Finance Committee on March 26th, 2009

[The Chair, Conservative, James Rajotte]

I call to order the 17th meeting of the Standing Committee on Finance. Our orders today are pursuant to Standing Order 108(2), the study on measures to enhance credit availability and the stability of the Canadian financial system.

We have four distinguished guests with us here this morning. From TD Bank Financial Group, we have Mr. Don Drummond. From the Conference Board of Canada, we have Mr. Glen Hodgson. From the C.D. Howe Institute, we have Mr. Finn Poschmann. Finally, from the Canadian Federation of Independent Business, we have Mr. Ted Mallett.

Gentlemen, we thank you very much for being with us here this morning. Let's start in that order of organization. We have allocated about five minutes for an opening statement, if you could try to stick to that as best as possible, and then we'll do questions from members.

Mr. Drummond, we'll begin with you.

[Don Drummond, Senior Vice-President and Chief Economist, TD Bank Financial Group]

I thank you very much. Good morning to everybody.

I submitted beforehand a set of charts and tables on credit. I think I see it in front of everybody. I won't go through those one by one but just make some overview remarks about them. One of the reasons I did them was to try to put the discussion of credit in a broader context. Quite often the discussion is solely on what banks are doing, but of course, traditionally there's a variety of other sources of credit available.

The first thing that's obvious from those charts is that bank credit is growing quite strongly. In fact, unlike in previous recessions when the economy has weakened, credit from the banks has not slowed down, and for both households and businesses it is growing at a double-digit range. This will likely soften, and since I sent those charts out to you, we've had one more month of data that show the double-digit pace of growth of bank lending to business has dropped into the very high single digits--slightly below 10%. In previous cycles this has always been the pattern, that as economies weaken, particularly when nominal GDP is weakened, you've seen the demand for lending from the banks soften up.

On the household side, the lending continues to go from the banks at a double-digit range. The lines of credit are growing particularly strongly, at more than a 20% annual pace, but we've seen traditional household loans, credit cards, and mortgages also growing very strongly.

Just putting it in a broader context, the main source of funds for companies is typically retained earnings. Retained earnings have held up quite well in Canada until recently. In fact, if you look at 2002 through 2006, you'll see that retained earnings in Canada were extraordinarily strong and there wasn't actually a large demand for bank lending during that period because companies were funding it internally. Of course, it softened towards the end of 2008, and we expect that to get hit quite hard in 2009, not only by the real economy being weak but also by the drop in commodity and other prices.

In terms of the total market financing, there has been an increase in the reliance upon external funding, and I'll go through some of those sources. Share and bond issuances were reasonably strong in Canada, although they did decline from 2007. As I mentioned before, we had the largest increase ever in Canada's history in bank lending in 2008. That certainly did fill some of the gap left by some of the other sources of funding, but it was not the complete source.

I've also included for you some pieces of data on credit from the United States. The thing that's remarkable in the United States is that despite what we typically read in the newspapers, the bank lending in the United States is continuing to grow as all the other sources of credit have virtually disappeared. So once again, in 2008 there were actually negative issuances of shares. In other words, companies bought back more shares than they issued. There were virtually no issuances of corporate bonds. There was very little trade credit, and there was a virtual disappearance of the other sources, the shadow banking system--if you will, the non-banks, the hedge funds, the subsidiaries of companies that were in the financial arm. In the United States, we really did see that the banks were the only game in town, and while they did increase their lending, clearly that didn't fill the gap left by other sources and we did have a problem of credit.

I gave you a couple of charts as well on the cost of credit. This has been a major issue over the last couple of years. I've split that into two: the short-term cost and the medium-term cost.

Regarding the short term, there is good news. We have had a restoration of something approximating normalcy in the short-term end of corporate markets. Commercial paper rate is operating again. The cost of borrowing in the very short term, up to about 90 days, has come down quite a lot. It blew up in the wake of the Lehman Brothers failure, and it's been coming down steadily, quite a bit in the last two months in particular. The spreads are still not as low as they were prior to the summer of 2007, but that part of the market, the very short term, is working reasonably well. The last auction from the Bank of Canada providing 28-day funding was not fully subscribed from the banks. I think one of the reasons was that they were able to go to the market and get funding for that duration themselves.

