Why Is Canadian Banking the Envy of the World?

Canada's Banking System Really So Smart?

One of the odder turns in the financial crisis has been the emergence of what can only be described as a worldwide cult of the Canadian banks. Yes, those Canadian banks: fat, slow, bone-stupid, deniers of loans and graspers of fees, easy targets for generations of low-rent columnists and politicians on the make.

Yet look at them now, the toast of five continents. The Financial Times calls Canada's banks "the envy of the world." Newsweek's Fareed Zakaria gushes that, thanks to its banks, "Canada has done more than survive this financial crisis. The country is positively thriving in it." Barack Obama, no less, confessed during his recent visit that Canada "has shown itself to be a pretty good manager of the financial system in ways that we haven't always been here in the United States," while Paul Volcker, the former Federal Reserve chairman and eminence grise in the Obama administration, has touted Canada's banks as the model for what a reformed American system should look like.

He's not alone. At this week's conference of the G20, Stephen HARPER would have found an attentive audience whenever the subject turned to financial regulation. The notion that "the Canadian system" offers a blueprint for other countries' BANKING sectors has become accepted wisdom - in Ireland, for example, they are more or less explicitly copying it. And, needless to say, the Prime Minister has not been shy about trumpeting our success at home, even urging Canadians to set aside their usual modesty and toast their banks' good health. If other countries wish to idealize Canada, who is a Canadian politician to argue?

But what is this "Canadian system"? Are we really as others imagine us, an island of financial prudence in a sea of recklessness? What accounts for this, if so? Is it, as so many suggest, our more strict system of oversight and regulation? Or is it the more buttoned-down, risk-averse culture of our bankers? Is the future of banking the simple, no-frills model that Volcker suggests, where banks take deposits and make loans, but do little else? You know, like they do up in Canada?

We can date the origins of this particular mania with unusual precision. On Oct. 8 of last year, with stock markets collapsing around the world and several major banks threatening to do likewise, the World Economic Forum released its annual Global Competitiveness Report, a dense compendium of statistics purporting to rank the "competitiveness" of various national economies across a number of categories, or "pillars": infrastructure, innovation, labour market efficiency, and so on. Canada ranked 10th overall in 2008, up from 13th the previous year: a respectable showing, but hardly earth-shattering. But buried in the numbers was one striking figure, of unusual interest at this particular moment: in the category of "soundness of banks," Canada ranked number one. The world's soundest banking system. That caught people's attention.

The methodology of the report may be debated. It's survey-based, for starters. The World Economic Forum did not collect a lot of hard data on each country's banking system - leverage ratios, loan-loss provisions, that sort of thing. Rather, they asked 75 Canadian executives what they thought of their country's banks. And they compared this to the responses other countries' executives gave to the same questions about their banks. As it turned out, our guys thought our banks were sounder than their guys thought their banks were.

Still, there's no denying that Canadian banks have weathered the storm better than most. It's true that we have suffered no bank failures since the crisis began: the United States had 25 in 2008, with more banks likely to shut their doors this year. It's true-ish that Canada's banks have not had to be rescued by their government, if you don't count the $25 billion - later raised to $75 billion, then $125 billion - in government purchases of MORTGAGE assets through the CANADA MORTGAGE AND HOUSING CORPORATION: not a bailout, as such, since the CMHC was on the hook as the insurer of the mortgages anyway, but not quite laissez-faire either.

And it's true that, by virtually any measure, Canada's banks are in healthier shape than their international rivals: profitable, well-capitalized, even raising $9 billion in capital since the fall through fresh share issues - an unheard-of feat in today's markets. As American banks have tumbled, collapsed, or merged, Canadian banks have risen in relative terms. Of the 10 largest banks in North America, measured by assets, four are now Canadian; a decade ago, we had none in the top 10. Just seven banks in the world retain a AAA rating from Moody's Investors Service. Two - Royal and Toronto-Dominion - are Canadian.

