Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 23 - Evidence - May 16, 2007
OTTAWA, Wednesday, May 16, 2007
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:20 p.m. to examine and report upon the present state of the domestic and international financial system. Topic: Study on hedge funds.
Senator Jerahmiel S. Grafstein (Chairman) in the chair.
[English]
The Chairman: Welcome to honourable senators and our Canadian audience viewing these important hearings from coast to coast. Not only will our proceedings be seen from coast to coast to coast in Canada, but also your words will be echoed around the globe via the Internet. Proceed with care and caution.
The Standing Senate Committee on Banking, Trade and Commerce was in New York City last October to discuss a number of issues within the committee's mandate. During our discussions with American regulators at all levels and representatives of the financial services sector, hedge funds emerged as a key issue. As an aside, we were encouraged to conduct this study by the Governor of the Bank of Canada some months ago. The sector is anecdotally valued — and I say ``anecdotally'' because we have not been able to wrap our minds around the exact numbers — at approximately $2 trillion. The numbers we have heard range from $1.1 trillion, $1.7 trillion to in excess of $2 trillion. The best we can determine, that is the value of hedge fund assets globally. The Canadian hedge funds were estimated in 2004 at $26 billion, but we have been assured that the number has more than doubled in that period of time.
We have also been told — and again this is anecdotally, because we have not been able to confirm the figures with the sector moving so quickly — that the number of hedge fund companies have increased from approximately 600-700 five or six years ago to more than 9,000 worldwide, and still growing exponentially.
We also heard about hedge funds during our recent study of consumer issues in the financial services sector. In our report on this topic, we recommended the appointment of an eminent person to review appropriate regulatory oversight of hedge funds. Nevertheless, a key question remains regarding the extent to which and how these kinds of financial products should be regulated or supervised in order to protect consumers as well as the stability of domestic and global financial markets.
We are open on the question as we grapple with the problem from two perspectives: The first is the systemic risk to the economy or economies as a whole; and second, fairness and equity with respect to the investors in the sector.
I am pleased to welcome representatives from the Canadian Bankers Association and several chartered banks. We have with us Mr. Steve McGirr, Mr. Brian Porter, Mr. Dennis Pellerin and Ms. Karen Michell.
Let me introduce the members of the committee. On my right is the deputy chair of the committee, Senator Angus, from Quebec. Also with us is Senator Tkachuk, from Saskatchewan, Senator Meighen, from Ontario, Senator Ringuette, from New Brunswick, Senator Moore, from Nova Scotia, and Senator Goldstein, from Quebec.
Mr. McGirr, please proceed with your introductory comments.
Steve McGirr, Senior Executive Vice-President and Chief Risk Officer, Treasury and Risk Management, CIBC, Canadian Bankers Association: I am here today in my capacity as the chair of the Senior Risk Management Committee of the Canadian Bankers Association.
We welcome the opportunity to provide an overview of the banking industry's involvement in hedge fund markets and to describe the measures that we have in place to safeguard against the risk from hedge funds. I will begin by outlining the scope of the banks' involvement in hedge fund markets. This includes the prime brokerage services that the dealer arms of many of our Canadian banks provide to hedge funds. Next, I shall describe the safeguards that banks have in place to mitigate risk from hedge funds. Finally, I shall outline our role in the hedge fund markets as it relates to the availability of these funds to retail investors through the sale of principal protected notes — PPNs. I shall also describe our disclosure policies for PPNs, including those linked to hedge funds.
As you know, the dealer arms of many Canadian banks offer prime brokerage and other services to hedge funds and other institutional clients. While not all banks offer the same kinds of services, prime brokerage services could include the following: financing of securities and other inventories; the clearing and settlement of trades; custodial services; risk management and operational support facilities; and research and consulting services.
I wish to comment on the view that this prime brokerage role may increase the risk that a disruption in one firm or financial market will spread to other parts of the financial system. This view maintains that direct credit exposure of prime brokers to hedge funds could affect the overall stability of the financial system. On this point, we would refer to the view of the U.S. President's Working Group on Financial Markets, which stated that market discipline by creditors, counterparties and investors is the most effective mechanism for limiting systemic risk from hedge funds. It also stated that counterparties and creditors can help to ensure stability by continually enhancing their risk management practices. On that note, we intend to do our part.
Effective risk management is at the core of the banking business and we take that responsibility very seriously. We are continuously adapting and updating our risk management practices so that they address the emergence of market trends such as hedge funds. The adequacy of these practices must meet stringent standards established and supervised by the Office of the Superintendent of Financial Institutions, OSFI.
You will note that OSFI recently completed a review to determine the extent of Canadian banks' credit risk exposure to hedge funds. It also examined our credit risk management practices for hedge fund counterparties. OSFI found that all Canadian banks have documented clear strategies, policies and procedures governing the extent and nature of these activities.
Among other things, these policies articulate the process for hedge fund counterparty risk approvals and the limit- setting procedures. They require the procurement and maintenance of comprehensive up-to-date financial and non- financial information on hedge fund counterparties. In short, we must have policies in place to ensure that we have the right credit approach to this industry. We must know ultimately who we are dealing with; there must be limits on the nature and the volumes of business we are supporting; and the policies must ensure that we have the financial and non- financial information that we need to conduct business appropriately. OSFI concluded that the Canadian banks are taking a cautious approach to hedge funds. It does not have any concerns about the participation of Canadian banks with hedge funds.
It is also important to note that the chair of the Ontario Securities Commission recently expressed the same view. Mr. David Wilson said: ``The hedge fund industry in Canada has an appropriate oversight framework.''
On one final note on the importance of risk management practices. Counterparty credit risk is only one of the risk categories that has a high priority for banks. We also take our reputational risk seriously. We make it our business to know who we are doing business with.
I also wish to comment briefly on the linkage between PPNs and hedge funds. There is a concern that PPNs give retail investors access to an asset class without sufficient disclosures of the fees and risks associated with PPNs. The OSC has estimated that $27 billion is invested in hedge funds today in Canada. Of this total, $7 billion is invested by individual Canadians through the purchase of PPNs. There are three key points.
The Chairman: For the benefit of the listening audience, would you explain PPNs?
Mr. McGirr: A PPN, or principal protected note, is issued by a counterparty, in this case a bank, that offers the principal or money-at-risk protected by the counterparty in question but offers a return that is linked to an underlying security. In this case, it would be linked to the performance of hedge funds. The investor has his principal protected but the return is indexed or related to the return on the hedge fund.
The first of the three key points I wish to make is this: About 95 per cent of bank-issued principal protected notes are not linked to hedge funds. Rather, they are linked to other underlying interests such as stocks, bonds, commodities, exchange rates, interest rates, global indices and, in some cases, mutual funds. Second, for PPNs that are linked to hedge funds, the risks are managed in the same thorough manner as they would be for any other hedge-fund-related instrument or transaction. Third, the disclosures provided to the holders of PPNs are mandated by federal regulation.
Bank-issued PPNs have always been sold with an accompanying detailed information statement. We are always looking for ways to enhance that disclosure to ensure that information is provided to investors in a format that is easy to understand.
The March 19, 2007, federal budget indicated that the federal government will issue principle-based regulations for PPNs. These regulations will accomplish three objectives: First, they will ensure that consumers are informed of the fees, returns and risks as well as the cancellation and redemption rights associated with PPNs; second, there will be a principle that this information be clearly disclosed by qualified individuals, to ensure that investors have the information they need to make the most informed investment decisions; and third, there will be a requirement for additional disclosure after purchase, to aid investors in monitoring and tracking their investments.
In our view, the banking industry currently has best-in-class disclosure related to PPNs, however, disclosure is extremely important. The industry has been working proactively to enhance these practices and will continue to work with federal government officials to propose enhancements for disclosure on PPNs.