The remaining problem continues to be at the medium and longer terms. The spreads on medium-term bonds in the corporate market are extraordinarily high. We really have to condition ourselves to not think about monetary policy in the traditional fashion. We tend to look at the central bank rate and think that's what's happening to all interest rates, and that is not the case. We have quite low mortgage rates, very low Government of Canada bond rates, very low U.S. government treasury rates, but the corporate bond spreads are extraordinarily high. Back prior to the summer of 2007, on average a Canadian bank could have raised five-year funding at 50 basis points above the Government of Canada rate. Our own bank was substantially below that. Until about a month ago, a Canadian bank would have faced a 300 basis point spread to raise five-year funding. So they went from less than 50 basis points to about 300 basis points. That's crept in a bit recently, but not very much.

So we still have a credit market that's gummed up on that medium to longer term on the corporate side. Hopefully the announcements of Geithner in the United States and hopefully what we might see in Canada in terms of quantitative easiness that gets into corporate bond markets will bring down that spread, but I think it's the last remaining piece of this puzzle. We need to see some improvement on that before we can have some confidence of a return to normalcy in credit and some economic growth.

Thank you.

[The Chair, Conservative, James Rajotte]

Thank you very much, Mr. Drummond.

We'll go to Mr. Hodgson, please.

[Glen Hodgson, Vice-President and Chief Economist, Conference Board of Canada]

Thank you, Mr. Chair.

I'm going to do something a bit different. I want to touch on four points in about five minutes. The first one is on what the U.S. is doing, because it's an interesting case study on the biggest credit crisis I think the world has ever faced. The second one is comparing where we are. The third point will consider the fact that I think our system is now in a state of healing. A lot of the data that Don just gave you is evidence that we're now on the right path. It's a question, really, of what more could be done to accelerate the healing. Finally, I want to talk just for a minute about the existing state instruments, like BDC and EDC, and frankly, how lucky we are to have them as a backstop for our financial system.

On the U.S., I think the number is up to $10 trillion now of policy intervention. When you add up all the action--the TARP program, the fact that the Bush government got $700 billion from Congress last fall, that he injected a quarter of a trillion dollars into the banking system--we've now seen the kind of action that Don's just referred to, with government stepping in to particular credit markets, building a program to buy back distressed assets.

So it's an incredible degree of intervention we're seeing in the United States. The evidence is hardly clear as to whether it's working yet, but the U.S. has more or less played all its cards. I think quantitative easing is the final card, trying to fight off deflation and having really improved conditions in long bond markets at the same time. The cards are all in. I'm confident that they're going to work, but it's going to take time. I think we're going to watch all of this year, frankly, before we see any semblance of normalcy return to the U.S. financial markets.

Compare that to what we've seen happen in Canada. I think government policy to this point has been very effective and it has been very well constructed. I think, for the most part, governments have done what they had to do in terms of offering to buy back mortgages, for example, and the various programs to try to restore credit conditions in credit markets. The bottom line is that we haven't seen a dime of taxpayer money go into banks in terms of equity because we haven't had the same sort of crisis.

So we're obviously in far better shape than almost anybody in the industrial world, and therefore I assume we're going to see a return to more normal conditions in Canada much sooner than we do in almost any other industrial country. But again, it's going to take time.

So we're now in a healing mode. The fact that we had all the chartered banks report profits in Q4, the fact that they're operating in the black.... Having to put provisions aside against old bad assets and the declining credit conditions is obviously very important. It's going to probably hurt their bottom line going forward, but we're in a situation where our system can work in the black.

It's really about the banks right now rebuilding their balance sheets and having healing, and dealing with the fact, as Don mentioned, that the non-banks and foreign banks have more or less retreated from our market. The evidence of that is pretty clear.

