In many different contexts overexposure can lead to a great deal of trouble. Too much sunshine can cause serious health risks. In photography a picture can be ruined. In the financial field, banks’ overexposure to risky investments can and does trigger grave consequences.
It should be noted that although the United States in the depression of the 1930s experienced the failure of thousands of banks, Canada did not have a single bank failure. Canadian banks diversified their sources of funding and loaned money to a varied range of borrowers. Canada experienced the same decline in the quantity of money available for lending and had a depression of essentially the same severity.
However, above all, our banks were much more prudently managed, and the effects of branch plants ensured that if one region were badly hit, other areas could counterbalance that.
Nowadays changes in the banking system here made those institutions uncommonly vulnerable to collapse. New forms of competition already have shown the effects of banks’ current practices. Hitherto, our banks took in depositors’ money, paid interest on those funds, and then loaned the funds to borrowers at a higher rate of interest, thereby generating profits. That was long considered the essence of our banking operations.
Canadian banks increasingly became impatient with that ordinary activity, and have expanded their trading operations. They have made a dramatic push into credit derivatives. A derivative is an instrument such as a future option, whose value derives from and is dependent upon the value of another variable asset, such as a commodity, currency, or stock, or bond.
That has exposed Canadian banks to a great deal of potential risk. Banks or investors are having a great deal of difficulty in understanding or disentangling the huge volume of derivatives that banks now have outstanding, and are trading with their literally trillions of dollars of derivatives.
The reality is that the trading operations of each of the big banks is so complex that investors must trust that banks’ risk-management functions are designed effectively and operating as planned. Bank exposure to credit derivatives is on the rise, pointing obviously to greater dangers.
Recent results confirm this. In the latest reported quarter, the Bank of Montreal revealed that its commodity trading desk lost $680-million last year. With its portfolio of billions of dollars in derivatives – totals up 95 per cent in one year – the Canadian Imperial Bank of Commerce has such a direct exposure to them that it will incur heavy charges against its earnings. Other banks have similar problems.
It appears that Canada’s big banks, which formerly were conservative and well run, have abandoned their winning way, thereby dramatically changing the nature of their operations. As a consequence, banks are now more speculative investment vehicles.
