Stability of Canadian Banking Sector in the Face of the Global Financial Crisis

In September 2008 what started out as a housing
bubble transformed into the worst recession that the United States had seen in
decades. Although the crisis started in the developed countries, primarily the
US and European countries, all countries around the world suffered from its adverse
effects featuring bank
failures and government bailouts. Canada, although close trading
partners with the US, and Europe was the only G7 country (Refer to Fig. 1) with
no bank failures or bailouts and faced a
significantly milder recession (Haltom, 2013). Naturally,
economists became interested in the cause for this stability, notable factors being
Canada’s undeniable conservative approach and exceptionally strict regulation.

Why were Canada’s banks stable in the face of the 2008 global financial crisis? This paper argues that the initial banking framework constructed in the early 19^th century caused Canada’s banks to be stable. First, the resulting oligopoly allowed for easier regulation and implementation of restrictions by one overarching regulator. Second, Canadian banks, known to be less risky because of diversification allowed them to be less vulnerable to shocks. Lastly, with only 6 main competitors, there was low competition not leaving room for the shadow banking industry to thrive.

This paper is organized as follows: by comparing Canada’s banking system with that of the USA we begin by highlighting the direction that the Canadian banking system took in the 19^th and early 20^th centuries. We then consider reasons why Canada demonstrated such resilience in the 2007-2008 financial crisis. Discussing this question will allow for other countries to learn and possibly implement the successful aspects of the Canadian financial system to better handle crises of this sort in the future.

Figure Source: World Bank, 2012

Note that although, there exist trade-offs
between stability and competition, defined as the “regulator’s dilemma,” the
costs of stability won’t be identified nor will they be weighed against the
benefits. This paper will focus primarily on the reasons that Canada remained
stable in the face of the economic crisis in 2008.

The stability of the Canadian banking system in the 2008 global
financial crisis is not a singular event. Throughout history, the banking
system in the US faced at least eight major banking crises in the antebellum
era, under the National Banking system and until the Federal Reserve System was
established in 1913, unlike the Canadian banking system that experienced two
minor incidences in the 1830s associated with problems in the US (Bordo et al.,
2011).

This difference originated because of the establishment appointed the
jurisdiction over chartering and regulating banks. In Canada, the federal
government and in the US, the state government. A dual banking system emerged
during the civil war when the national banking system was established in
addition to the state banking system already in place. The American banking system
restricted nation-wide branch banking whereas the federal jurisdiction in Canada allowed branching across
provincial and territorial borders. In the British North American Act that combined
four colonies to create Canada in 1867, the federal government was given absolute
authority to build the banking framework. The Canadian banking system evolved
into an oligopoly that Bordo, Redish and Rockoff described as “a cartel backed
by the federal government and policed by the Canadian Bankers Association” as
the need for a charter limited entry into the industry.

Due to these
initial institutional foundations, although Canada currently has 80 banks, 93
percent of the market share is dominated by only six with one financial
regulator[1], Office of the Superintendent of Financial Institutions
(OSFI) unlike the US that have
managed to charter 7000 banks and multiple financial regulators (the Fed, Federal
Deposit Insurance Corporation, Office of the Comptroller of the Currency and
state regulators) (Haltom, 2013).
OSFI supervises every aspect of the financial institutions: mortgages,
insurance, investments, etc.

Although
branching is no longer prohibited in the US, this one restriction created a
fragile and fragmented “unit banking[2]”
in America as opposed to the highly concentrated and stable banking system in
Canada in the face of the 2008 global financial crisis[3].

It is well known that Canada enforces strict
regulations and restrictions on their financial system. Capital requirements
such as capital adequacy regulatory standards, permissible capital deductions
and regulatory capital are amongst the most restrictive in the world (World
Bank 2012). Canada has greater debt regulation such as restrictions on
leveraging and reduced incognito leverage or off-balance sheet (OBS) items. In
addition to strict regulations, every five years, Canada reviews charters and
regulations to incorporate and adapt to innovation and unfamiliar risks that
may be developing. What allows these regulations and changes in restrictions to
be feasibly enforced and easily implemented is the highly concentrated
structure of the banking system. This facilitated coordination is also
beneficial during a time of financial crisis.

