Counting the cost of failure

ANN SHORTELL September 16 1985

Counting the cost of failure

ANN SHORTELL September 16 1985

Counting the cost of failure


The casually dressed group gathered around a table in Finance Minister Michael Wilson’s 27thfloor Ottawa office late on the Sunday afternoon of the Labor Day weekend. But Wilson, dressed in a sports jacket, and Barbara McDougall, minister of state for finance, wearing a plaid shirt and pants, faced a grim and very formal task. After a week-long attempt to save

two foundering Alberta-based banks—the Canadian Commercial Bank (CCB) of Edmonton and the Northland Bank of Calgary—an exhausted Wilson signed documents that authorized the liquidation of the CCB and permitted a government takeover of Northland. That action ended a costly six-month effort by the Bank of Canada and its governor, Gerald Bouey, to save the institutions. The same day, curators from the Toronto-based accounting firms of Price Waterhouse Ltd. and Touche Ross Ltd. entered the banks and seized control. With that, the Conservatives became the first government to preside over a bank failure since the Torontobased Home Bank of Canada closed its doors in 1923 because of fraudulent lending practices. Said a fatigued McDougall: “I really feel badly that it had to come to this.”

Still, financial analysts say that the banking situation may, in fact, worsen. Unless the Northland merges with another bank, it too will almost certainly collapse—possibly within weeks. That would further damage the Alberta government’s attempts to keep alive the concept of regional financial institu-

tions. For its part, Ottawa moved last week to limit the political damage from the CCB’s failure by assuring depositors that they will not lose any money. The estimated cost of covering the losses is $670 million—a figure that could rise to $1.3 billion if the Northland, which was founded in 1976, collapses. Acknowledged McDougall: “This is not going to be cheap.”

At the same time, the Conservatives blamed the CCB’s failure on the weak western economy— where the two banks’ business was concentrated —risky lending practices by bank management, and ineffectual regulatory control. Indeed, this week the Tories will introduce legislation that will increase the regulatory power of federal bank inspectors to intervene in bank affairs. Still, Opposition MPs swiftly called for the resignations of McDougall, Bouey and William Kennett, inspector general of banks—whose department supervises Canadian banks. Said acting NDP finance critic Michael Cassidy: “The government has got to be a lot tougher and a lot less trusting than the governor and the inspector general were with these two institutions.” And last week finan-

cial industry critics declared that the Conservatives had seriously underestimated the gravity of the CCB’s situation last March and had propped up the bank for political reasons.

The failure of the nine-year-old CCB was narrowly averted six months ago when Ottawa, the Alberta and British Columbia governments and Canada’s six largest banks combined to provide a $255-million rescue. Already severely weakened by loan losses in Western Canada, the CCB suddenly learned that $100 million in loans to U.S. energy companies was in jeopardy, partly because of a sudden drop in world oil prices. Faced with a crippling drain on income that would have left it unable to pay back depositors, the CCB, headed by president Gerald McLaughlan, decided to turn to the government for help.

The crisis followed a series of failures and near-failures suffered this year by western Canadian trust companies and credit unions. Coupled with 18 bank failures in the United States in the first quarter of the year—as well as the temporary closure of 71 savings and loan banks in Ohio just 10 days before the CCB rescue—Ottawa feared that allowing a Canadian bank to collapse could lead to investor panic and jeopardize international confidence in the entire Canadian banking community.

The $255-million bailout package compensated the CCB for its loan losses and was intended to maintain depositors’ confidence. Instead, depositors who feared that the bank would eventu-

ally collapse began withdrawing their money. At the same time, the nearfailure of the CCB led depositors to begin pulling money out of the Northland, which had been struggling for two years to recover from losses on western Canadian real estate loans. As depositors continued to withdraw millions of dollars from the two banks, the institutions found it increasingly difficult to fund day-to-day Operations, and their cash reserves fell below legislated levels.

Both banks were forced to cover their lost deposits by repeatedly turning to the Bank of Canada for temporary funding. When the government finally concluded early last week that the institutions were not going to recover, loans from the Bank of Canada totalled $1.8 billion. And Maclean's has learned that following the March rescue CCB continued to make new loans despite its cash shortage.

Last week it became apparent that the lack of depositor confidence was not the only reason for the CCB’s failure. Indeed, banking experts said that the crisis exposed serious shortcomings in the monitoring of Canadian banks—shortcomings that, in fact, contributed to the latest problems.

