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Winnipeg Free Press - PRINT EDITION
Moody's finds RBC wanting
Moody's Investors Service last week poured cold water on Canadians' comfortable assumptions about the soundness of their banks. After a close look at the ways the world's 15 largest banks make their money, Moody's downgraded all of them. Royal Bank of Canada, the only Canadian bank large enough to come into the review, was knocked down two notches to Aa3, putting it at the same relatively high level as New York-based JP Morgan.
The problem is some of the largest banks have been relying more and more on trading in the market to make their money, and this has become an extremely dangerous game.
The core business of retail banks is to take small deposits from customers at low interest and lend the funds out to borrowers at higher interest, making a profit on the difference. This is a reasonably stable and predictable business. Trading in the market, by contrast, can produce spectacular profits and spectacular losses. Jamie Dimon, chief executive of JP Morgan, announced on May 9 his bank had incurred US$2 billion of losses in a sequence of trades by its London office. A hedging strategy, conceived to prevent losses, instead produced rapidly growing losses, to the great surprise of the bank. That misstep by an extremely large and sophisticated bank caught the attention of Moody's and led to last week's downgrades.
Banks eventually report a great deal of what they do. There is, however, a large shadow-banking sector whose activities are only partly known. The 1998 collapse of the New York hedge fund Long-Term Capital Management, whose bankers might have been destroyed by the failure of their largest customer, showed a private club of investors could, like the largest banks, get too big to fail. The Federal Reserve Bank of New York organized a bailout of LTCM by a consortium of banks. Because they do not offer shares or units or anything else to the public, these private funds need not tell anyone what they have, what they do and what risks they are taking. The shadow-banking sector has probably grown since 1998 and the imponderable risks to hedge funds and their bankers have grown accordingly.
Finance Minister Jim Flaherty rightly echoes Canadian pride that Canada's banks are among the soundest in the world. Moody's has added, however, that the largest of them is not as sound as it used to be. The lure of large profits from risky business is hard to resist, especially for firms that know they will be bailed out from any catastrophic miscalculation.
Republished from the Winnipeg Free Press print edition June 26, 2012 A10
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