CD HOWE PAPER
Walking the Tightrope: Canada’s Financial System between a Yes Vote and Quebec Secession
by David Laidler and William Robson

Despite the separatist proposal that an independent Quebec would continue to use the Canadian dollar, fear that Quebec might eventually adopt its own currency threatens a flight of funds from Quebec in the event of a yes vote in a referendum on independence. A severe flight could produce a credit crunch in Quebec, threaten the stability of financial institutions, or even cause fiscal crises -- events that could make a separate currency more attractive to Quebec, and thus bring the monetary union to an end in a self-fulfilling prophecy.

Coping with this challenge during the period between a yes vote and actual independence -- when pre-existing laws and practices would continue, but in time-limited form -- would likely prove impossible for existing federal institutions: the Bank of Canada, the Office of the Superintendent of Financial Institutions, and the Canada Deposit Insurance Corporation. Advance agreement with the government of Quebec on regulatory authority and security of collateral would be highly unlikely for political reasons. Without such agreement, federal institutions would find their obligation to protect taxpayers in the rest of Canada a formidable obstacle to the task of supporting financial institutions exposed to secession-related problems.

It therefore falls to the government of Quebec to position itself to head off a financial crisis. The key requirement would be a war-chest, raised well in advance, that was big enough to meet the demands of its financial institutions for liquidity support and of its depositors for effective insurance coverage. Only if such funds are available, and known to be available, could the government of Quebec hope to avoid a financial crisis during the period between a referendum and secession.

Press Release from CD HOWE - March 12, 1998

The Quebec government must amass a sizable stock of funds to backstop its banking system before the next referendum if it wants to minimize financial turbulence and provide greater assurance that Quebecers can continue to use the Canadian dollar after secession, says a C.D. Howe Institute Commentary released today.

The study, entitled Walking the Tightrope: Canada’s Financial System between a Yes Vote and Quebec Secession, focuses on the role of federal institutions after a yes vote but before actual independence -- an awkward period when the Bank of Canada and the Canada Deposit Insurance Corporation (CDIC) would still be operating in Quebec, but when their mandates would be time-limited. Faced with an imminent change of legal regime in Quebec, the Bank and the CDIC would find it hard to play their normal role of supporting financial institutions that became short of liquid funds. In the event of a flight of capital, their inability to act could weaken financial institutions headquartered in Quebec, scaring depositors and other banks alike, and intensifying the crisis. The best chance of preventing such a vicious circle from developing is for the Quebec government to be ready with the necessary funds.

The authors of the study, David Laidler, a professor of economics at the University of Western Ontario and an Adjunct Scholar of the C.D. Howe Institute, and William B.P. Robson, a Senior Policy Analyst at the Institute, argue that Quebec needs to build up a stock of funds to support its financial system well in advance of a referendum. Otherwise, they say, nervousness around secession could prompt a flight of funds from Quebec. If such a flight began, it could put Quebec banks, and perhaps even the Quebec government, under financial pressure and also create a crisis for the Canadian dollar. These circumstances would make a separate currency appear attractive, a prospect that, in turn, could intensify the crisis and create a self-fulfilling prophecy.

The authors maintain that alternatives to a Quebec war-chest, such as joint agreements between the federal and Quebec governments over financial regulation, are unlikely because advance preparations along these lines would be so politically awkward for Ottawa. It therefore falls to the Quebec government to begin setting aside the necessary funds early, before secession-related concerns become an obstacle to its borrowing, and to publicize widely its readiness to deal with any movements of funds before the referendum, to build confidence among depositors and financial institutions.

In the authors’ view, advance preparation and publicity are critical because confidence in financial institutions would likely be fragile if Quebecers voted to secede. "With a sufficiently large stock of funds in place, there is some hope of avoiding a financial crisis during the period between a ‘yes’ vote in a referendum and independence. Without one, that hope looks vanishingly small" they conclude.

