Risk: Canada’s Contribution to a Global Understanding

Risk is now the word on everyone’s lips. This did not happen all at once, of course, and its path to the foreground was much like that of a business that becomes an overnight success after many years of hard work. But risk is at the heart of every decision and understanding it suddenly became absolutely essential when credit disappeared from the economies of the developed world in August 2007.

The Context

The Canadian financial system performed remarkably well during the now-fading recession, but was that due to good luck or good management? Probably some of each, but there are at least three factors supporting the latter.

First, Canada’s capital standards exceeded international requirements prior to the crisis. The Basel III rules impose higher capital levels as one tactic to reduce systemic risk. As it happens, they are in line with those already in place in Canadian banks. In fact, most estimates of the tangible common equity of our domestic lenders range from about 8.5% to 10.4% of assets, more than double the minimums the Basel rules will require by 2013. That means that, while external discipline may require significant adjustments elsewhere, the Canadian banks already have ‘rainy day’ money at hand.

Then there were the limits on leverage. In Canada, the banks have a 20-to-one cap on leverage. Our banks entered the crisis with leverage in the high teens, compared to the 30s and 40s for many US and European banks.

Finally, Canada has sound and rigorous supervision. The very proactive Office of the Superintendent of Financial Institutions (OSFI) ensures that regulations are applied across commercial banks, investment banks and large insurance companies.

So there were at least three reasons to give the Canadian financial system credit for taking deliberate steps to avoid the insidious risks that crept into other economies. Canada relies heavily on commodities, exports into a world market that has taught the country to be cautious in the face of its caprice. This conservatism has earned the derogative ‘stodgy’ in the past, but as Tiff Macklem, senior deputy governor of the Bank of Canada, said in a February speech, “Suddenly, stodgy is the new sexy”.

Internal Discipline

In reality, no one fully understands the interdependencies that make financial systems so complex. Sometimes we make intelligent guesses, or we employ forecasting models to make predictions, but it will take a lot to gain the deeper knowledge that could inform public policy and corporate decisions alike. The Global Risk Institute in Financial Services was created to seek the understanding that could lead to the management of risk across the system.

The new institute is a public-private partnership created with the collective support of governments, the chartered banks, major insurance companies, the largest pension funds, equity managers, professional organisations, academia and so forth across the entire financial services sector and those who work in or for it. The governments of Canada and Ontario have each invested CA$1m per year for 10 years, while the private sector donors have pledged more than CA$2m annually to produce a first year budget of CA$4.2m. The Global Risk Institute became a non-share federal corporation on 1 January 2011.

In its application for letters patent, the Institute stated its purpose as “the continuous improvement of the financial services sector through applied research into the integrative management of risks, the advancement of risk education, professional development for practitioners, executives and boards, and the ongoing examination of the mutual interests of the financial services sector and public policy makers”.

The overall goal is simple: to improve risk understanding among financial leaders, policy makers and boards of directors – because that will contribute to the safety and efficiency of the financial services sector. That goal will be sought through three collective aspirations:

1. Research into risk. The emphasis will be on applied research, addressing industry-specific issues, with particular attention to multi-jurisdictional and international risks. New research chairs will be located at selected universities and supported by a cadre of researchers recruited from around the world. International forums will disseminate findings and promote discussion of their effects on the sector.

2. Education about risk. The ready availability of educated, sophisticated people is one of Canada’s strategic assets. The Institute will seek to build on that base by closing any gaps in the education system that feeds that inventory and by creating a new and innovative ‘risk literacy’ programme for risk practitioners, executives and boards of directors. Academic institutions and professional organisations will be engaged as partners to develop and then deliver the learning initiatives.

3. Informed discussion of risk. The Institute is independent, and thus able to create an effective and trusted nexus between government and the financial services industry. It will convene industry leaders to identify common issues, inform those discussions by research findings and develop consensus positions to transmit to government.

Canadian financial institutions and the regulators that guide them have the wind beneath their wings as the world admires their performance. That said, there is no intention of remaining content with the status quo. They created the Global Risk Institute and gave it the mandate to aid in understanding risk, especially its macro-prudential implications. While it will serve its Canadian founders, financial systems are naturally global, so the Institute’s contribution will have that scope.

