CHAPTER 10 Economic Analysis of Financial Regulation 241 deposit insurance, the government was guaranteeing that the deposits were safe, so depositors were more than happy to make deposits in the Canadian Commercial and Northland banks with the higher interest rates As already noted, the managers of Canadian Commercial and Northland did not have the required expertise to manage risk in the permissive atmosphere of western Canada Even if the required expertise was available initially, rapid credit growth may have outstripped the available information resources of the banking institution, resulting in excessive risk taking Also, the lending boom meant that the activities of Canadian Commercial and Northland were expanding in scope and were becoming more complicated, requiring an expansion of regulatory resources to monitor these activities appropriately Unfortunately, regulators of chartered banks at the Inspector General of Banks (the predecessor of the Office of the Superintendent of Financial Institutions) had neither the expertise nor the resources that would have enabled them to sufficiently monitor the activities of Canadian Commercial and Northland Given the lack of expertise in both the banks and the Inspector General of Banks, the weakening of the regulatory apparatus, and the moral hazard incentives provided by deposit insurance, it is no surprise that Canadian Commercial and Northland took on excessive risks, which led to huge losses on bad loans In addition, the incentives of moral hazard were increased dramatically by a historical accident: the combination of sharp increases in interest rates from late 1979 until 1981 and a severe recession in 1981 1982, both of which were engineered by the Federal Reserve in the United States to bring down inflation The sharp rise in interest rates produced rapidly rising costs of funds for the banks that were not matched by higher earnings on their principal asset, long-term residential mortgages (whose rates had been fixed at a time when interest rates were far lower) The 1981 1982 recession and a collapse in the prices of energy and farm products hit the economy of Alberta very hard As a result, there were defaults on many loans Losses for Canadian Commercial and Northland mounted and the banks had negative net worths and were thus insolvent by the beginning of 1985 Later Stage of the Crisis: Regulatory Forbearance At this point, a logical step might have been for the regulators the Bank of Canada and the Inspector General of Banks to close the insolvent banks Instead, the regulators adopted a stance of regulatory forbearance: they refrained from exercising their regulatory right to put the insolvent Canadian Commercial Bank and Northland Bank out of business There were two main reasons why the Bank of Canada and the Inspector General of Banks opted for regulatory forbearance First, the CDIC did not have sufficient funds in its insurance fund to close the insolvent banks and pay off their deposits Second, because bureaucrats not like to admit that their own agency is in trouble, the regulators preferred to sweep their problems under the rug in the hope that they would go away When Canadian Commercial and Northland were declared insolvent in September of 1985, rumours of financial trouble caused many large depositors to withdraw large deposits from the Bank of British Columbia, Mercantile Bank, and Continental Bank By the time Mercantile was acquired by the National Bank of Canada, Bank of British Columbia by the Hongkong Bank of Canada, and Continental by Lloyds Bank of Canada (a subsidiary of a U.K.-based banking powerhouse), the Bank of Canada had lent over $5 billion The loss of public confidence in the Canadian banking system led to the financial reforms of 1987 1992 (see Table 10-1) and the consolidating of financial institution supervision under the Office of the Superintendent of Financial Institutions