In summary, the hedge fund markets will continue to mature and develop. The banking industry will continue its work to further develop and update its risk-management practices. It is important to note that our primary regulator, OSFI, has found that the banks are taking a cautious approach to hedge funds. OSFI testified that credit risk exposure to banks is low and that banks have clear strategies, policies and procedures in place to manage our exposure today and in the future. We are also working with the Department of Finance to ensure enhanced disclosure measures for all PPNs. This includes the small number that are linked to hedge funds. Our goal is to ensure that these practices continue to meet the needs of retail investors so that they can make the most informed investment choices.
We appreciate this opportunity to share our views today and we look forward to senators' questions.
The Chairman: Thank you, Mr. McGirr, for the concise presentation on behalf of the CBA.
Before proceeding, I welcome Senator Massicotte, from Quebec, Senator Eyton, from Ontario, and Senator Harb, from Ontario.
We will now move to questions.
Senator Angus: Thank you, Mr. McGirr, for your lucid introductory comments focusing on hedge funds.
We have been told by more than one witness, but principally by Mr. Eric Sprott, of Sprott Securities in Toronto, I think known to most of you, that perhaps our focus is a bit off beam here, in that concern that we have detected, both in the U.S. and elsewhere, with a growing circumstance that is generically referred to as the hedge fund industry, is really not the hedge fund industry as you sophisticated people would know it but rather what they called the levered debt industry or derivative products that are levered up way beyond the one-to-one or one-to-two, which is more typical of a vanilla, normal type of hedge fund. Mr. Sprott spoke about what he referred to as the lending mania.
In the front page of today's The Globe and Mail, someone made a comment yesterday about all these big sales to private equity funds of major businesses, and so on in Canada, in particular, linking it to ``the lending mania'' and the willingness of institutions, including banks, to extend credit to less than prime-type risks or prime-type interest, and that this is the real problem we should be focusing on.
That is a bit of a mouthful, but could you comment on that? Would you agree with that? Even when you are talking about PPNs, you are saying that 95 per cent of them are related to structured products and derivative markets rather than hedge funds. That rang the bell for me.
Mr. McGirr: I do not think we would be so presumptive as to tell you what you should focus on, but I will make comments on the general leverage in the financial system.
We are in an interesting time in financial markets, where we are seeing many new entrants into the markets, hedge funds being one of those entrants, who are taking on risk and providing for the diffusion of risk through the financial system.
Banks are in the business of providing leverage. Clearly, credit is leverage. Since we are in the business of taking risk, we spend an awful lot of time worrying about that risk and about how we can protect ourselves and, consequently, the financial system against the risks of leverage.
One of the features of the current market is that it is very liquid. By ``liquid,'' I mean that there are a number of institutions and entrants into the market who are buying securities and providing money into the credit markets. That has resulted in much more freely available credit. It has also, in a very competitive banking market, as we operate in, resulted in better terms for borrowers in some cases, including better terms for private equity, who are buying a number of these companies.
I would say, though, that in banking we take risk extremely seriously. We have policies and procedures in place to limit our exposure and also to limit the credit risk to many of these players in the market. While we provide leverage, we feel we do it in a way that is well-controlled, prudent and well-considered. We actually provide multiple benefits to this because we ultimately underwrite many of the transactions that come to the market that are then distributed through the system to these providers of liquidity to the market. It is done in a very controlled and prudent way.
I would invite my other bankers to comment on that.
Brian Porter, Executive Vice-President and Chief Risk Officer, The Bank of Nova Scotia, Canadian Bankers Association: By way of background, Mr. McGirr alluded to the two phenomenon we have seen in the marketplace in the last five, six or seven years, and that is the proliferation of hedge funds and the proliferation of private equity and the impact it is having on the marketplace.
I do not know whether you have heard this, but, in the background, you have seen a convergence of credit markets and public bond markets in the U.S. primarily and, to some extent, in Europe. Previously, those markets were separate and distinct. You saw banks in the bottom of a credit cycle have write-offs because they had bad loans. They held those loans and did not have concentration limits or industry or facility limits.
Today, the market is extremely different. Banks are able to originate products in terms of loans and distribute that to the market place. They are distributing it in the United States, the U.K. and to some extent this country to insurance companies, mutual fund companies, hedge funds, people out there looking for yield. The marketplaces have converged. I think that is an important distinction, in terms of the world that is looking for yield. That is a phenomenon we have seen in the marketplace clearly in the last three years.
As well, you have heard some element that there has been a tremendous amount of new products developed in the marketplace, whether they are CDSs or LCDSs, so that banks and other market participants can hedge, by a variety of instruments —
The Chairman: Mr. Porter, when you give an acronym, give us the explanation.
Mr. Porter: CDS means credit default swap, which is a form of insurance you can buy on a loan. That is an active and developing marketplace in the U.S., the U.K. and, again, to some extent in Canada. That has been a phenomenon. That is open to different market participants.
I am saying that hedge funds, in terms of the marketplace, add to the functioning of the day-to-day marketplace by providing liquidity, et cetera. Hedge funds also add in terms of the dispersion of risk in the marketplace, because they might very well be buying pieces of these bank loans. Hedge funds might be sellers or purchasers of insurance in the marketplace. That is a phenomenon we are seeing in the marketplace.
Denis Pellerin, Senior Vice-President, Operational and Market Risk Management, National Bank of Canada, Canadian Bankers Association: I could offer some comments about the leverage level of the actual hedge fund industry.
You have referred to the risk that results from leverage. Really, the hedge fund industry is using leverage day in and day out. It is hard to put a number on where the leverage level is. Recently the FSA, the Financial Service Authority in the U.K., has published data that suggested that 80 per cent of the hedge funds they regulate are using leverage. Basically, it is an industry norm. They are also saying that the average leverage level of the hedge funds that they looked at went from 1.6 down to 1.3 times. That is a fairly reasonable leverage.
The other aspect I should like to bring to the hedge fund industry leverage issue is that this industry, as you said, senator, is developing very rapidly, but it is also learning. The people that are learning are not only the hedge fund managers themselves but the investors in the hedge funds. More and more today, institutional investors take significant position in the hedge fund industry. Most of the time, when they do, they do it with what we call full transparency — that is, they do not buy a unit of a hedge fund; they actually invest in a hedge fund with full knowledge of what is in the hedge fund, the positions and investments, as well as the leverage level of the hedge fund. The institutional investors have a risk tolerance that is a lot more reasonable than other types of investors that are after the extra yield.
As they grow as a source of investment for the hedge fund industry, they put pressure on the industry to look at leverage in a much more reasonable manner. Does that mean there are not hedge funds out there that have unreasonable leverage levels? Certainly not, but this industry is evolving. While it is growing rapidly, I do not have the impression that it is getting out of control, and the average risk level that it presents to the overall financial system is growing. Leverage is something that, most of the time, is reasonably handled by both the managers themselves and their investors that more and more are asking for more information about the level of risk that they live with.
Senator Angus: Listening to the three of you, and the young lady who was the oversight person for the banks from OSFI who was here not long ago, one would have the impression that all was fine. On the other hand, in terms of learning and evolution, the example always given to us is that in August 1998 there was the issue of Long-Term Capital Management, where the whole house of cards would have tumbled down if certain people in your business in the United States had not come in with billions of dollars to protect the situation.
On the other hand, a year and a half ago there was the matter of Amaranth, which had significant numbers, and it seemed to take care of itself, as you say, the people playing the game. Yet, within 24 to 48 hours of the problem becoming known, nobody within the structure of Amaranth knew who owed what to whom. That scares the people who are reading the financial press. It may not scare the risk managers of our banks or Teachers' or OMERS, et cetera. Then we read that one of your members suddenly had a $450-million loss in one of these situations the other day. We are told it is a mere bagatelle in the bigger picture.
We are also told that the credit and the cost of credit is a function of the risk involved, just as the return on an investment is a function of the risk. Theoretically, these funds are getting a higher return, so ipso facto they must be more risky, like junk bonds.