A Global Point of View

While regulators around the world are struggling to modify their financial systems, seeking an elusive balance between safety and growth, between policy makers and entrepreneurs, Canada has an opportunity to build upon its experience and financial record. It can examine what worked in the past and what might work in the future. That is the thread running through the new Institute’s mandate and why it is emphasising global aspects from day one. All financial systems are, in the end, global systems, and the Institute will take its cue from that fact. Even now, in its earliest days, the Institute has garnered support from well-respected international organisations. It has opened a dialogue with prominent business schools in Europe while simultaneously working on the details of international risk forums, with the first pair of back-to-back events planned in China and Toronto, Ontario. Establishing these relationships now is the cornerstone to meaningful collaboration in the future.

Turning the Black Swan White

The credit crisis was not a Black Swan that flapped over the horizon to splash into the sea of finance. Wall Street trader turned academic Nassim Taleb would argue that, although the credit crisis may have seemed highly improbable, it was entirely predictable. Peter Stuyvesant’s wall is long gone, replaced by the eponymous street, but the cracks in the modern wall of finance were apparent long before they opened wide.

Why were the danger signals ignored? After all, stand-up comedians and talk-show hosts had been making jokes about sub-prime mortgages long before August 2007, so at least some people were wondering about them. The truth is, there were flaws in the system. The extraordinary growth of derivatives and securitisation could have, perhaps should have, been seen as an indicator that regulation was weak or absent. Financial sector compensation was out of control, rising to a multiple of 1.7 times the average across all other industries. There were compilations of risks that were never understood or were ignored because extraordinary incentives were to be had. It was a classic example of the unequal relationship between private and general benefits, a situation for which Garret Hardin coined the phrase, “the tragedy of the commons”. That was in 1968, but it was in a different field of study, and the financial system still struggles with the risk that relative personal advantages will overshadow decisions that may cause a general decline in the overall system.

The Global Risk Institute is a serious and calculated attempt to discover solutions to complex risk problems. The key stakeholders have committed funds as well as expertise, and a new organisation has been dedicated to the task. Risk experts and researchers from around the world have become interested and are quickly becoming engaged. Conferences, publications and forums are being planned to share what is learned. This new venture may not discover all the risks, nor devise solutions to every problem, but its contribution will be felt in every corner of the financial services world.

Toronto as a Base

Last September, the World Economic Forum named the Canadian banking system the soundest in the world for the third year in a row (ahead of Sweden, Luxembourg and Australia; the US slipped to 40th place). Also in September, Chicago-based Aon Consulting ranked Toronto, Ontario as the ‘lowest risk city’ in the world for employers. Aon’s People Risk Index studied 90 cities around the world and ranked them according to criteria such as demographics, education, employment practices and government policies. New York came in second place, followed by Singapore in third and London in fourth. Finally, an Economist survey of 90 countries ranked only Finland and Sweden higher than Canada on the attributes of honesty and reliability in business.

The Global Risk Institute will operate from Toronto, Ontario, the heart of the Canadian financial system. The sector is concentrated in this city, contributing 12% of its jobs (370,000 in all) and 22.4% of its gross domestic product (GDP). The city provides an outstanding environment for the study and advancement of risk management – it has a low risk investment climate, an exceptional workforce, competitive business costs, a diversified financial sector and world-class universities on its doorstep.

Going Forward

A lot has happened since the Institute was formed in January this year. Financial commitments have become reality, office space has been found, the first people are in place, a website has been built. Equally important, the Global Risk Institute has begun forming relationships with think tanks, universities and research organisations across Canada and around the world.

A marquee board of directors is about to be announced, as is the Research Advisory Council that will guide that board’s decisions on research strategy and specific projects. An ambitious slate of events, conferences and seminars began rolling out at a February launch, bringing together stakeholders from all points of the financial services spectrum to identify issues, discuss policy and share knowledge. The risk literacy programme will deliver its first session in late September.

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