As well, a report issued last June on the CCB rescue by the Commons finance committee said that the inspector general of banks had known since 1982 that there were some problems at the CCB. For one thing, the inspector general’s office was increasingly concerned about the high concentration of the CCB’s loans in the volatile western real estate and energy sectors, the committee, chaired by Toronto-area Tory Don Blenkarn, said. The inspector’s office had the au-

thority to issue guidelines and instructions to the bank about its lending decisions but did not do so.

The Blenkarn report added that the inspector general failed to force the CCB’s auditors to reassess their approval of the financial statements in the bank’s 1984 annual report. The auditors had, in fact, sent letters to management stating that they were critical of the bank’s accounting practices. Kennett told Maclean's that government banking regulators have traditionally left detailed examinations of accounting transactions and valuations in the auditors’ hands. But in the case of the CCB the system failed.

Kennett said that his department has relatively limited powers, adding that it has traditionally relied on “moral suasion” to convince companies to change what it thinks are unsafe business practices. Added Kennett: “We talked to banks about concentrating in real estate lending and warned them about what this could mean. But the fact is that year after year they made a lot of money out of it.”

The real limitations on bank regulators’ powers were revealed three weeks ago when Northland announced the sale of $100 million in nonperforming real estate loans. The purchase of the loans—by Gordon Dickson, a Calgary lawyer, and Ronald Derrickson, a Northland director—was financed by the bank itself. Northland also received a fee for arranging the deal. It was that type of one-time “fee income” from what Kennett called “imaginative deals” that enabled Northland to declare a small profit of $291,000 only a week before the government moved in. Although Ottawa did not have the authority to prevent the

sale, Kennett said that it was a contributing factor in the government’s decision to appoint its own representative at the bank.

To strengthen the deficiencies of the inspector general’s office, minister of state for finance McDougall last week proposed a series of legislative reforms. Those included giving Ottawa the power to evaluate real estate properties that are used to support bank loans and empowering bank regulators to intervene more quickly when a financial institution is making decisions that threaten its solvency. As well, McDougall is considering changes that would force financial institutions to diversify their loan portfolios. Said McDougall: “The system was designed for another age.”

The most immediate impact of last week’s bank failure was on the CCB’s shareholders, mainly pension funds and insurance companies holding about $70 million in now-worthless shares. Depositors who had less than $60,000 in the bank will be fully compensated by the Canada Deposit Insurance Corp. McDougall also said that special legislation would be passed to pay back uninsured depositors—at a cost to taxpayers of $420 million. That action concerned some bankers who said that depositors who placed uninsured funds in the CCB in return for higher-than-average interest rates knew that they were taking a risk. Declared Robert Korthals, president of The Toronto-Dominion Bank: “It says that people who have taken imprudent risks are smart and those who have taken lower rates are the fools.”

Still, the effect of CCB’s failure on the Canadian banking system as a whole was far milder than either the government or the banking community had predicted. Allan Taylor, president of The Royal Bank of Canada, said that international financial markets sometimes react violently to sudden collapses. But, said Taylor: “there has been some conditioning with these two banks.” Added Terry Shaunessy, a banking analyst with Toronto-based brokers Merrill Lynch Canada Inc.: “There was not even a ripple in New York for Canadian banks.” Indeed, the big five Canadian banks refused lastminute appeals by the government to take over the bank.

But the CCB’s collapse will have farreaching implications for the future of regional financial institutions. For one thing, at week’s end industry experts predicted that the Northland Bank now cannot survive. Although Ottawa appears to be offering tax concessions or outright grants to interested buyers, major banks—including the Royal and U.S.-owned Citibank Canada of Toronto-stated flatly that they would not participate in a merger.

The problems of the two banks have also dealt a severe blow to the aspirations of western provincial governments trying to escape what they say is the domination of the eastern Canadian big five. Said TD’S Korthals: “It will be harder to persuade shareholders to put up money for new regional banks now.”

But the federal Conservatives are acutely aware of the importance of their political power base in Western Canada. And the government is clearly determined to continue supporting the concept of regional banks. Said Blenkarn: “We are prepared to do a number of things that will cost the taxpayer money to keep a bank like Northland headquartered in Calgary.” The demise of CCB has shown that those costs can sometimes be very high.





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