A funny thing happened on the way to the recent global financial meltdown. Our northern neighbor, Canada, has just six banks, all “too big to fail.” But not one of Canada’s banks failed—or even come close. As reported by Fareed Zakaria in Newsweek, the World Economic Forum in 2008 labeled Canada’s banking system the healthiest in the world, while that of the United States languished in 44th place.
Why have Canada’s banks continued to prosper while so many in the United States, Britain and Europe either failed or required massive government bailouts? New York Times columnist Paul Krugman claims it’s because Canada has a financial consumer agency that restricts subprime lending, and because the U.S. banking system is plagued by “Reagan-era deregulation.” But Krugman is wearing his usual political hat—or, rather, blinders—conveniently ignoring the role of Congress, the Department of Housing and Urban Development, and the government-sponsored enterprises Fannie Mae and Freddie Mac, whose edicts to increase U.S. home ownership added gasoline to the fires of banks making loans to home buyers who couldn’t afford them.
Zakaria attributes the stability of the Canadian banking system to several factors. First, Canada has maintained common-sense regulations that kept bank leverage well below that of United States and (especially) European banks. Second, Canada doesn’t recognize mortgage interest as an income tax deduction, avoiding a massive tax incentive for individuals to over-leverage their home purchases. The Canadian home ownership rate, at 68 percent, is almost identical to that in the United States, so rethinking the mortgage interest deduction here may be in order.
A third factor aiding Canadian bank stability cited by Zakaria is that Canadian lenders have recourse to other assets of defaulting buyers, unlike the United States, where mortgages are usually “non-recourse.” Home buyers here feel free to walk away with impunity from a mortgage when the value of the mortgaged property falls below the amount of debt against it.
A somewhat more scientific explanation for the greater soundness of Canadian banks comes from Rocco Huang of the Philadelphia Fed and Lev Ratnovsky of the International Monetary Fund (IMF) in Washington. In a July 2009 IMF working paper, Ratnovsky and Huang reported the results of their study of the impacts of the 2007 and 2008 credit crisis on banking and financial systems of the developed market economies of the world. They noted:
“The impact of the credit turmoil on Canada appeared serious but clearly mild in comparison with a number of other OECD (Organization for Economic Cooperation and Development) countries…Public bank recapitalizations were not needed, and government guarantees on bank funding (put in place for precautionary reasons) were not drawn upon. This resilience may appear somewhat surprising given the high exposure of the Canadian economy to the U.S. economy, and highlights the fundamental strengths of Canadian banks.”
Canadians often take the rap for being “boring.” Given our experience of the 2007-2008 credit meltdown, when it comes to banking, boring seems pretty good.
So why did Canadian banks fare so well compared to those of other developed countries? Banking regulators typically focus on capital structure (how much capital versus how much debt) and liquidity measures (how quickly bank assets can be turned into cash). Ratnovsky and Huang found that the capital and liquidity ratios for Canadian banks going into the 2007-2008 credit meltdown weren’t markedly different from those in other developed countries. However, the Canadian banks funding structure was significantly different.
Canadian banks rely primarily on funds from retail depositors, whereas banks in other countries that ran into problems relied much more heavily on “wholesale funding”—short-term deposits from other institutions. Using statistical analysis, Ratnovsky and Huang found reliance on wholesale funding was the single best predictor of banks likely to get into trouble and require government bailouts when the financial crisis arose.
In addition to better funding structures, Canadian banks also operate in a more conservative regulatory environment. Canadian banks are required to hold greater capital than banks elsewhere, and limits are placed on the amount of short-term wholesale funding on which Canadian banks can rely. Also, the Canadian mortgage market is considerably more conservative than that of the United States. Mortgages of more than 80 percent of the value of the real property securing them must be insured for the full amount of the loan, not just the amount over 80 percent as in the United States. And only 30 percent of Canadian mortgages are securitized (sold to investors), compared to 60 percent in the United States.
The current debate over financial and banking regulatory reform in Washington has assumed the typical giving-birth-to-elephants approach. Do we really need to reinvent wheels here? If some relatively simple and straightforward requirements permitted Canadian banks to avoid blowing up in the face of a deflating U.S. real estate bubble, shouldn’t we regard those requirements as “best practices” and figure out how to apply them to banks here?