But their record is hardly unblemished. If Canada's banks did not issue the dodgy sub-prime mortgages that were at the root of the crisis, they did buy them, or rather derivative products based on them: CIBC, for example, was forced to take a $3.5-billion charge on its portfolio of mortgage-backed securities last year. All told, the banks have taken some $20 billion in writedowns since the crisis began - nothing on the U.S. scale, but hardly chicken feed.

The banks also played a small but pivotal role in the collapse of the asset-backed commercial paper (ABCP) market in Canada. What turned a debacle into a full-blown crisis was the Canadian banks' refusal to honour their commitments to the issuers of these products to be the buyers of last resort. That was no doubt prudent, but it's probably not the sort of thing the banks' new-found fans have in mind.

What explains the less-awful performance of the Canadian banks, when compared to their international counterparts? For many, the answer lies in the stringency of the Canadian regulatory system, the most conservative, by some accounts, in the world. Viewed strictly in prudential terms, there is some truth in this. Where the international standard, as set out in the first Basel Capital Accord - a 1988 agreement among the world's leading monetary and banking authorities - required banks to hold no less than $4 in "tier 1 capital" (common equity, published reserves and equivalents) for every $100 they lent out, and where U.S. regulators consider a bank well-capitalized at a six per cent ratio, Canadian regulators set the bar at seven per cent.

But it's a long way from this to explaining the relative performances of Canadian and, say, American banks as a simple matter of regulation versus deregulation. For one thing, the actual capital of the Canadian banks has consistently been in the neighbourhood of 10 per cent, well in excess of the regulatory standard. To be sure, banks would normally want to add some margin of safety, just to be sure of not running afoul of their overseers, but the size of the margin suggests their prudence had a commercial rationale as well, whether impressing the ratings agencies or reassuring prospective business partners.

For another, there was no deregulation of American banks in the last decade, or certainly none that had anything to do with their willingness to issue subprime mortgages. Nor was there any regulation to prohibit it here; indeed, subprime mortgages make up about seven per cent of the Canadian market. And while American banks were typically more leveraged, it's not clear that imposing higher capital ratios would have changed matters, given the American banks' heavy reliance on securitization, that is, on selling mortgages to third parties. Since the purpose of securitization was to get these assets off the banks' books (so they would not be counted against their capital), tighter capital requirements might have simply spurred even more securitization.

Finally, in important ways Canadian banks are actually less heavily regulated than the American. Canadian banks do not labour under anything like the Community Reinvestment Act, for example, which obliges American banks to extend mortgages to low-income households, even at the cost of watering down their usual lending standards. Nor is there any Canadian equivalent to the government-sponsored enterprises known as Fannie Mae and Freddie Mac, which by their own strenuous efforts to provide funding for subprime mortgages did so much to bring the system to ruin.

The truer statement about the Canadian approach to financial regulation is not that it's tighter, but that it's different. Where other countries adopt a detailed, "rules-based" approach to regulation, Canada uses a more discretionary, "principle-based" approach. The Office of the Superintendent of Financial Institutions doesn't set out a fixed formula for what it considers adequate provision against loan losses, for instance, but it knows it when it sees it - and has the power to step in to compel banks to make the necessary adjustments. Likewise, where other countries' bank regulators have involved themselves in a wider range of concerns, from privacy to racial profiling, ours have kept the focus on risk - risk, whatever its source or precise form.

An example: long before the 1999 reforms lifting the long-standing ban on American banks owning other types of financial institutions, Canadian banks were free to do the same. After the MULRONEY government's 1987 deregulation bill, most of the country's large investment houses were swallowed up by the Big Five. But whereas each subsidiary of an American banking conglomerate might be subject to a different regulatory authority, according to whether it was classed as an insurance company, investment bank, or commercial bank, in Canada power was consolidated in the OSFI to regulate the whole entity. So, far from destabilizing the banks, the brokers' absorption into the banks served to stabilize the brokers. Where a Lehman Brothers or Bear Stearns had neither parents with deep pockets nor prudential regulation to save it from disaster, our investment banks had both.