We have been told that the differential between the high and low risk is disappearing because the system is awash with cash. We are trying to put some order to our thinking about it. So far, we think there might be need for some kind of oversight in terms of retail investors and unsophisticated people, and maybe a finer definition of what a sophisticated or accredited investor is in this context.
Without beating it to death, is not one of you concerned at all? Are you telling us that we should just drive on, and Bob's your uncle?
Mr. Porter: I do not think any of us are, senator. We are trying to give you some background in terms of how we view the marketplace. All of us are paid to worry, and we do a lot of worrying — there is no question about that. We are worried about systemic risk.
Not to be alarmist, but what happens to the system in the event of an Amaranth, where they could not sell $2-billion worth of Euro loans in a hurry is a situation where the market is not as liquid as it is today.
Having said that, if anyone tells you they know how the market will react, that is not the case. We take a lot of safeguards in terms of running our business; all sorts of processes and controls are reviewed by the board.
I can speak for the Bank of Nova Scotia. We are in 50 countries; we deal with up to 100 different regulators on a global basis. The spotlight is on us, from rating agencies, different stakeholders, shareholders, analysts, and so on. We spend a lot of time in terms of our internal risk-management structures, whether they are robust, whether we have the right people in place. Then we do stress tests under different scenarios.
In 1998, what will happen? We stress our different portfolios, our hedge fund exposures, what will happen and what is the maximum one-day loss in that type of event. My colleagues and I spend a lot of time with our colleagues internally, our CEO, our respective boards and executive risk committees, where we consider the appropriate level of risk, whether we are getting paid for it and whether it is in line with the overall strategy of the institution.
I would have to say that, given how quickly this marketplace has grown, the Canadian community has been very prudent about it. I do not think we are taking undue risk. We go to different conferences globally and interact with some of our competitors. We see things going on in different marketplaces that do not make sense to us, in terms of economic return and risk management, but they are out there and they are happening.
In summary, these are things we deal with and think about all the time.
Senator Angus: That is very comforting to us. That is what OSFI said — namely, that they have looked at that.
There are other counterparties and investors in the funds that are at risk. Do they have the same degree of risk management and checks and balances as you do?
Mr. Porter: Let me give you a practical example. There are 7,500 to 10,000 hedge funds out there globally. From a Bank of Nova Scotia perspective, we deal with less than 100. We have rigorous criteria: Who are they? Do we know the principals? What is their track record? We visit their location, to see if they have the proper risk-management system, the people, all those different things in terms of knowing your client and appropriate counterparty knowledge, if I can call it that.
We deal with a finite group of hedge funds. I am not saying that we might not have issues in time, depending on how markets react, but ``hedge fund'' is a big term. It means different things to different people; I am trying to give you a practical example of how we deal with it.
Senator Angus: You said when you go to conferences on the global scene you see things. I understood you to mean you see things you do not do. What are they? Will you give us an example?
Mr. Porter: Again, the evolution of product development is very fast and rapid. What Mr. Sprott was alluding to was the rapid growth of CDOs, collateralized debt or loan obligations, where banks or hedge funds are packaging up different loans and selling different slivers. They will sell an equity sliver on a first loss and second loss. That business has grown dramatically. As an institution, we do not participate in all levels of that. We might participate in a certain CDO with a counterparty we have a lot of time and respect for, and they have the knowledge and experience to do that. That does not mean we deal with everybody in the space.
There are certain products we do not deal in.
Senator Moore: Thank you for being here this evening.
Mr. McGirr, with regard to your presentation, you cited Mr. David Wilson, chair of the Ontario Securities Commission saying, ``The hedge fund industry in Canada has appropriate oversight framework.''
We have heard about the need of oversight from Mr. Sprott and the possibility of having a selected list of auditors from which hedge funds would be required to select an auditor to audit their affairs.
Beyond what Mr. Porter has said with regard to each individual bank doing its due diligence as to which hedge fund it may do business with, what is the oversight framework that exists?
Mr. McGirr: From a banking perspective, we would say that the people who are extending credit to the hedge funds and the counterparties to hedge fund transactions, being the banks in main, are an important source of control.
Senator Moore: You are regulated.
Mr. McGirr: Not regulation, but control. The kind of practices we have in that space would be controls on the collateral that we take for transactions. Those implicitly control the amount of leverage that any one asset a hedge fund or any counterparty can have and limits the amount of exposure that individual banks and, therefore, the system will have to the credit granted to hedge funds — the earlier point of the overall amount of leverage in the hedge fund.
Our perspective as bankers is that there is an appropriate, prudent oversight on the amount of credit that is granted to these kinds of institutions in Canada.
Senator Moore: Is that what OSFI meant when they say that — and you cited them in your presentation — ``The banks are taking a cautious approach''? Is this the caution or is the caution up to each individual institution, as mentioned by Mr. Porter with regard to the Bank of Nova Scotia?
Mr. McGirr: OSFI analyzed each individual bank and then came to some conclusions on the overall industry.
OSFI looked at the strategies that were in place to do business with hedge funds, the policies that govern the credit granting and other business by each individual bank and the procedures that were in place to ensure that we had the appropriate controls in place. They came to the conclusion, on an industry basis, that all of those were appropriate for the amount of business that the banks were taking on.
Senator Moore: You say the banking industry currently has best-in-class disclosure pertaining to PPNs. What do you mean by ``best-in-class disclosure?''
Mr. McGirr: I will ask Mr. Pellerin to embellish on my answer. Currently, all of the principal protected notes sold in the banking system have the benefit of information disclosure, which gives investors the information they need. This information can be improved. As I said, disclosure is central to the integrity of the financial system so we are very interested in working with the Department of Finance to making that disclosure better.
I would ask Mr. Porter to comment on what our investors get.
Mr. Porter: National Bank is the only member of the CBA that actively distributes a retail product related to hedge funds. I am the best person to offer you the banking industry's perspective on disclosure of products related to hedge funds.
I have to go through the various products that we distribute because they have different attributes and the disclosure is related to the risk level.
We have several classes of products. The most risky product that we distribute is what we call the extra notes. There are about $150-million worth of these notes in the market.
Senator Moore: What is an extra note?
Mr. Pellerin: Extra is a brand product, and the note is not a deposit, so there is no guarantee for the principal or interest. Everything that the investor receives at the end is related to the performance of the hedge funds that we manage. It is fully exposed to our fund of hedge funds.
Senator Moore: As opposed to the PPN where the principal is guaranteed; correct?
Mr. Pellerin: Correct. As you can understand, there is a world of difference in terms of risk with a product that is fully exposed than with a product that is partially exposed.
The Chairman: Mr. Pellerin, what would be the risk reward there? What would be the fee structure for the risky one compared to the one that is more secure? What would be the spread?
Mr. Pellerin: The risk rewards —
Senator Moore: It depends on the performance.
Mr. Pellerin: Obviously, the more risk, the more return there would be. The fees will depend on the product.
There are several types of fees. It can get very confusing. The first type of fee is those the hedge fund manager collects. The person that manages the hedge fund collects two types of fees typically. There is an annual fee based on the volume of funds that the hedge fund manages, and that is about 1 per cent. The other type of fee is the incentive fee, which is a percentage of the profit they generate. Typically, it will be in the area of 20 per cent. If a hedge fund generates 10 per cent of return per annum, they get basically the same sort of return that a mutual fund manager gets. If the hedge funds generate a higher return, they will get a higher fee. The fee structure is structured differently than mutual fund, but it is not totally different.
The fund that we manage has fees added to it. A fee that is for us as the risk manager and the manufacturer of the product is 1 per cent.
The other fee normally collected is a 1 per cent fee for the distribution network of the product. There is another fee there.
That is the general fee structure, which is different. Everyone that brings something to this equation collects a fee but provides a service. We provide a risk-management service. We collect a fee for that. That is the structure of fees.
Senator Moore: Could you go back to the best-in-class disclosure?
Mr. Pellerin: The riskier product is full disclosure, like any other security. It is actually a prospectus that we issue that is approved by provincial securities regulators.
