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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 19th 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 19th and early 20th 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, 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” in America as opposed to the highly concentrated and stable banking system in Canada in the face of the 2008 global financial crisis.
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 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) and collateralised debt obligations (CDOs) which are asset backed securities. These securities generated high returns and incorrectly received good credit 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 19th 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.
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/
 Although securities markets are provincially and territorially regulated, they work cooperatively
 many individual institutions but no branches
 the advantage to the highly concentrated system in Canada was also apparent during previous financial crises that both countries faced
 loans that do not meet standard criteria for good credit quality
 asset backed security backed by a mortgage or collection of mortgages
 pool of assets – mortgages – that are debt obligations that act as collateral
 Received high ratings based on geographically diversified mortgages
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