So what else could be done? I thought about that as I gave advice to the government in the budget context, and I hadn't had a chance to appear before you before, but it's really hard for me to come up with a magic solution at this point. There's no magic wand; there clearly is no silver bullet. The fact that we're getting evidence now that the full mortgage buyback program is not going to get taken up, I think, is a real sign of healing going on in markets. I don't know what cards, frankly, the government has left to play except within the assets that you own.

Here's where I'll wrap up. I think we're very lucky to have organizations like Export Development Canada, BDC, Farm Credit, and CCC as real key players within our financial system. I know there has been debate for a long time about privatization, about whether they're taking too big a market share, but aren't we lucky to have such strong institutions as a backstop for the commercial banks and for the private financial system right now? They're players through the market cycle. They have the skills, they have the knowledge, they have the balance sheet, frankly, to step up right now and fill gaps.

I had a chance to appear before the Senate committee earlier this week on the EDC legislation. I hope that when it comes back to the House it gets passed as quickly as possible, because it's time to take time away from management. Management should not have to think about the rules of operation. They should really have the chance now to use that insured capital they've been given, and the expanded mandate, and really try to accelerate the healing of our financial system right now.

I'll stop there, Mr. Chair. Thank you.

[The Chair, Conservative, James Rajotte]

Thank you, Mr. Hodgson.

We'll go to Mr. Poschmann, please, next.

[Finn Poschmann, Vice-President, Research, C.D. Howe Institute]

Thank you, Mr. Chairman.

Thanks to the committee for inviting me. I think this is my first visit to the committee in 2009. It's a delight to be back to see familiar faces and some new ones as well.

I want to start with some observations on financial market performance, turn to what the government and the Bank of Canada have been doing to respond to recent issues, and look at some specific measures introduced in the 2009 federal budget.

I won't rehearse events, as I'm sure financial market history since summer 2007 is well known to this committee. Suffice it to say that since mid-2007, doubts about the quality of assets underlying a broad range of securities and the financial derivatives layered thereon drove a meltdown in trust among financial institutions. That meltdown was so profound that banks that had earlier engaged in short-term lending to each other, at interest rate spreads in the single or very low double digits relative to risk-free lending, either ceased to do so or provided liquidity to their neighbours only at rates otherwise unknown in recent financial history.

This rocketing up of risk assessments of counterparty risk between financial institutions partly reflected a contraction of financial liquidity. It became clear through late 2007 into 2008 that there was more to the story than liquidity. After all, governments and central banks across the western world, including Canada, had been providing liquidity to the system by the trillion, when you added it all up. However, the risk spreads since fall 2008 were in the triple digits. We should add very quickly that they're down near normal levels in Canada, although the volume of lending that's going on isn't so high.

It became clearer that the counterparty risk I described was a more persistent problem than Iiquidity. Governments in Canada began to pay more attention to improving the quality of assets on financial institutions' balance sheets, hence the United States' troubled asset relief program as originally conceived in fall 2008, and the insured mortgage purchase program that has been operative in Canada for some months now.

Budget 2009 significantly expanded the capital available to the Canadian government to buy National Housing Act mortgage-backed securities from financial institutions. The mortgages underlying those securities were already contingent liabilities, from the point of view of the government's books and the federal taxpayer, so our risk exposure changed little while the program offered marginal improvements in the quality of domestic institutions' balance sheets. It seems to be working reasonably well. Glen just pointed out that there has been less take-up in recent weeks, which perhaps suggests that the program has partly run its course. So far so good.

In Canada, notwithstanding numerous contrary anecdotes, bank lending overall has continued to grow, not shrink. There was some flat-lining in late 2008, but the fact remains that overall bank lending in Canada is up in the past year, not down. However, we can't ignore the existence of significant financial market troubles. Most obviously, the collapse of several securities and derivatives markets, as well as much hedge fund activity, has crushed numerous non-bank financial intermediation channels. Don mentioned this. As a result, the broad supply of credit to the Canadian economy, like that elsewhere, has come under severe pressure. For example, at the end of 2008 the asset-backed securities market in Canada was about four-sevenths the size it was at the end of the previous year.