Senator Moore: Is that for a minimum $150,000 investor? What are those types of investors deemed to be?
Mr. Pellerin: There are two distribution channels for this product. One is with our subsidiary, National Bank Trust. They have a product for their wealthy individuals. There are 12,000 clients. The minimum is close to $500,000 that you have to invest. It is a full discretionary management product. That is the first channel. Out of $150 million, they distribute $100 million to these clients. They are very wealthy individuals. The other $50 million is distributed through our full service retail brokerage subsidiary, National Bank Financial. Again, it is with their wealthiest clients. It is the clients that will demand more risk diversification. With riskier products there is extensive disclosure. It is a 70-odd page document.
The second layer of products is in between, in terms of risk level. This is a true PPN. It is a seven-year instrument. The principal is fully protected and guaranteed by the bank. It is a deposit note issued by the bank; the note has principal protection but the return or the interest collected will depend on the performance of the fund. This product is structured in a way that it will present more risk than our core product, which I will talk about later on, because it will be structured with certain of our managers within our pool of funds that we manage. This will all be detailed in the information document that we distribute. It is structured to propose a better yield but with slightly more risk. Once again, however, risk is only limited to the interest portion of the deposit. There is this full secondary market that we provide. Information is provided in a 72-page document that details everything from risk to fees. It is very detailed.
Senator Moore: I have one last question. I want to go back to the first page of your presentation, Mr. McGirr. You discussed the prime brokerage services offered. Financing of securities is the first one; the last one is research and consulting services.
Is there no conflict there, between offering a customer a product that the bank thinks is good and then providing the financing?
Mr. McGirr: I will make two points. First, not all banks offer the same services, so that is a menu of services that could be provided. Consulting is a basket of potential services. Most hedge funds do not have the kind of infrastructure that a prime broker would offer — that is, the basic nuts-and-bolts consulting on some of their basic infrastructure. Banks would not be in a position to get into a conflict over those services. Consulting was meant to deal with that.
Senator Meighen: I will ask one short question. There is a recommendation from Canadian Security Administrators that there be a requirement for hedge fund administrators to be registered. Is that a useful suggestion in your view?
Mr. McGirr: The suggestion is well worth considering.
Senator Meighen: Do all of you share that view?
Mr. Porter: I would agree with my colleague. There is enough spotlight on the industry, given its growth, as there should be. From different stakeholders in the industry, there is enough rigour on the process in terms of who you are dealing with, their track record, et cetera.
The Chairman: When we went to New York, we found out that the hedge fund industry had agreed to ``Regulation Lite,'' which is registration in some back room and administrative and operating supervision. Some hedge funds went to the courts, and then the famous Goldstein case overturned that, and they were free to run. Our sense is that major players in the hedge funds welcomed what I would consider to be regulation oversight light, as opposed to heavy regulation.
Senator Meighen: I should like you to respond to my concern for the unsophisticated investor who is now directly or indirectly getting into the hedge fund market principally through the PPNs. My understanding is that they are sometimes structured so as to be exempt from regulation. I worry that investors are being advised by people who are not always as sophisticated as they should be. This area is not straightforward, clear and easy to explain and advise on, so it requires financial advisers with a good deal of experience. It is my opinion that regulation is not the panacea for everything, at least enforced regulation from the top. You gentlemen appear to have done a pretty good job within your industry, which is at a higher, more sophisticated level. Getting down to the so-called grassroots of investing, is there anything we can do to ensure that people do not get into hedge fund areas when it is not appropriate for them?
Mr. McGirr: I will be more unequivocal and say, yes.
Mr. Porter pointed out earlier that the number of investors, including retail investors, moving toward higher potential return asset classes is strictly demand and supply. There is a quest for yield and return. In the banking industry, we need to find ways to ensure that those clients are served and that they get the products that are needed.
The keys to ensuring that investors make wise choices are disclosure, appropriate training of the sales staff, so that all information needed by investors is forthcoming, and after-sales service, in terms receiving information on the performance of their instruments. All of these are contemplated in a statement by the Department of Finance.
It is true that PPNs are deposits. The banks are federally regulated and PPNs are protected by the banks, so that is why they are deposits. The return on PPNs is linked to the hedge funds. We are committed to developing better and better disclosure. Instruments that have substantially higher risk are sold by people who are trained to be able to sell them.
I would ask Mr. Pellerin to comment on that because of his bank's involvement in hedge fund PPNs, as to the training and disclosure.
Mr. Pellerin: The product has to be distributed by people who are knowledgeable with the product. The manufacturing of the product is key because most of the risk management is done when we make those products available to clients. When making the products available to clients, we have to know what kind of client is right for this specific product.
Senator Meighen: It is necessary to know your client.
Mr. Pellerin: We have been building that risk-management platform and performing careful distribution of the product for 11 years. We are quite aware of the inherent risk in the product that we are proposing to a client. We are happy that they have an adequate level of disclosure when they buy the product.
For us, it is not a product that offers an amount of risk that is worrying. There are other products that will carry more risk that are actual hedge fund products. Normally, hedge funds offer risk diversification, low volatility, low risk level, and are not correlated with other indexes. They aim for absolute positive return.
If all of those ingredients are found in the product that you promote, it will not be the best performing product in terms of yield but it will achieve those three targets. If the client is after diversification as opposed to the extra points of yield, he will invest in a product that has a decent place in his portfolio. Not every client should have that in their portfolio so it is up to the people who distribute the product to know which clients it will suit.
Senator Meighen: That is often where you run into problems.
Mr. Porter: Each of our respective organizations would have a two-committee process to review someone else's product or our own product. Assessment of reputational risk is done to ensure that there is no undue accounting or tax arbitrage in the structure that might not work over time.
The Chairman: How is the committee structured?
Mr. Porter: The committee would be made up of senior executives in the organization, including, in our case, our chief general counsel and a senior vice-president from the risk area in the bank and some business practitioners from the business line. There is a mix of staff and business functions at a very senior level. The next committee is a structured product committee, which will review the product to determine whether there is a proper level of transparency, whether the fees are disclosed and whether it is appropriate and feasible to sell to our sales force. There are numerous considerations.
Senator Meighen: Are there some products that people cannot buy unless they demonstrate that they are sophisticated investors? Should hedge funds fall into that product category? Is there any legal constraint to prevent a widow on a limited income from buying a hedge fund? I do not think there is.
Mr. Porter: No, there is no such constraint. If you are an accredited investor with $150,000 to invest, you can buy a speculative oil and gas or high tech stock. You are relying on the risk factor disclosed in the prospectus or the offering document. As a committee, we are saying that with the process in place, the investor will get an offering memorandum, as Mr. Pellerin pointed out, disclosing the risk factors, commissions, fees and performance, et cetera.
The Chairman: Just on that point, I have recently gone through some risk statements in various IPOs and stuff like that, and these are now so fulsome in terms of the risk analysis that they say essentially it is totally risky. When people say now they can rely on the fact that there is a risk factor, it goes all the way. We have moved from usefulness to total disusefulness because they are all so broadly based that they say it is a total risk package.
Senator Goldstein: I want to deal first with PPNs. You indicated that a purchaser of a PPN obtains an information document. Do I take it that that information document is complete as a prospectus would be?
Mr. Pellerin: Yes, the same, but it is not approved by the provincial regulator. It has the same basic information.
Senator Goldstein: You do not have to have it approved by a provincial regulator, and I understand that, but I am talking about the form of the document the investor obtains. Absent the fact that it does not have the imprimatur of a security commission or commissions, it is, I take it, as complete as a prospectus would be, and the purchaser purchases on the basis of that prospectus.
Mr. Pellerin: Yes.