So the notion that seems to be afoot among some of our international admirers, that "the Canadian model" amounts to confining banks to the traditional deposit-and-loan knitting, untainted by any suspicion of investment banking, currency hedging, or other dark arts, is hard to square with the facts. It's not true, and it wouldn't be a good idea if it was.

Perhaps of greatest importance, Canadian banks are federally chartered, and nationally based. There never was any Canadian counterpart to state and federal laws forbidding interstate banking or even branch banking within states, which has stuck the U.S. to this day with more than 8,000 banks of hugely varying degrees of solvency, not to say competency. Likewise, Canadian banks are spared some of the wilder state laws, such as those permitting homeowners to tear up their mortgages once their houses are "under water" (when the value of the house sinks below that of the mortgage). Much of the behaviour of the American banks can be explained as an attempt to get around the limits imposed by regulation: just as the securitization craze was driven in part by banks' efforts to diversify their asset base beyond their immediate surroundings, so their traditionally greater reliance on commercial paper markets for funds, as opposed to deposit-taking, owed much to legal restrictions on the interest rates they could pay depositors.

Similarly, the Canadian banks' more restrained behaviour is probably best explained as a consequence of historical accident - dumb luck, in other words. In broadest strokes, where financial regulation in America, with its populist, agrarian tradition, has historically been tilted to the benefit of creditors - notably in the matter of mortgage interest deductibility - ours has tended to favour the lenders. Partly in response to earlier American adventures in hyper-localized "unit banking," dating back to Andrew Jackson's dismantling of the Second Bank of the United States, the FATHERS OF CONFEDERATION chose to make banking a federal matter. Banks were thus able to develop broad, national branch systems, which the best of them soon did. Indeed, in a curious way our thinly dispersed population proved to be a source of strength for the front-runners: once a bank had gone to the trouble of setting up the extensive branch networks needed to service such a customer base, each additional branch cost much less.

Economies of scale and survival of the fittest quickly served to winnow down the number of banks, from 38 in 1890 to just 10 in 1925. With the collapse of the Home Bank in 1923, the last major bank failure in Canadian history, the industry had assumed broadly its current form, with five or six major national banks (the Toronto and Dominion banks merged in 1954) dominant, all with roots going back to the 19th century. With a broad base of depositors to draw upon, and similarly diversified loan portfolios, our banks have been less hostage to the ups and downs of local economies, while the steady stream of fees from their retail banking activities lessened the need to gamble on riskier ventures. The dominance of the big five banks, moreover, disadvantageous as that can be at most times, may well be a source of strength in a crisis. Fewer, larger banks makes for greater institutional memory, better risk management, and, if necessary, more easily coordinated responses.

Still, attempts to explain our banks' ability of late to avoid the worst excesses of their international rivals in terms of a more risk-averse national culture have to reckon with repeated episodes in the past where those same banks collectively showed a talent for rushing off the nearest cliff. From the Third World debt crisis of the early 1980s, through the Dome Petroleum fiasco and Northland and Canadian Commercial bank failures later in the decade, all the way to the Olympia & York meltdown of the early 1990s, Canada's bankers have shown themselves capable of blowing their brains out with the best of them. Had they been permitted to merge some years ago as they intended, the better to compete in foreign markets, they might have spent the last decade following the global herd to disaster.

Therein may perhaps lie the best explanation for their recent, relative success. Having sown their wild oats, as it were, in previous decades - with painful, though not fatal consequences - the Canadian banks were a chastened lot by the time the party was really getting under way. A stable industry structure, a firm regulatory hand: these played their part. But there's nothing like a crushing hangover to bring a sinner to Jesus.

Maclean's April 13, 2009