Governments have launched new measures that aim beyond the financial institution marketplace that regularly engages with the Bank of Canada. The key Canadian exhibit is the Canadian secured credit facility, CSCF, outlined in budget 2009. This is intended to jump-start the moribund vehicle and equipment lease and loan marketplace. The program is not yet fully formed. Yesterday the C.D. Howe Institute released a brief on the potential shape of the program, which will be run by BDC.

Our brief was written by Alexandre Laurin, who is well known to many members of this committee, and it makes a few simple points.

First, if the government is committed to restoring the lease and loan market to something like its recent form, a long job is ahead. It will almost certainly be necessary to commit more than the $12 billion contemplated in the budget.

The second point is that if the program is to succeed it must become active fairly quickly--certainly before summer this year. To the extent possible, it should take advantage of existing securitization channels.

Having said that, we can't forget that there are risks involved. No doubt the Canadian ABS marketplace has been hurt by contagion from other types of securities and other markets, and that has chased off investors. Perhaps the rollout of the new program will make the market perform better and bring back retail and commercial investors, as well as improve the financing available to auto and equipment dealers.

We should not for a moment forget there's a reason why investors left the marketplace. While we acknowledge that no Canadian AAA-rated ABS has failed to this point, markets remain unsettled by potential increases in default rates among underlying loans and leases, as well as declining residual values on vehicle leases. These worries can't and shouldn't be wished away.

To sum up, partway through an extraordinarily difficult economic period some things appear to be working better on their own. Others, such as mortgage markets, appear to be improving with little help from government actions to improve the balance sheets of mortgage lenders in particular.

Other parts of the financial marketplace have been performing far less well, hence actions in Canada and the U.S. to jump-start securitization markets. I'm hesitant to say this is a bad idea, but I must immediately add that one of the lessons we learned from 2007 is that we can spread risk around but we can't make it go away. Efforts to entice investors back to the securitization marketplace by lifting risk from that market--as we've seen in the U.S. and may yet see in Canada--inevitably park risk at taxpayers' doorsteps. That is something on which parliamentarians should be keeping a very close eye.

I think my time is up. I thank you for your time.

[The Chair, Conservative, James Rajotte]

Thank you, Mr. Poschmann.

We'll go to Mr. Mallett, please.

[Ted Mallett, Chief Economist and Vice-President, Research, Canadian Federation of Independent Business]

Thank you, Mr. Chairman. Thank you for inviting us to present to you today.

CFIB represents 105,000 small and mid-sized business owners. It's a sector that accounts for a major share of GDP, roughly 45%, and certainly a large amount of demand for operational capital financing. It's an area that we have been monitoring for decades, both on the financing and the economic performance sides.

Historically we have conducted studies, say on a three-year rolling basis, on bank financing. On the economy side, we've been running a quarterly barometer since the year 2000. Before that, we ran it on an annual basis, back to 1987. We have a huge amount of context, through good times and bad, in terms of how small businesses are responding to tough economic times.

Yesterday we released our “Business Barometer”. You have it in front of you. There's something there for both the optimists and the pessimists. The pessimists will see that clearly we're in a trough. Our index level is 87.3. Compared to 1988, when we first started doing this kind of measure, clearly it's in the category of negative economic growth. The good news is that it's really no different from what we found in December. The view that the economy has not continued to decelerate over the past three months is perhaps positive news, if you can take it in that context.

You see, in figure 2, that there are still businesses out there that are very successful. It's clearly not as large a number as we have seen in previous years, but it's important to recognize that there are pockets of strength and growth. One should never develop policy, whether it's financial, banking, or sales policy, on the assumption that every business is actually suffering, when in fact many of them are still doing well.

You'll see that GDP does track our numbers very closely. We're in the plans of developing a monthly barometer for the economy, and we're looking at combining that with some financial indicators as well. So we are moving forward on looking at where business financing demand and economic performance are with respect to small firms.