Senator Goldstein: We have been reading about and we have been told about new phenomena that are occurring in the investment field. We find ourselves with equity funds that are purchasing Chrysler, for instance; we find ourselves with other organizations purchasing all sorts of enterprises and industries in the United States and elsewhere. We find ourselves, in the result, in a situation where acquisitions, mergers, with borrowed money — and there is nothing wrong with borrowed money, but nevertheless with borrowed money — are using a tremendous amount of cash. As recently as today, we have been reading in The Globe and Mail and Toronto Star among others, people expressing concern about the extent of cash being used. Some refer to as a frenzy, others as a lending mania. I do not want to quote a great deal, but Anthony Bolton of Fidelity International is quoted in this morning's The Toronto Star as saying that too much money is being spent on mergers and acquisitions. He said that ``buyout companies are overspending on takeover and are getting loans with few safeguards from banks.'' I do not know whether that is true or not, but he is a pretty responsible person.
If that kind of thing is happening throughout the system, and if hedge funds, admittedly supervised and admittedly limited exposures by banks who are in turn supervised, and we understand that, are involved in this ongoing frenzy, and if we saw 10 years ago an LTCM — Long-Term Capital Management — which came close to creating a terrible crisis in the market, why is everyone so sanguine about the fact that we do not need any regulation or oversight or concern about this, and that, effectively, everything within the system is regulating itself and there is no significant systemic risk? Do you continue to feel calm about this?
Mr. McGirr: By nature, risk officers at banks are not calm and sanguine. We worry about everything, and we are paid to worry. I will make a couple of background comments.
It is important to understand that there are other root causes as to why we are seeing private equity purchasing companies. It is a worldwide phenomenon. One issue is that private equity generally has a higher risk appetite than some public shareholders, so they are taking risks that would not normally be taken in the public market. A second reason, as you pointed out, is available leverage, and that leverage is being distributed into the market and the risk is diffused in a way it never was before.
Having said that, we are in a market where there is more demand for yield-bearing securities than there is supply. In that kind of market, risk premiums go down and bank risk appetite tends to become more and more prudent and we spend more time on limits and concentration and credit policies, et cetera.
Another reason for this phenomenon happening is there is a burden to being a public company that does not exist in private companies. There are causes other than straight leverage.
I would say that, as risks go up, our tendency to be more controlled and more prudent also goes up, and we are at one of those points in the cycle. I would not be sanguine, and I would not be dismissive of what is happening. There is a massive amount of liquidity in the system.
Mr. Porter: I tried to address some of these comments about systemic risk earlier, but we as an institution have been an active participant in the corporate lending market in the U.S. for 25 years. We have also been an active participant in what we call the HL tier, the more highly-levered transactions. We really have not been there for the past three or four years, because we, as an institution, came to the conclusion that we were not getting paid for the risk or we did not think we could manage the tail-end risk, which is the loan on our balance sheet.
Senator Angus asked earlier whether there were businesses or products in which we do not participate. That is not to say we have not participated from time to time in the marketplace, but we are not an active participant. That is a strategic decision we made.
We worry about systemic risk all the time. However, as seen in the LBO market today, if the three of us had a choice to commit capital to an LBO that is levered seven or eight times a single B credit or to buy a package of 20 single B loans that I can hold on my balance sheet and have 25 per cent collateral, and I have to do one of the two, I know which one I will do. It will be the latter.
Senator Goldstein: Since you are endemic worriers, what kind of supervision or control or regulation would make you less worried?
Mr. McGirr: We worry about the risks that are taken on the balance sheets of banks, and we worry about how we manage that risk in a way that is prudent and that safeguards the system. Fundamentally, we think that market forces — that is, prudential practices in terms of credit granting — are a fundamental defence against those systemic risks. We basically feel that with the limits, policies and procedures that we have in place, along with the continuous improvement in risk-management practices, that is the major part of the safeguarding of the financial system.
Senator Goldstein: Would your advice to us be to close down this inquiry?
Mr. McGirr: We can only comment on the risk issues pertaining to credit and the banking system, so we focused our comments on those issues. We wanted to assure you that, in the function we perform as a check and balance by credit granting, we think we are well under control and are not adding to the systemic risks.
Senator Massicotte: I want to separate my comments twofold.
One is the whole issue of the systemic risk and the possible jeopardy to our monetary system and economy. When you listen to OSFI or the central bankers of this world, they are comforted by the fact that, while they do not know much about hedge funds, the banking systems are so heavily involved with those hedge funds that have given comfort to the banks and their own internal controls would ensure that the other players are acting well.
I have a sense that in the United States banks are predominantly the lenders to the hedge funds. Is that the case in Canada?
Mr. McGirr: This is a difficult question. It is very difficult to get accurate data as to the extent of the hedge fund market. I will give you a backwards answer. Lending to hedge funds is a minute part of a bank's balance sheets. By inference, I would say that likely we do not have a large concentration of hedge fund risk in the Canadian banking system.
I cannot extrapolate that piece of information to actually answer your question about whether there are other financial participants in the sector; perhaps one of my colleagues will comment on that. It is hard to get accurate data. As the chairman pointed out earlier, we are dealing in trillions of dollars in the world financial system and I have not seen a study or information that would give me comfort to quote a number as to exposure.
Mr. Pellerin: As Mr. McGirr said, banks are important providers of funding devices to hedge fund managers. If you want to locate a spot where there is significant leveraging done, you have to look at the prime brokers, which are banks — Goldman Sachs, Union de Banques Suisses, Bear Stearns in Chicago. They are big firms and they are highly regulated. Most are in the U.S., but they do operate out of London and Switzerland. Their regulators are aware of the importance of these prime brokers to the stability of the financial system. It took a LTCM to bring the awareness that this is a more sensitive spot, because there is a concentration.
We deal with prime brokers because we do not want to have a hedge fund manager working for us who is not well controlled. The use of a prime broker is part of our control system. We see how they operate, how professional they are and how well they manage the risk with the same efficiency that we do. We select prime brokers carefully. They are important providers of financing for hedge funds. They are very professional.
Obviously, there is an element of risk there. Amaranth — which was a major collapse — happened without any prime broker noticing any problem. Some of them are at their trading rooms taking positions and making profit at the same time with hedge funds. That is one of the tests.
It does not mean that there is no risk, but the prime brokers are a sensitive link in this chain. The people we work with are professionals; they know what they are doing and are highly supervised by a very demanding regulator.
Senator Massicotte: That is the conclusion: If it is not you, in nearly all cases it is someone significantly regulated. They take immense comfort in that. They do not control them directly, but they say they control them indirectly. If it is not a bank, it is another heavily regulated institution.
Mr. Greenspan said earlier this week that he expects world interest rates to increase. I am sure each of you conducts sensitivity analyses, such that if interest rates go up 1 per cent or 2 per cent, it is not serious. Is that accurate? World inflation has been under control; expectations of returns and interest rates have come down. Everyone is now using leverage. Eventually, it will do the reverse. Are you all protected against increasing interest rates?
Mr. Porter: We all do a variety of stress tests, as I mentioned earlier. As an example, we would do 1987 crash-type scenarios, 1998 Russian-crisis scenarios. Usually, when you have an equity market that goes down dramatically, yield markets go down; we will stress the opposite. We stress it in the gravest scenario in terms of a financial market outcome. We do that all the time. The regulators see that. It is shown to our board and actively managed in-house.
Senator Massicotte: You said earlier that possibly outside the country some hedge funds are not as conservative as we are. Is there any systemic threat issue to Canada's economy from hedge funds outside the country that could affect our own economy?
Mr. Porter: I made the comment that some of the activities we are seeing in the U.S. market or in Europe are a bit troubling, not to sound the alarm bell. The LBO market is seeing companies leveraged at seven or eight times and equity in those transactions of 20 or 25 per cent. Some of the big global banks are putting equity in the equity box. It is not just the private equity sponsors; it is the banks directly. They may syndicate that, but they are directly putting in hundreds of millions of dollars or more.
What happens in times of stress? Let us say they get caught and have to commit that to three or four different transactions. These are sizeable transactions, LBOs that are $20 billion, $30 billion or $40 billion. So, not to be alarmist, but that is behaviour in the marketplace that is end-of-the-cycle behaviour.
