Our financial system saved us from the worst of the 2009 crisis, now it’s holding our economy back
Discussion of Canada’s lagging productivity performance was missing from the recent federal election campaign, which is perhaps no surprise. It’s not a subject that lends itself to daily announcements and photo ops. But now that the electoral dust has settled it’s time to take steps to address the issue.
There is no better place to start than to boost productivity in the financial services sector, where Canada possesses an international comparative advantage. The sector not only employs relatively more educated workers and generates higher earnings than the rest of the economy, it has the unique ability to boost the entire economy’s productivity while boosting its own.
Sluggish growth suggests the pendulum may have swung too far in the direction of safety and stability
Surprisingly, however, the financial services sector’s contribution to overall productivity growth is underwhelming. Using the OECD measure of industry contribution to productivity, from 2001-2017, we rank behind countries we are often compared with, such as Australia, Norway and Sweden. How can we turn this around?
As we argue in a recent C.D. Howe Institute report,
the place to look is regulation and policy, and what we need to do is ensure we have the right balance between safety and stability, on the one hand, and creating an environment for competition and innovation, on the other.
It’s true that Canada’s financial regulatory framework insulated us from the 2008-09 financial crisis and its aftermath but sluggish growth in the decade since the crisis suggests the pendulum may have swung too far in the direction of safety and stability. Regulation and policy should promote competition, create a desirable location for attracting capital, and ensure an efficient allocation of credit, with more credit going to productivity-enhancing businesses.
Take competition. While it can be difficult to generate the optimal level of competition in a particular industry, it is critical for regulation and policy to allow the entry of innovative firms to the market and to ensure these firms can compete with traditional players on a level playing-field.
Fintechs in Canada tend to be either under- or over-regulated
The regulation of fintechs provides a cautionary tale. Fintechs in Canada tend to be either under- or over-regulated. Those that offer payment platforms often find themselves facing regulatory gaps as regulators typically focus on their more traditional debit and credit payment card counterparts, e.g. Interac. Uncertainty is costly for any business, let alone startups.
Fintechs that lend to businesses, on the other hand, often face onerous regulations similar to those faced by their traditional brick-and-mortar counterparts. That leads to an unlevel playing field, where these small but innovative firms have to adhere to regulations meant for systemically important financial institutions. To alleviate these concerns without sacrificing safety and stability, regulations should be more function-based and less entity-based, i.e., they should be more about what you do rather than who you are. At the same time, however, they should also be proportional to the risks created by the particular function a firm is performing. For example, though certain exemptions exist, peer-to-peer lenders, like traditional lenders, have to file a prospectus for each loan that involves selling securities to investors. In this case, the functions are the same but the cost could be prohibitive to less risky startups, damaging the potential for increased competition in this market.
More broadly, Canada’s regulatory and policy framework also impacts our overall productivity through the environment it creates for attracting capital and encouraging its efficient allocation.
One way of measuring Canada’s attractiveness to capital is to look at how we compare with other countries in net foreign direct investment inflows. Unfortunately, at the moment we rank behind Australia, to which we are often compared, as well as such global leaders as the Netherlands, the U.S., and despite Brexit, the U.K. Many factors go into foreign direct investment decisions, including regulatory structure. As it is, businesses with money to invest in Canada confront multiple hurdles, including different federal and provincial regulators. Adopting international best practices in financial services regulation can be complicated in Canada because of constitutional divisions of authority but more could be done to reduce fragmentation across function and geography.
Canada also scores poorly in small business lending, both as a share of total business lending and as a percentage of GDP, and it has one of the largest spreads between interest rates on loans to large businesses and loans to small and medium businesses (SMEs).
One reason why productivity-enhancing SMEs get less access to capital is simply that capital is being allocated elsewhere, in particular to residential mortgage lending. Canada Mortgage and Housing Corporation (CMHC) provides lenders of insured residential mortgages a 100 per cent guarantee, making these loans effectively risk-free. Mortgage insurance does help insulate the economy from a potential housing crash but tweaks in the rules might encourage a more efficient allocation of capital to innovative and productive SMEs. For example, CMHC currently charges a flat percentage for the insurance premium based on loan-to-value ratio, i.e., the ratio of the size of your loan to the value of the house, regardless of the characteristics of individual borrowers. If instead it charged different premiums based on different risk profiles, lenders might rethink how they allocate credit, freeing up more capital for business loans.
These are only a few of the many steps Canada can take to move toward a regulatory and policy framework that will boost both financial services and economy-wide productivity. Election campaigns may not be the best time for hashing out regulatory and policy details but the election is now over. It’s time to tackle Canada’s lacklustre productivity performance.
Farah Omran is a policy analyst and Jeremy Kronick is Associate Director, Research, at the C.D. Howe Institute.