When discussing the 2008 global financial
crisis, it’s important to note the role in lack of regulation and restrictions
in causing it. The problems started with sub-prime[4]
housing loans, which by 2006 were approximately 15 percent of pending mortgages
in the US (Edey, 2009). There was a lack of regulation in identifying risk
associated with administrating credit to borrowers with unreliable credit
history and legitimate proof of income and lack of restrictions regarding
loan-to-valuation ratio. The crisis continued to develop as the securitization
of these sub-prime loans through mortgage-backed securities (MBSs)[5]
and collateralised debt obligations (CDOs)[6]
which are asset backed securities. These securities generated high returns and
incorrectly received good credit[7]
ratings by rating agencies attracting investors (Edey, 2009). The inevitable
rise in mortgage delinquencies, reaching 11 percent at its peak, on these
sub-prime mortgages that followed eliminated the confidence in these
investments as the housing bubble burst. The first impact on the global
financial markets was apparent when French banks suspended funds they were
investing in US MBSs. Other European banks and OBS agents linked to them had
also invested to a great degree in these securities making them prone to heavy
losses (Edey, 2009).

In contrast, Canada’s mortgage financing
regulations aren’t structured to allow for such careless lending. In Canada,
banks keep mortgages rather than selling them to investors. Before the
financial crisis, approximately 30 percent of Canada’s mortgages were
securitized, much less than the US which stood at almost 70 percent (Halton,
2013). In addition, less than three percent were sub-prime mortgages,
significantly reducing the risk that Canada was exposed to as tight regulation
encouraged safe mortgages (Halton, 2013). Financial institutions are prohibited
from giving loans without at least a five percent down payment. If the down
payment is less than 20 percent, mortgages are required to have insurance.
Strict restrictions for insurance are also in place as it is only approved if
total household debt-to-income ratio is less than 40 percent. These
restrictions kept mortgage default rates below the historical average of less
than one percent in Canada (BLACK**). This highly concentrated banking system
also provided incentive to banks to engage in less risky activities as a single
failure would severely injure the financial system. Due to the small number of
institutions in effect their engagement in less risky activities, OSFI
successfully prevented the failures that sub-prime mortgages brought to the
global market from entering Canada’s banks.

Figure Source: World Bank, 2012

The unit banking system of the US resulted in small,
fragile and undiversified banks. There was a chartered bank per city or region
with no branches. Historically, these small banks held similar assets which
were primarily local loans and mortgages. Leading up to the 2008 crisis, most
banks were engaging in MBSs and CDOs investments attracted by the promise of
high returns. According to the Bond
Market Association of the $25.9 trillion bond
market, mortgage debt contributed to $6.1 trillion (Lambert, 2006).
Already
less diversified than banks in Canada sub-prime lending added to this risk.
Rating agencies gave CDOs high credit ratings on the basis that they were
backed by mortgages that were regionally diversified. The CDOs were incorrectly
rated as they consisted of primarily sub-prime mortgages, the regions in which
these mortgages were issued made little or no difference to their risk.

The banks in Canada with nation-wide branching
originally started off with geographically diversified assets, customers and
risk constructed to be less risky which allows them to absorb shocks. With a
small number of chartered banks, individual banks grew to be very large and in
1987 after the Bank Act was revised to increase competition, Canadian banks
absorbed securities brokerages making them bigger than ever. This resulted in
diverse sectors, investments as well as loans credited to customers. Canadian
banks were now engaged in wealth management, insurance, mortgages lending, and securities
brokerage (Pruss, 2015). Although attractive to smaller banks, the
trade-off between higher return and high risk wasn’t one that Canadian banks
needed to weigh. Only three percent of Canadian mortgages were sub-prime which
further supports my argument that Canadian banks maintained diverse assets
despite the pull of high return that CDOs and MBSs offered. The effects of this
diversification were demonstrated historically with the small number of
recessions and bank failures that Canada has faced in comparison with the US
and in their ability to absorb shock in the 2008 financial crisis. 

