug War – looked at in isolation, the measures are helpful, but without considering the broader picture no real solution can be found.

  • This is a great exchange … thanks Arun for getting it started.

    I think the overhang caused by the contract between the rapid creation of financial capital and the sluggish growth of real capital is a key underlying feature of this crisis.

    Speaking of which, can anyone suggest data sources with which to measure the financial flows to the business sector on a global basis? I would like to show that non-financial businesses are not even re-investing their available cash flow (including depreciation allowances) in new investment — which casts great doubt on why we even need a financial sector! I seem to recall an IMF report in 2005 or so that showed a secual downward trend in global corporate leveraging in the non-financial sector (again implying that cash flow exceeds reinvestment), but I can’t find it anymore, and I suspect there may be more recent sources. I know where to get this information for one country (Canada, U.S., etc.), but would be interested in any global studies. Thanks in advance for your suggestions, Jimbo

  • Hey Jim,

    I think the BIS might have some useful information — try their statistics page and this link in particular:

    I’ll keep on this and get back to you if there’s anything else I can think of.



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