liquidity support to banks

The mystery of the ‘secret canadian bank bailout’

Stephen Gordon is concerned that the CCPA put out a press release saying that the Canadian Government secretly bailed out banks during the global financial crisis. I heard him on CBC yesterday and I listened carefully, partly because I know him to say things that are interesting and sometimes galling.

One of the most helpful things Gordon said was that banks essentially loan money long term and borrow money short term. That’s what they do. That’s their business plan, and that’s what makes a bank, a bank. And the money they borrow, in the short term, is from global markets.

“Banks lend and banks borrow. Banks lend long term and they get the long term interest rate. They borrow in the short term and they get the short term interest rate. Long term interest rates are generally higher and that’s where banks make their money. So banks are lending long term and borrowing short term. Now hearing the news that banks need to borrow short term, that does not mean they’re in trouble, that means they’re a bank – that’s what banks do. They borrow short term, that’s how they, that’s how they function.” – Stephen Gordon, CBC Radio, May 2, 2012

But when the global markets dried up, they had to find somewhere else to borrow from.

Full disclosure: economics and finance are both subjects that I have little understanding of. Well, I more or less understand inflation and opportunity cost, and I can call up some basic demand, supply and price graphs. But that’s probably it. But this issue, of whether the support  was a bailout, interests me! People seem to be saying all kinds of passionate, somewhat contradictory, and confusing things about it.

I recommend you try to read the report. Here’s an excerpt from the executive summary:

Ever since the global financial crisis struck in 2008, Canadians have been subjected to a constant refrain: Canada has the “most sound banking system in the world”. During the worst of the crisis—2008 to 2010—the official line was that Canada’s banks did not require the extraordinary bailout measures that were being offered in other countries, particularly in the U.S. We knew that as early as 2008 the federal government had made provisions to buy insured mortgage pools from Canada’s banks in order to keep credit flowing during recessionary times. The government was careful to call it a “liquidity support”, not a “bailout” but, as this report reveals, government support for the country’s biggest banks was far more generous than the official line would suggest. Support spanned the course of two years and Canada’s banks turned not only to the Canadian federal government and the Bank of Canada for help during this protracted period, they also took advantage of American bailout programs.

To be fair, the author of the report, David Macdonald, never seems to actually say the Canadian support constituted a bailout.  But he does suggest that given the extraordinary size of the support, and that given the extraordinary global market crisis, the short term lending by the Government constituted a kind of bailout. I think.

The report, at least in part, is about the amount of profit those same banks made during those periods. It’s also about the amount of money the CEOs of those banks made during those periods. And it’s about the need that banks have for government support and that questions are raised about the relative different capacities the banks had for dealing with the market crisis.

All of this is new terrain for me. I get that a few folks think that markets are always wrong, and some folks think that markets are always right. Stephen Gordon is not in either of those two categories. Very few people are. I don’t think Gordon is bothered by governments using their cash to intercede in and adjust markets to help folks out. My sense of his approach to economics is just this. Markets aren’t all right or all wrong, so sometimes we have to regulate them, or support them. I believe that his view is the dominant view.

The tricky issue is where to draw the line. Between the extremes of “the market is always right” and the “the market is always wrong” is most of the terrain. This is where most of the differences in values and theories lie. And it’s a confusing mess.

Was it a secret? Was it a bailout?

Sounds like everyone in the financial sector pretty well understood that the government was supporting banks. The part that is secret is how much and to which banks. That said, I think a lot of regular folks – the mainstreet, shall we say – are somewhat surprised. So it was a kind of secret. A secret in plain sight perhaps.

From what I understand, whether the support was actually a bailout, relies partly on the necessity of the support. Canadian banks were solvent, but not liquid. So the money was liquidity support. But in order for banks to be banks they had to be able to borrow short term. So the support was very necessary.