There clearly is a retrenchment going on within our membership. We see it in the numbers. One of the most obvious is at the back of the report, looking at capital expenditure plans. That is a figure that has really never changed since we started asking this form of question. We didn't think it was ever going to change, except that in the past six months a roughly 20% reduction in capital expenditure plans has been noticed. Clearly, there's something going on there.

We have also noticed that pricing and wage increase plans have basically stopped dead. The median price increase and median wage increase is roughly zero or 0.5% at this point. Where we were concerned about inflationary pressures in mid-2007, those pressures are clearly gone from the system.

Turning to the financing side, you'll also see a chart summary. This is from our new monthly foray into looking at the demand side of things. Roughly 50% to 55% of our members say they are underfinanced. Because these numbers are so new, we don't have the numbers to compare with what happens during better economic times. But comparing that with other surveys, we think we'd normally expect roughly 20% under better economic conditions.

We also track what their state is: are they borrowing money right now? There's a bit of good news and bad news there too. Roughly a third of our members don't borrow; they don't have any outstanding loans, which means they are highly conservative in their approaches to business. It means they're also less at risk to these kinds of shocks to the economy.

The other side of the coin is that they are not levered to grow as quickly when the economy does pick up. The small business sector, at least when they're presenting this kind of outlook, shows a high degree of stability, which is a good thing in this context, but the huge growth opportunity is not there.

We also get a sense of where total lending is. Don and a number of others said there is greater outstanding financing out there. We have asked our members why this is the case. Typically, most businesses say the reason they have increased their level of debt—largely through outstanding lines of credit—is that their cashflow has slowed down. They have higher expenditures or lower revenues, and their revolving lines of credit have increased somewhat as a result. That is perhaps the major reason why small business credit has increased, at least in the short term or the past little while.

We have a number of recommendations. They are the same as they've always been. Information on credit and borrowing is absolutely vital in this kind of environment. We need to ensure that we have competitive choice and multiple levels of lending or borrowing opportunities for small firms. And we need to ensure that financial institutions, whether banks or credit unions or others, really have the skills to properly assess the level of risk in the small and mid-sized business markets.

Those are the sorts of things we've have always been recommending in the past number of decades.

Thank you.

[The Chair, Conservative, James Rajotte]

Thank you, Mr. Mallett, for your presentation.

We'll start with Mr. McCallum. You have seven minutes.

[John McCallum, Liberal, Markham—Unionville, ON]

Thank you, Mr. Chair.

Welcome to you all.

My apologies for being slightly late. What happened was that my colleague Mr. Mulcair and I were led to the wrong building by our friend the parliamentary secretary over there.

[Some hon. members]

Oh, oh!

[An hon. member]

Our former friend.

[John McCallum, Liberal, Markham—Unionville, ON]

Not maliciously, I might add.

There is an element of humour in this meeting, because the government was pushing for you gentlemen to be included in the same session as the Parliamentary Budget Officer, on the assumption that you would offer a measure of protection for the government from his projections. But I believe—and this is a question for Mr. Drummond—that whereas the Parliamentary Budget Officer projected a two-year deficit of $73 billion, or $9 billion higher than the government's projection, TD Bank is projecting $82 billion, or $18 billion higher than the government.

I'd also ask you to confirm whether it's correct, based on my look at the charts, and partly on consensus projections—and maybe some personal input from the Parliamentary Budget Officer—that real GDP will fall by about 2% in the year 2009, and nominal GDP by about 4%, with the unemployment rate averaging about 8.4%. This is what the Parliamentary Budget Officer is projecting.

So am I right in thinking that on all four counts the TD forecast is more pessimistic?

[Don Drummond]

Yes, that's true. Actually, if you had invited both Glen and I to appear, you wouldn't have gone anywhere, because he's at the top of forecast pile and I'm at the bottom. So we would have just cancelled each other out, and you would have been right back where the parliamentary budgetary officer was.