This publication continues the C.D. Howe Institute’s postreferendum research agenda, which comprises two Commentary series. One series is The Secession Papers, which, in the light of the results of the 1995 Quebec referendum, aims to assist Canadians to "think about the unthinkable." Papers already published in this series are Coming to Terms with Plan B: Ten Principles Governing Secession, by Patrick J. Monahan and Michael J. Bryant with Nancy C. Coté; Looking into the Abyss: The Need for a Plan C, by Alan C. Cairns; Ratifying a Postreferendum Agreement on Quebec Sovereignty, by Peter Russell and Bruce Ryder; and this study by David Laidler and William B.P. Robson.

Complementing this effort is another series, The Canadian Union Papers, which focuses on ways to enhance Canada’s political, economic, and social union. Papers published in this series are: Securing the Canadian Economic Union: Legal and Constitutional Options for the Federal Government, by Robert Howse; Drawing on Our Inner Strength: Canada’s Economic Citizenship in an Era of Evolving Federalism, by Daniel Schwanen; Language Matters: Ensuring That the Sugar Not Dissolve in the Coffee, by John Richards; Time Out: Assessing Incremental Strategies for Enhancing the Canadian Political Union, by Roger Gibbins; and Citizen Engagement in Conflict Resolution: Lessons for Canada in International Experience, by Janice Gross Stein, David R. Cameron, and Richard Simeon, with Alan Alexandroff.

Both series are being published under the supervision of David Cameron, a political scien-tist at the University of Toronto.

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Main Findings of the Commentary

• Continued use of the Canadian dollar is a central element in the secessionist program for an independent Quebec. A sovereign state can, however, always introduce its own currency. Individuals, businesses, and financial institutions will be wary of this possibility, not only in the aftermath of secession, but also in the runup to it.
• Doubts about the monetary union’s durability after secession threaten a vicious circle. Nervousness among depositors about their money, among lenders about their loans, and among financial institutions about the robustness of interbank markets might produce a credit crunch in Quebec and a plunging dollar, perhaps even bank failures and fiscal crises. By making a separate currency more attractive to Quebec, these pressures would intensify the nervousness that created them in the first place.
• Preserving the currency union would require preventing such a vicious circle from developing. Awkwardly, this challenge would arise during the possibly protracted period between a yes vote and actual independence, when pre-existing laws and administrative practices would continue in force, but would be obviously about to expire.
• Without advance preparation, the task of coping with a flow of funds out of Quebec, or worse, would fall largely on existing federal institutions. The Bank of Canada might encounter demands for funds to support financial institutions and the payments system. The Office of the Superintendent of Financial Institutions might be asked for judgments about solvency. And the Canada Deposit Insurance Corporation might face demands for payouts and for loans to troubled institutions or to its Quebec counterpart, the Quebec Deposit Insurance Board. Without advance agreement on regulatory authority and security of collateral, these institutions would find that their obligations to protect taxpayers in the rest of Canada conflicted with the task of supporting financial institutions exposed to secession-related problems.
• Since advance agreements on regulation and collateral would appear to abet the separatist cause, the government of Canada is highly unlikely to pursue them. It therefore appears that the government of Quebec, whose jurisdiction would continue to run after independence, would be wise to position itself to support the financial system during this period.
• The key requirement for Quebec is a war-chest of Canadian dollars big enough to provide liquidity support and deposit insurance to exposed financial institutions. Such a war-chest would be large, it would need to be raised in advance of a referendum to avoid the financing difficulties and higher interest rates that may arise afterward, and its existence would need to be publicized widely, to ease the nervousness of depositors, lenders, and financial institutions that might otherwise prompt a flight of funds.
• The key role of confidence in financial matters makes energetic advance preparation and publicity critical. With a sufficiently large stock of funds in place, there is some hope of avoiding a financial crisis during the period between a yes vote in a referendum and independence. Without one, that hope looks vanishingly small.

Full text of the paper, (in .pdf format), or hard copies, may be obtained from the CD HOWE INSTITUTE