Concerned about the increasing frequency of banking crises? Don’t worry. Bad things can’t happen to banks in Canada.

Certainly we are not Spain. Or Iceland. Or Ireland. Well, let’s just say Europe more generally over recent years. Or, come to think about it, the USA with its subprime crisis and its major banks on the rails in the 2008 financial crisis.

Canada is smarter than all those other countries. Canadian banks are just better behaved than banks elsewhere, and in any case the extraordinary vigilance of Canadian banking regulators will protect us.

This self-congratulatory myth of Canadian exceptionalism is an act of willful denial. Not too long ago, the U.S. and Europe were thought to have the most sophisticated banks and the most state-of-the-art regulatory supervision in the world. And then they were blindsided by banking crises, as both questionable behaviour on the part of banks and unforeseen inadequacies in regulation combined to create big trouble.

Why do bank crises keep happening? In hindsight, you might wonder whether bankers and their regulators were in la-la land while these problems were brewing. But it is notoriously difficult to get out the crystal ball and understand the distant signs of the next round of bank trouble.

Consider the subprime mortgage fiasco. Years before subprime mortgages wreaked havoc on the financial system, lenders and their regulators did not grasp that they were playing with fire. Or perhaps the lenders did grasp it, but couldn’t restrain themselves since subprime shenanigans were just too darn profitable. And the regulators? Well, the U.S. financial services lobby has so much influence that regulators can become positively Zen if the bankers ask them to relax.

Those that see trouble coming are often ignored. Federal Reserve chair Alan Greenspan squelched concerns about subprime lending from one of his own Federal Reserve governors, Edward Gramlich.

“Maestro” Greenspan was a rock star in those days, and his deregulatory mission was not going to be sidetracked by worrywarts fearing the consequences of predatory mortgage lending practices. It wasn’t until much later that Greenspan’s celestial reputation was brought back down to earth by questions about the Fed’s role in the subprime mess and other problems contributing to the financial crisis.

Hindsight is 20/20, but spotting how the next speculative excess will exploit regulatory weaknesses is not so easy. There might be troubling indications, but it is never clear when and how a confluence of negative developments will brew into a full-scale crisis down the road. In the complex world of contemporary finance, there is just too much convoluted stuff going on to be certain of how the ramifications will play out once the system is under stress.

I prefer Warren Buffet’s approach: “You don’t know who is swimming naked until after the tide goes out.” Admit that you just can’t tell who is doing what when a high tide makes a lot of skimpy attire look like acceptable beachwear. Often by the time regulators understand that they have some serious skinny-dipping on their hands, the tide is rapidly dropping.

Aftermath of the financial crisis of 2008: A clothing-optional beach for banks

One of the unfortunate consequences of the financial crisis of 2008 is that really big banks have even more incentives to swim naked.

Banks are better behaved if they are nervous. If they worry that that they will bear the full consequences if their risky activities go sour, they tend to be more prudent. But since 2008, governments have pulled out all the stops to protect their banking sectors during financial crises. And what have banks learned from that experience? Now they unambiguously understand that they are “too big to fail”.

Because banks are confident that they will be given support in a crisis, this safety net unleashes precisely the wrong incentives. Banks are more likely to pursue riskier (and potentially highly profitable) activities, confident in the knowledge that they will be saved in a worst-case scenario. As Julie Dickson, Super­intendent of Financial Institutions said, “[u]nfortunately, as a result of the global financial crisis, there is now a deeply embedded presumption that govern­ments will use taxpayer dollars to bail out banks, creating a strong incen­tive for banks to take undue risks.”

Overconfident banks have a perverse incentive to do just what we don’t want them to do — take foolish risks that jeopardize systemic financial stability. This doesn’t mean that they will always do so. I’m guessing with events in Europe right now bankers want to look squeaky clean. The real problem comes when we all relax and the memory of the last crisis fades. Then bankers with superiority complexes will be tempted to ratchet up risk.

Will new regulations protect us? Supposedly regulators learned so much from financial crises since 2008 that their new rules will avert the next financial crisis.

Sorry folks. We have all been down this road before. After every financial crisis they create new regulations, and the next financial crisis exposes their weaknesses.

One of the key regulatory responses to the 2008 financial crisis is the Basel III rules. Why, might you ask, are they called Basel III? Well, because Basel I and II proved inadequate. Basel III was created to fix the problems evident in Basel II, the revised international regulatory agreement that was barely in place before the 2008 financial crisis blew up. And Basel II was supposed to fix the problems with its predecessor, Basel I. So we are supposed to believe that after three tries, they now have the magic formula?

Every regulatory system has flaws and unforeseen consequences, and there are lots of them in these new regulations. But now that big banks in Canada and elsewhere unambiguously understand that they are “too big to fail,” they are more likely to exploit regulatory loopholes if the lure of profits proves irresistible. The perverse incentive to pursue risky activities conferred by their “too big to fail” status makes the next financial crisis more likely.

A little humility, please

What should Canadians do in the face of increasingly common worldwide banking instability? Denial is not a good option. All that bragging about Canada’s banking sector’s resilience in the 2008 financial crisis is no guarantee about the future.

We should confront the fact that regulations will always have limitations, and the incentive to find loopholes in regulation will become irresistible if the profits to be made are high enough.

There are things we could do to make the banking sector safer. I discuss these options in my recent paper, No More Swimming Naked: The Need for Modesty in Canadian Banking. But here is the short version.

Banks should stick to their core functions (taking deposits and making loans) and forgo the complex financial market activities that our big banks currently get into. These activities have lots of risks. Just ask Moody’s, who recently downgraded the Royal Bank’s capital markets arm for participation in these volatile activities.

Today big banks now feel more comfortable getting into these risky activities because they realize that the Canadian government will have their backs if anything goes seriously wrong. The only way to stop banks from abusing the government safety net is to make sure the safety net is only covering core banking functions. If financial service institutions want to deal in derivatives and trade securities with their own money, these activities shouldn’t be protected by the public. We also need to take a serious look at whether these stripped-down core banks can continue as for-profit, private sector firms.

This is a major shakeup of Canadian banking, for sure. And since we can’t see who is swimming naked, it is hard to generate the political will for these changes when things look good on the surface. But we do need to face this. The time to make changes is before the next crisis gathers momentum.

Need a little extra motivation? If you really wanna get scared, consider the possibility that speculation in the commodities sector (and the boom-and-bust cycles speculation fuels) might become intertwined with financial instability in the future. This is a sobering scenario, given that Canada’s economy is increasingly dominated by financial institutions and natural resources. But then years before the 2008 financial crisis hit, how many worried about subprime mortgages?

Ellen Russell is an economist and professor of journalism at Wilfrid Laurier University. Her column comes out every two months in rabble.ca.

Photo: Sam Javanrouh/Flickr