There is a huge range of uncertainty. And yes, for some time we've been at the bottom of the pile of forecasters. And I must say it's been a good space to be in. In fact, we haven't been low enough; everybody, including us, until this point, has had to keep revising their forecasts down.

We're somewhat weaker than the consensus on the real side. Our biggest distinction has been on the price side, if you will, largely because of lower commodity prices. I'm not quite sure if everybody else has figured out how the low commodity prices feed into our export prices, which depress incomes in Canada. It's a particularly important variable. Government revenues don't depend only on real GDP. It has always amazed me when we talk about the economy solely through the prism of real GDP, which depends on nominal income. And so does the banking world. In fact, there has traditionally been an almost perfect relationship between changes in nominal GDP and bank lending, with about a six-month lag. And that six- month lag is exactly what Ted has talked about: your income first goes down, and you start by drawing on lines of credit, and then you weaken somewhat later—

[John McCallum, Liberal, Markham—Unionville, ON]

Okay, thanks.

[Some hon. members]

Oh, oh!

[Don Drummond]

I was trying to get back to—

[An hon. member]

It's like trying to stop Niagara Falls.

[Some hon. members]

Oh, oh!

[John McCallum, Liberal, Markham—Unionville, ON]

So the conclusion I draw from this is that if TD Bank is on the optimistic side and the Conference Board is on the pessimistic side--or the other way around--the Parliamentary Budget Officer is right in the middle, sweetly reasonable. Thank you for that.

Let me now turn to credit, and this is really to Don Drummond and Finn Poschmann.

I certainly agree 100% with the government's move of viability to $12 billion in the auto leasing, and I think it's approximately another $12 billion in lending authorized by BDC and EDC. Where I get extraordinarily frustrated and my usually laid-back self gets frustrated with the head of BDC is when he comes and displays zero sense of urgency. To me, the priority is to get that money out in 2009 because the problem is now, and not in 2010 or 2011 or 2012. I think both BDC and the car leasing facility....

Finn Poschmann said that yesterday he came up with the potential shape of it. How long will it take before it actually happens? It could have happened some weeks or months ago and people today would be buying more cars. Business is crying out for those loans from BDC, and the head of BDC was not even able to tell me anything about when any money would get out the door.

So I have a double question to both. I'll begin with Finn Poschmann. First, do you agree that there is a sense of urgency in getting this money out the door? And second, if you do, do you have confidence that this money can move quickly? We certainly haven't been told anything that would inspire such confidence.

[The Chair, Conservative, James Rajotte]

Can you each take about a minute to answer?

[Finn Poschmann]

Sure, I'll go very quickly.

The lease and loan financing industry, and the auto sector, and the vehicle sector certainly perceive a sense of urgency in seeing financing move quickly. Absolutely they do. From the point of view of designing and running a program, however, there are just a few things that you have to get right.

One of the issues is that we're talking about government buying securities from the marketplace of a form that doesn't actually exist yet. So it is possible that the government could use existing channels of securitization; however, if we want credit-enhanced products, as described in the budget, and if we want them to provide adequate taxpayer protection, it's going to take just a little bit of time to design and bring those securities to market. The sector can do it, and the program will roll out, as I understand, in the very near future. I also understand it would be quite reasonable to look for a rollout in June of this year.

[The Chair, Conservative, James Rajotte]

Mr. Drummond.

[Don Drummond]

I can't answer very definitively regarding BDC, because we have not had a long history of collaborative arrangements with BDC, unlike EDC. EDC is a very close partner of ours; in fact, of all the banks, TD does the most business with EDC. It's been a wonderful partnership, and I really have a sense of confidence that if a loan proposition is made to us with which we're uncomfortable, we will be able to involve EDC and make an arrangement that will allow them to go forward. We've had nothing but excellent exchanges with them previous to the budget, but particularly with the recapitalization and the possibilities afterwards.

I'm hopeful we can get some kind of an arrangement with BDC, but we just haven't had that track record historically with them.

[The Chair, Conservative, James Rajotte]

You have time for one question.