Senator Massicotte: Our interest is not whether someone could lose money. The concern we have is systemic risk where it affects a broad base. It may not be prudent to do so, but that is for the bank to determine. Do Canadian banks do stress testing to ensure if that occurred we are not affected in a material sense? Are we threatened by those things?
Mr. Porter: No, the Canadian financial system is sound and will remain so under any of those stress scenarios.
Mr. McGirr: If interest rates do go up and the risk-free rate people can achieve on a government bond is higher tomorrow than it is today, then markets will become more of an equilibrium state and you will see the quest for yield abate a little bit as people move their money into less risky and risk-free products.
Markets have a wonderful way of correcting. As much as we like to stress the system, there could be equilibrium.
Senator Harb: Thank you for your presentations. My question relates to the percentage banks have invested in hedge funds, and what percentage of that investment is done either in the U.S. or Europe.
The second part to my question is that CNBC host Jim Cramer said that the following: ``A lot of time when I was short at my hedge fund, meaning I needed a stock down, I would create a level of activity beforehand that could drive the futures. It is a fun game and a lucrative game.''
He goes on to say that hedge fund operators from time to time tend to manipulate the market in order to take advantage of it.
Mr. McGirr: We reckon that the exposure is less than 2 per cent of the bank assets. We do not have data on the exposure internationally, so I cannot give you an answer to that question.
As to the Cramer question, large investors have an immense metal liquidity in the market. This is not the first time we have heard that comment, but it is very hard to respond to that because we do not observe that day to day.
The Chairman: Is it possible for you to provide us with any data that would be useful to the committee? The questions are on the record.
Mr. McGirr: We will do our best to respond to that.
Senator Eyton: We are concerned with highly leveraged hedge funds. Where there is not high leverage and there is less risk, we are less worried.
A popular theme we have heard from witnesses, both here and in the United States, is that the best oversight is by the financial institutions that deal with the hedge funds we are concerned about. I listened carefully, particularly to Mr. Porter and his description of how it is constantly reviewed. I do not know a lot about hedge funds, but I do know that there are many new hedge funds, that they are complicated, almost by definition, in their activities, that they involve vast sums of money, that they are pretty smart operators, that there are many different positions, that they relate to all geographies and commodities and that change happens quickly.
Against that background, those same operators will be dealing with other institutions, not only a primary or a secondary bank. I can understand how you can have good oversight with respect to a particular hedge fund, but it seems to me almost impossible for you to be able to judge the other activities going on with the same hedge fund dealing with other financial institutions or other bodies of one kind or another. If you do not have a good view overall, I do not see how that oversight can be truly effective when it comes down to it.
Can you reassure me? To what extent can you understand all of the activity of any particular hedge fund given the trades and their positions, including those in which you are not directly involved?
Mr. McGirr: The first fundamental principle is that we know our client. We make it our business to ensure that we know their business. We will back away from taking risk if we do not get appropriate financial and non-financial disclosure about what those transactions are.
However, there are legitimate risk issues that we worry about such as one-way trades, where all institutions are on the same side of the market. Where we do not feel we are getting disclosure about the amount of the risk and the risk management practices, the transactions will be outside our policy and, by and large, banks will not do those.
Mr. Porter: Again, we have internal procedures for knowing our client. You visit them, get net asset value returns and you see how they are performing. If we do not like how they are performing, we will put them on an internal watch list and put them on notice.
Senator Eyton: Do you get timely information? Trades happen in the morning and may close in the afternoon. It is that process where you can review and visit people.
Mr. Pellerin: We do plenty of business with hedge funds to manufacture the products that we distribute. I could bore you to death with the details of our risk-management platform.
The Chairman: Please, do not do that. Please curb your responses, because we are out of time.
Mr. Pellerin: The most important feature is full transparency. With respect to every investment the hedge fund manager wants to make on our behalf he must disclose to us within the same business day. We have a cut-off time, normally of four o'clock, and before that time everything has to be communicated to us. We feed that into our risk- management system and can monitor the book on a continuous basis.
Senator Eyton: My concern was really the currency, and you have answered that.
Senator Ringuette: Thank you for appearing this evening. I am sorry that this committee has not reserved a full two hours for your presentation. As the senior representative of our Canadian banks, you deserve that much. I am very sorry as well that we are infringing on the time allotted for another important issue. Therefore, I will send my questions to you in writing and hope that the steering committee of this committee will look into this issue very seriously.
The Chairman: Thank you, witnesses. This has been so compelling that I have allowed some senators to proceed longer than was fair. I will ask any senators who have questions to direct them to you in writing, and we will read all of your responses. Thank you very much for your evidence.
I intend to bring the next witness back at a future time as well. He is based in Ottawa and we want to be fair to him as well.
Thank you very much. I apologize to senators who did not have an adequate opportunity to ask their questions. As you can see, we are very much involved in getting at the root problems. We believe that we have not fully explored the issue, so this is a work-in-progress.
Honourable senators, we are now moving to a different topic, the barriers to trade within Canada. We do not have a free trade zone in Canada; we have a number of interprovincial barriers. Our Standing Senate Committee on Banking, Trade and Commerce is now examining interprovincial and inter-territorial trade barriers that exist in Canada and more particularly the extent to which these trade barriers are limiting the growth and profitability of the affected sectors, as well as the ability of businesses in these provinces and territories, jointly with relevant U.S. states, to form new economic regions of growth that we believe will enhance prosperity.
We are looking at the impact of interprovincial barriers and new ways of forming partnerships along the border to increase productivity in Canada.
The committee believes that the topic of internal barriers to trade is critically important as we seek a prosperous and competitive future. The barriers, in the view of this committee, often increase costs for business and perhaps ultimately for the consumers and may lead to inefficiencies in the marketplace that reduce Canada's productivity and competence. We need to focus on actions that will enhance competitiveness and productivity and removing internal barriers to trade that are harmful to achieving this goal.
We also believe that the hearing today is important in the context of the Minister of Finance's statement back in November 2006 about increasing competition and productivity.
There are two particular policy commitments in terms of our industry, namely, to foster a stronger economic union by continuing to engage with provinces and territories with respect to internal trade and labour mobility — there has been some news on that front — and to work with provinces to create a common securities regulator, and more about that in the future.
With are pleased today to have before us a representative of the Canadian Labour Congress, Mr. Weir, who is an economist.
Mr. Weir, before you start, let me apologize. The hearing got a bit out of hand because of the intense nature of the question. We will go as long as we can and then we intend to have you back at the earliest opportunity, if that is okay with you. You are in Ottawa, I take it, so it is easy for you to return.
I apologize on behalf of myself and the deputy chairman. Please proceed.
Erin Weir, Economist, Canadian Labour Congress: Thank you for the opportunity to appear before this committee. The main message that I want to bring today is that the issue of alleged interprovincial barriers has been significantly overblown and that in many cases the proposed cures are worse than the supposed disease.
In Canada, we have neither customs stations along provincial borders nor any sort of tariff on interprovincial trade. The Constitution clearly assigns jurisdiction over interprovincial trade to the federal government and the courts have consistently struck down attempts by provincial governments to obstruct it.
What many commentators refer to as interprovincial trade barriers are in fact differences in regulation between provinces, which I would argue are inevitable in a federal system, but most important, there is no economic evidence that these regulatory differences between provinces have any effect on interprovincial trade. I have submitted to you a paper by Dr. John Helliwell. Research that he has conducted demonstrates that relative to distance and market size, trade between provinces is just as intense as trade within provinces. In other words, there is no indication that provincial boundaries obstruct trade in any way.
Statistics Canada data shows that from the year 2000 through the year 2006 Canada's interprovincial exports grew four times faster than our country's international exports. There, again, it is not clear that interprovincial barriers are obstructing interprovincial trade.