It looks like most definitions of bailout include both financial assistance and liquidity. But most definitions also require that the bailout is a save from the brink of collapse. And the Canadian banks were not on the brink of collapse. But it’s unclear to me if the folks putting this forward are actually just defending the Conservatives. Wiktionary says that a bailout is just a “rescue, especially financial.” That said, apparently there are special economics definitions (although I haven’t found them) that make it obvious that the Canadian liquidity support was not a bailout. So I’ll trust Stephen Gordon on this one: it was not a bailout.1

I think most Canadians, however, will be surprised to learn that banks received government support in the form of $114 billion dollars to keep their business model intact, because the market failed. 2 I think most Canadians will probably also agree that it was the right thing to do, in principle, if not in actual detail.

Did taxpayers make money?

This is an interesting issue. Most right leaning analysts have claimed that the Conservatives made the taxpayers money by letting the banks borrow short term from them. But I know enough about economics and finance to know that this calculation can be done many different ways and can mean many different things.

So I want to know. Who says the Conservatives made money on the money borrowed by banks to the tune of $114 billion? How much? Adjusted for inflation? Compared to the interest accrued on our national debt during the same period? What was the opportunity cost of supporting banks?

I’m not saying the government shouldn’t have provided the liquidity support. I’m asking for some way to understand the cost to taxpayers that is not a soundbite from Flaherty or Harper.

[Update: Stephen Gordon has replied that the interest rate at the CMHC is higher than the rate at which governments borrow.]

  1. UPDATE #2: Now I’m not so sure that it wasn’t a bailout. The banks were solvent. And we don’t want to conflate solvency with liquidity. But it appears to be commonplace to refer to liquidity support as liquidity bailout. Forbes does it here in reference to government intervention in support of the the Euorpean banks. Huh.
  2. The U.S. government loaned money to G.M. and that was a ‘bailout’ – although I’m not really sure what the difference is.

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  1. Good post! Is bailout a technical or standard term at all? There are standard definitions for economics terms like inflation, supply, demand, deficit, surplus, GDP, I could go on, but bailout? wikipedia seems to think so, but that article is disputed.

    If there is no standard definition, then the bailout is a judgement call based on what would have happened to Canadian banks at the height of the financial meltdown. As you pointed out, financial writers seem to have no issue calling this a bailout, including this piece

    The CCPA report is a good antidote to the triumphalism displayed by the banks, and the bonuses they awarded themselves in 2009 knowing that government support saved their skins.

    From what I can tell, taxpayer support of the banks was crucial to their performance, was a good program. And this is not a pure market transaction. Banks operate with less caution and less liquidity because they know that the government and taxpayer are the lender of last resort (which happened in Canada in 2008). So, to say that the government made money/not as helping define a bailout is also problematic. Of course, the lender of last resort is expected to make money. In the real world, the lenders of last resort are pay day companies, and we know what they extract from you on a bailout!

    The “secret” part is a bit more interesting. Of course, most details of the program were available, but what is the overwhelming media narrative? Canada was awesome, the banks did super well, everyone came out smelling of roses. This was not true. The banks were in a lot of trouble. Well designed regulation (opposed by the banks, remember) and a good government program (yes!) “saved” (the precise degree of the save is not knowable because banking is not linear or science-based). So, I wouldn’t use the word “secret”. But really, this invalidates the entire report?

    The opposition to this is mostly political and cultural, though “analysts” who pretend to have no biases whatsoever wouldn’t agree. The CCPA over-reached a little bit in the press release (hello, science news cycle! and in their overuse of the word “secret”. But the report stands up well.

    Thanks for writing this, needed to be said.

  2. Thanks. Yeah it’s interesting how many ‘analysts’ pose as uninterested and independent critics of this report. Gordon himself accuses the report of conflating liquidity bailout with solvency bailout. I can see how the report might compare those things but I don’t see Macdonald actually conflating them.

    Also interesting is whether the money was a loan or a trade. I think if you stare at this long enough, you realize that most loans can be understood as trades. I think what it comes down to for people is the degree of risk. So solvency bailouts are usually riskier than liquidity bailouts, and this fact is important when you don’t want the government to be seen supporting, yes *supporting*, businesses or banks.

    I think you’re right to point to the regulation and oversight of banks and markets as one of the political motivators around this mystery.

    I think one of Gordon’s main concerns is that many folks read the media headlines and not the actually report and thought that the government gave money away for free. He thinks, in other words, that the report does more harm than good – which is not clear to me.

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