The shadow banking activities, approximately 95
percent of the American economy played a large role in the global financial
crisis (Haltom, 2013). Due to the highly concentrated nature of the Canadian
banking system that fostered low competition and enforced tight regulation, the
risky shadow banking industry didn’t have the same demand or freedom to grow
the way it did in the US. The financial sector in the US consisted of two
parallel banking systems, one that was regulated by multiple parties and
another that transformed from investment banks and other financial
intermediaries into the shadow banking industry, a market for activities
restricted in the first (Bordo et al., 2011). Naturally, high risk activities
gravitated towards the shadow banking industry which had vague restrictions and
were mostly outside the regulatory umbrella (Haltom, 2013). This lack of regulation was
followed by a lack of understanding in the risks associated with the industry
as confidence levels were almost equal to that of the regulated sector. Krugmen
(2009) claims that the problems associated with the crisis are less from
deregulated institutions instead involve risks associated with “institutions
that were never regulated in the first place.” As
the shadow banking industry grew, the US moved towards the same financially
vulnerable position that they experienced before the Great Depression. In
addition, the Bush administration used their power and relation to the Office
of the Comptroller of the Currency to eliminate any attempt to regulate
sub-prime housing loans (Krugman, 2009).  

In the decades leading up to the global
financial crisis, the Canadian banking system diverged further from that of the
US. Following the 1987 Bank Act revision, Canadian banks began engaging in
securities brokerages, mortgages and other activities that in the US, unregulated
institutions partake in. OSFI
overtook the affairs of the Inspector General of Banks as well as the
Superintendent of Insurance becoming the sole regulator of all federal
financial institutions in Canada overseeing in addition to the bank, pension
funds, insurance and trust companies. With increasing risk, Canada increased
their regulation. Only approximately 40 percent of the Canadian economy
includes shadow banking activities, a considerable fraction of which Canada’s
banks have committed to. In addition, 60 percent of these are insured and have
access to lender of last resort thus protected by the federal government. The
competitive and unregulated environment that allowed the shadow banking
industry to grow in the US didn’t exist in Canada.

Countries around the world were left crippled in
the face of the 2008 global financial crisis, the most notable being the US where
the crisis originated and developed. Canada was one exception as its banking
system remained stable with no bank failures or government bailouts. Throughout
history, in comparison to the US, Canada has suffered through less recessions,
less panics and less bank failures. In the 2008 global financial crisis, Canada’s
resilience is to be noted as it was a result of the nature the original banking
framework created in the 19^th century. Canada’s highly concentrated banking
system allowed for tight regulation, diversification and low competition in the
industry resulting in a less risky sector equipped to absorb the disastrous crisis
of 2008. Although, Canada’s history has played a large part in constructing
this stable system and any one solution or explanation for financial stability
won’t miraculously save a nation, there is a great deal that other countries
can learn from Canada to better equip themselves to handle crises in the
future.

References

Bordo, Michael D., Angela Redish, and Hugh Rockoff. “Why Didn’t Canada
Have a Banking

Crisis in 2008 (Or In 1930, Or 1907,
Or…)?” National Bureau of Economic Research Working Paper No. 17312, August
2011.

Haltom, Renee.
“Why was Canada Exempt from the Financial Crisis?” Econ Focus, Fourth Quarter, 2013, pp. 22-25. Refer to:         https://www.richmondfed.org/~/media/richmondfedorg/publications/research/econ_focus/2013/q4/pdf/feature2.pdf

World Bank. Crisis-proofing
financial integration: Canada, June 2012, pp. 30-33. Refer to: http://siteresources.worldbank.org/ECAEXT/Resources/258598-1284061150155/7383639-1323888814015/8319788-1324485944855/03_canada.pdf

Edey, M. (2009), The Global Financial Crisis and Its Effects. Economic Papers: A journal of applied economics and policy, 28: pp. 186-195. Refer to: http://onlinelibrary.wiley.com/doi/10.1111/j.1759-3441.2009.00032.x/full

Krugman, Paul. The
Return of Depression Economics and the Crisis of 2008. New York:
W.W.

Norton & Company, 2009.

Lambert, G.D., 2006. Profit From Mortgage Debt With
MBS. Investopedia. Refer to: http://www.investopedia.com/articles/06/mortgagebackedsecurities.asp

Pruss, L., 2015. USA vs. Canadian Banking Systems. HQ Mortgages Inc. Refer to: http://hqmortgages.ca/2015/10/06/usa-vs-canadian-banking-systems/

[1] Although securities
markets are provincially and territorially regulated, they work cooperatively

[2] many individual institutions but no branches

[3] the
advantage to the highly concentrated system in Canada was also apparent during
previous financial crises that both countries faced

[4] loans that do not
meet standard criteria for good credit quality

[5] asset backed security
backed by a mortgage or collection of mortgages

[6] pool of assets – mortgages
– that are debt obligations that act as collateral

[7] Received high ratings
based on geographically diversified mortgages