Continuing on with this theme, the 1985 Macdonald Royal Commission examined the issue. Research conducted for that commission concluded that interprovincial barriers cost no more than 0.05 per cent of gross domestic product — that is, one twentieth of 1 percentage point of GDP. We have seen since then that the agreement on internal trade has eliminated many or most of the barriers that existed at the time of the Macdonald commission. This percentage of 0.05 percentage of GDP corresponds to less than $1 billion based on Canada's current economy, but the cost of those barriers that still remain must be closer to zero than to $1 billion.
I wish to give you the conclusion put forward by that commission in 1985: The direct costs of existing interprovincial trade barriers appear to be small. Their quantitative effect on the level of economic activity in Canada is not sufficient to justify a call for major reform.
I would suggest that those few barriers that remain are certainly not sufficient to justify the sweeping legalistic approach of the Trade, Investment and Labour Mobility Agreement that recently came into effect between Alberta and British Columbia. This agreement's extremely broad language combined with almost unlimited capacity for private interests to sue provincial governments, municipalities and school boards could have all sorts of pitfalls, risks and negative effects on provincial policy. The papers that I have submitted to you by Gould and Shrybman outline a number of ways in which this agreement would constrict the ability of provincial governments to act in the public interest.
My conclusion essentially is that if we are talking about the proposed Trade, Investment and Labour Mobility Agreement, it would deliver no meaningful economic benefit but would entail significant costs in terms of reduced policy capacity for any provincial governments that sign on to it.
Senator Ringuette: I wish to invite this witness to appear at another time so that we can go through all these papers and be efficient in our quest.
Senator Moore: I find your comments interesting. You said that it is not clear that interprovincial barriers are the cause of loss of productivity, and you quoted some numbers. You said that the agreement between British Columbia and Alberta was not warranted, especially in view of the significant labour costs that would be involved.
That is contrary to everything we have ever heard. Everyone who has been before us, from the Governor of the Bank of Canada to other premiers, have all said the contrary.
In the case of the British Columbia and Alberta deal, we were told that it would enhance the economy of Alberta alone by $450 million in the first year and would add about 4,400 jobs, which I thought was indicative of the value of such an agreement. Obviously, Ontario must have thought similarly because Ontario is now trying to become part of such an agreement.
Senator Meighen: Quebec wants to join the agreement.
Senator Moore: That is right, Senator Meighen.
I find your comments to be interesting. Maybe you can enlighten me. Are all those people wrong? The numbers are happening, it seems. Tell me the basis for your thesis that that it is not a good thing.
Mr. Weir: You are absolutely correct in suggesting the perspective that I have presented is different from ones you have heard in the past. That is precisely why I appreciate the opportunity to appear before this committee.
The numbers that you alluded to regarding the benefits from this Trade, Investment and Labour Mobility Agreement were generated by the Conference Board of Canada. Those numbers are open to significant question. The paper that I coauthored with Marc Lee, which I have submitted, presents a detailed critique of the Conference Board of Canada's estimate with respect to British Columbia. The board estimated that British Columbia would gain $4.8 billion from the agreement, which is more than half the value of all the goods and services they currently export to Alberta. It is just not believable that an agreement that would slightly facilitate those exports of goods and services would deliver benefits equal to half or more than half of the current value of those exports.
I have also submitted to you a note by Patrick Grady, a former senior finance official, who essentially endorses my critique of the conference board's report with respect to British Columbia.
Finally, turning to Saskatchewan, the paper by John Helliwell that I have submitted deals with the conference board's study of that province. He is a former president of the Canadian Economics Association. He writes that ``there is no empirical support for the conference board estimates of GDP and employment changes.''
Senator Moore: Is that in this report?
Mr. Weir: Yes. It is on page 7, the start of the section entitled ``Summary and Possible Next Steps.''
Senator Meighen: Senator Moore, may I have a supplementary question on that?
Senator Moore: Yes, go ahead.
Senator Meighen: Mr. Weir, even if those estimates are wildly exaggerated, you alluded to some dangers or negative effects, as I interpreted your remarks. What would those be in those labour mobility agreements?
Mr. Weir: The negative effect is essentially that the agreement — the acronym is TILMA, Trade, Investment and Labour Mobility Agreement — does not try to ban measures that are discriminatory between different provinces, but, in fact, purports to ban any measures that ``restrict or impair'' interprovincial trade, investment or labour mobility.
The Chairman: Mr. Weir, just for a moment, TILMA refers to the Trade, Investment and Labour Mobility Agreement. We now have two. We have one between Alberta and British Columbia; we understand other provinces are joining. We now have one between Ontario and Quebec. We understand that now Mr. Charest wants to expand.
Senator Ringuette: We do not.
Senator Meighen: We do not. The Charest government is proposing one.
The Chairman: Mr. Charest is proposing one, but there is one in Alberta and other provinces are now negotiating to be added on. That is what TILMA refers to.
Mr. Weir: To be crystal clear, I am referring to the agreement between British Columbia and Alberta.
It proposes to ban anything that restricts or impairs these economic activities. I have a great deal of difficulty thinking of any significant public policy or law or regulation that does not in some way influence those economic activities. The agreement, I suppose, has yet to be tested before these dispute resolution panels, but it seems to me that at best the agreement will have a chilling effect where municipalities and school boards will be afraid to do all sorts of things or to strengthen their standards in any way for fear of being sued for up to $5 million under this agreement. It is far more sweeping than the North American Free Trade Agreement. We have already had some problems with chapter 11 of that agreement in some of the cases brought forward. This agreement's dispute resolution process makes it even easier for private interest to challenge public policy. That is the real risk I see, the fact that it could constrict the ability of governments to fulfill their duties and act in the public interest.
As I mentioned, these papers by Gould and Shrybman go into specific examples of how that might happen.
There has already been a case of a school board in British Columbia that was proposing to ban junk food in its schools and was told it would not be permitted to do so because it would violate TILMA.
Senator Goldstein: I have read what trade unionists have been saying about TILMA. Larry Hubich — who, I assume you know, is the president of the Saskatchewan Federation of Labour — spoke to the concerns that he had, and I am quoting here, ``that school boards would lose the ability to mandate healthy lunch programs, municipalities would be powerless to limit building heights or ban pesticides, provinces would be incapable of regulating nursing homes,'' et cetera.
Surely, that is an issue where the extent of interference by a pact or an accord of this nature is measured only by the language that is within that pact. If the language within the pact deals with and limits itself to the reduction or elimination of barriers to free trade without regard to wider language, then surely you should have no concerns about this.
Second, out of an interest of clarity, it seems to me that your example of the B.C. school board was an example of someone giving advice to the school board or to the school and is certainly not a judgment that was rendered by a court or by an arbitration tribunal.
Frankly, I get the feeling — and I am going to be blunt about it and I apologize if you think I am too blunt — that trade unions that are provincially based are very interested in maintaining their power base within the province and do not like the idea of having a broader interprovincial type of trade going on. I refer, for instance, to the NAFTA agreement where, with all of its problems, we have not had schools not being able to ensure that junk food is not sold. It just does not happen that way.
Mr. Weir: To go to the first part of your question, the unfortunate thing about this agreement is that the language is very broad and does not restrict itself to dealing with the genuine interprovincial trade barriers. In fact, as I have suggested, very few such barriers exist. What I would prefer to see is some sort of agreement that identifies specific problems and proposes specific solutions rather than an agreement that purports to be comprehensive for almost all of the entire economy and then gives private interests the ability to sue governments for alleged violations.
It may be that all of these pitfalls will not come to pass. However, why take the risk, given that the problem is not that great and given that there are better ways of addressing it?
In terms of the B.C. school board case, you are absolutely right, that is not a tribunal judgment. In fact, the agreement does not come into force for school boards and municipalities for another two years. I think it does speak to the chilling effect that I mentioned where having this broad agreement out there may deter entities from pursuing good public policy.
In terms of the notion of trade unions being provincially based, I would simply point to the fact that the Canadian Labour Congress is very much a national organization. In fact, we are very much in favour of strong national standards in many of these areas. What we are concerned about is an agreement that might push standards in all provinces down to the lowest common denominator.
