Canadian governments brace for higher debt costs

January 11, 2012

Canadian governments are bracing for major changes to banking rules in the U.S. that would make it more difficult and expensive for them to borrow money, at a time when many need greater access to international investors to finance their debts.

The proposed reforms, known colloquially as the "Volcker Rule," are designed to avoid a repeat of the global banking crisis triggered by the collapse of Wall Street brokerage firm Lehman Brothers in 2008. They attempt to limit the risks big banks can take by restricting them from trading securities for profit, an activity known as "proprietary trading."

The rules are expected to add significant costs to banks that deal in securities because they will have to prove to regulators that trades they make are being done for their clients, and not for their own account. But certain kinds of government securities – U.S. Treasuries and bonds issued by American states, for example – are exempt.

Bonds issued by foreign governments, including the Government of Canada and the provinces, do not enjoy that same exemption. Government officials and banking regulators here say that as a result, the Volcker Rule will interfere with the liquidity of this country's sovereign securities, driving up the cost of borrowing for governments.

More than $1.3-trillion in Government of Canada bonds were traded by foreign investors last year.

"We are supportive of ensuring that there isn't a blow up in financial markets," said Gadi Mayman, chief executive officer of the Ontario Financing Authority, the entity that manages the province's borrowing. "We don't want a repeat of 2008-2009. But we also don't want to screw on the lid so tightly that the businesses of the banks in providing capital for government and corporations in Canada is constrained."

Canada is not alone in expressing concerns. European bankers and traders have sounded similar warnings about the potential impact on the euro zone government debt market. The federal government, along with Canada's banking regulator, the Office of the Superintendent for Financial Institutions, points out that the proposed rules are unprecedented because they greatly expand the reach of U.S. regulators into other jurisdictions.

"We understand the motivation for the U.S. rules to restrict a bank's risky trading activities," said Department of Finance spokesman Jack Aubry.

"At the same time, we are concerned about the extraterritorial reach of U.S. regulations into Canada and on the operations of Canadian financial institutions outside of the U.S., which could have unintended consequences."

While all three levels of government – federal, provincial and municipal – could see their access to international investors stifled, the new rules would have the biggest impact on those regions with large debt loads.

The timing of the proposed rules is bad for the federal government and many of the provinces, which need to tap the bond markets to finance their large deficits and debt. Ontario alone needs to borrow $35-billion this fiscal year to manage its deficit, invest in capital projects and refinance maturing debts. To date, it has borrowed $27.2-billion.

The Volcker Rule would apply to the global activities of banks with operations in the United States. Canada's big banks are subject to the rule by virtue of their subsidiaries in the U.S.; some, such as Royal Bank of Canada, have significant trading operations there.

The controversial rule is part of the massive 2010 Dodd-Frank financial oversight law and is named for Paul Volcker, the former chairman of the Federal Reserve who campaigned for it. The rule limits most proprietary trading, a lucrative practice where a bank places bets for itself rather than for clients.

It also spells out an expansive internal control regime that banks must follow, creating layers of expensive and time-consuming compliance, to determine whether a trade is proprietary or for a client.

The deadline for public comments on the proposed rule has been extended one month to Feb. 13. The final version takes effect in July.

Craig Alexander, chief economist at Toronto-Dominion Bank, said the rule has a "very American-centric dimension" to it because it exempts U.S. sovereign debt but not debt issued by foreign countries. Officials in Canada are seeking a similar exemption to bonds issued by the federal government and the provinces.

The federal and provincial governments do significant business in U.S. financial markets, where they easily attract investors with their highly-rated bonds. The OFA's Mr. Mayman said Canada's global reputation as a country with a strong banking sector has helped Ontario enjoy ready access to U.S. and other foreign investors to help support the province's borrowing program.

"One of the reasons we're able to borrow so much, is people love Canada right now," he said. "We're happy to take advantage of that."

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