Senator Goldstein: Mr. Weir, if I am a master electrician in northern Manitoba and a member of the union, and I get a job offer to go do some work next door in Ontario, I cannot do that without joining the union — correct?
Mr. Weir: Are you suggesting that the existence of trade unions is an interprovincial issue?
Senator Goldstein: No, that would be the last thing I would suggest. I am, however, suggesting that the restrictiveness of union membership and the absence of agreements between different provincial unions preclude labour mobility, in very large measure.
Mr. Weir: I will speak to labour mobility specifically within the skilled trades. The federal government has established something called the Red Seal Program, which sets up high nationally recognized standards in many trades, including electrician.
Senator Goldstein: Yes, but the Red Seal standards have yet to be adopted by a single trade union.
Mr. Weir: I beg to differ. My father trains apprentice electricians in Saskatchewan and all of them are trained to meet the Red Seal standard in that province.
Senator Goldstein: Yes, but being trained to meet the Red Seal standard does not permit a Saskatchewan electrician to go work in Manitoba.
Mr. Weir: I believe that it does, unless Manitoba does not recognize the Red Seal Program.
Senator Goldstein: It is the unions that do not. They recognize it, but they will not, nevertheless, accept the master electrician that goes from one province to the other.
The Chairman: This is a factual dispute. Perhaps you might look into it and given us a letter to respond to it. I think there is a difference of opinion here, and we cannot settle it here. Maybe you will do a little bit of homework and we will do the same. Please send in a letter of clarification to our clerk.
Senator Massicotte: You are an economist by profession, so I need some of your help. What I learned at school is this: The more fluid the markets are, the more fluid the labour markets and the capital markets, basically product, will assist the economy adjust more quickly to all economic adjustments it must make on a consistent basis and therefore allow the market economy to be more efficient and eventually in satisfaction of allocation of its needs within the society.
As a starting point, you say, no. When you read the objective of that agreement, it is fluidity of adjustments in the economy. However, you are saying, no, that could not be the interest. Help me out there. Explain why that objective would not be in the interest of the best economy.
Mr. Weir: I believe you have correctly articulated the basic economic theory of free trade. My argument is that there are really no interprovincial barriers that impede fluidity in any measurable way.
If you look at interprovincial trade flows, we find that relative to distance and market size, Canadian provinces are about 12 times more likely to trade goods with each other than with American states. They are about 30 times more likely to trade services with each another than with American states. Undoubtedly, some provincial regulations do impose costs on business in achieving certain public policy objectives, but I have not seen evidence that those regulations impede trade between provinces or impede the overall fluidity of our economic union.
Senator Massicotte: Yet, in my province of Quebec, it is normal politics whereby there is political pressure for the premier to adopt policies that favour votes, and therefore it seems to be in his favour. However, a lot of common sense analysis suggests that it is really only short term. It does impede trade and fluidity of the labour markets, or capital markets or materials markets. Therefore, only in conjunction with a master agreement where all parties put down parochial, partisan interests can Canada benefit. Just that common sense observation would suggest that there are many of these agreements and therefore merit to free trade agreements, but are you saying there are not?
Mr. Weir: This is an area where this committee could make a useful contribution to the debate. It does make sense to scrutinize provincial regulations and weigh the costs that they impose on business against the public policy objectives they seek to achieve. If we find that there are regulations that do not achieve a worthy objective and do entail economic costs, then by all means those are good grounds to reform. However, we should look at provincial regulations on their own merit rather than through this fog of concern that has been created about interprovincial trade. Many of these regulations are worthwhile issues to debate; however, there is no evidence that they influence interprovincial trade. Therefore, I do not find it helpful to discuss them in that context.
The Chairman: Let me take a minute or two. I want to take up Senator Moore's line of questioning. This comes as a bit of a surprise to this committee. Perhaps we have been suffocated by the so-called fog of lack of information. However, the report you referred to was the report of Donald Macdonald in 1985. We are talking about the change in statistics at that time to the present time.
This committee did a study, and we received information, not just from the Conference Board of Canada but also from the Canadian Centre of Living Standards. Based on the information we received at that time, we concluded that a number of sectors of the economy that were inefficient. One of the leading sectors was the financial services sector. We do not have a single regulator. Ours is the only country in the world that does not have a single securities regulator, and that is inefficient and it costs more to raise capital and slower in Canada than in other places. Therefore, that impedes growth.
We also heard from individuals from the construction industry — and this I believe relates to Senator Goldstein's question — with respect to the construction industry. We know in Toronto, for example, there was a splurge of construction and we could not get, because of the interprovincial trade barriers, bricklayers or electricians or others to come across the border, and they were out of work and not doing well in Montreal.
Somehow you have raised the issue for us and we will obviously have to go back and track this, but just talk about the construction industry for a moment, which by the way is one of the most unproductive in terms of productivity, and we have satisfied ourselves with that. Do you not think that that present a problem? Does this labour mobility agreement between, for example between Alberta and British Columbia, not help that situation, allow labour to move easily across the border to where there is demand?
Mr. Weir: I will begin by saying I support the idea of a national securities regulator. In terms of the construction industry; I also support the Red Seal Program and would support expansions of that program. Both of those types of approaches speak to establishing high common national standards recognized by all provinces, which is a good idea.
The agreement between Alberta and B.C. in terms of the construction trades simply recognizes and goes along with the existing Red Seal Program. The agreement does not do anything more to increase labour mobility in that area. In fact, if you read the Conference Board of Canada's impact assessment on British Columbia it even makes the argument that there could not be gains in the construction industry because there already is labour mobility there under the Red Seal Program. Even the conference board, which is quite an aggressive advocate of getting rid of interprovincial trade barriers, concedes that in the case of construction there really are no such barriers.
In general, I reiterate that in cases where there are specific problems I am all for federal and provincial governments sitting down and figuring out specific solutions to those problems. I object to signing a sweeping agreement that purports to apply to almost all areas of the economy and then relying on these tribunals to interpret it in a limited way so that it applies to specific barriers.
The Chairman: As I understand it, and senators can correct me if I am wrong, the number of exemptions in the labour mobility agreement between British Columbia and Alberta was approximately 178. It is not as if it is total free trade. It is full of exemptions. We heard evidence on the question of accountants, the dispute between the chartered accountants and the certified general accountants. They could not move freely because of so-called high standards. When we cross-examined and determined those standards, those high standards were really productive measures, they were not those that would increase mobility in terms of allowing CGAs to move easily across borders and be recognized. When you say ``high standards,'' we automatically think: Is it high standards, or are they protective measures in themselves that decrease labour mobility?
Mr. Weir: You are definitely right to pose the question with respect to the regulated professions. In many of those professions, mutual recognition agreements are already being signed between different provinces. Some of the reasons that some of those professions are exempt from TILMA is that those professions are regulated at arm's length from provincial governments, so it is very difficult to iron out those things through any sort of interprovincial agreement. There certainly is the possibility for self-regulating professions to abuse their regulatory power to protect their turf, but it is difficult for me to think of what the constructive solution to that could be other than negotiation with those bodies or provincial governments being quite heavy handed in taking over the regulation of those professions, which it does not seem to me anyone is advocating, including the supporters of this B.C.-Alberta agreement.
The Chairman: We are at the end of our meeting. Mr. Weir, I would hope that you will come back again. I intend, subject to a steering committee, to invite back representatives of the Conference Board of Canada, and perhaps you could bring your experts, so that hopefully we can get to the bottom of this factual dispute between yourself, your advisers, and the conference board and others. Perhaps we might have them, as Senator Goldstein says, at the same time. We will refer this matter to our steering committee because we want to get at the facts here and we want the facts to speak for themselves.
Thank you for your evidence. We will bring you back at time convenient to you and to this committee. We want to thank you for this very interesting and quite different information that we have received today.
The committee adjourned.