Canada has earned much praise for the soundness of its banking of system, and for good reason.
It weathered the financial storm well and has been honored with the World Economic Forum’s top rating for soundness annually since 2008. Its record dating back to the 1920s and even earlier has been marred by only a few failures of trust companies and small banks.
Canadian financial institutions did not escape the financial crisis unscathed. The market value of the Big Six banks fell by 44 per cent in the two years following the start of the crisis. The government responded by putting together a substantial support package.
The central bank undertook larger and more frequent purchase-and-resale agreements, provided new longer-term credit facilities, and accepted a broadened range of collateral for borrowings.
The federal housing authority agreed to purchase up to $75 billion insured mortgages from financial institutions to give them liquidity, and the government itself offered guarantees for new unsecured debt issued by financial institutions, though the offer in the end was not taken up.
While less drastic than measures taken elsewhere, these dwarfed any previous efforts to support Canada’s financial institutions. Even though the banks’ relative strength might suggest the package was not needed, banks’ shares soared by 15 percent when the initial measures were announced and again in response to the guarantee program. The market reaction shows the measures did much to build confidence in Canadian banks.
Canada also experienced a meltdown in its market for asset-backed commercial paper (ABCP). The market was made up of so-called conduits, whose business was to hold long-term assets, including risky derivatives, financed by selling short-term commercial paper, mainly to large investors such as pension funds.
As doubts emerged about the U.S. sub-prime mortgage market in 2007, the market for the conduits’ notes dried up. Bank sponsored conduits were rescued by their parents, but conduits sponsored by others were unable to attract the funds needed to meet their maturing obligations.
After prolonged negotiations, the parties reached a resolution under which small investors were made whole and the others received claims on asset pools based on their conduit’s holdings. Despite the $32 billion failed claims on non-bank conduits, the troubles were contained and did not spread beyond the ABCP market.
Regulators in Canada were fortunate that they did not have to deal with some issues that fueled the crisis elsewhere. The housing market avoided the collapse experienced in the U.S. and the status of the agency insuring most mortgages was clear: It and its private counterpart were both backed by the federal government.
In addition, investment banking did not present the same threat to financial stability as in the U.S. Once the legal barrier separating commercial and investment banking was removed in the 1980s, the largest banks came to dominate investment banking.
Integration of investment banking within the large banks appears to have cushioned any financial shock it might have caused during the crisis.
Canadians fortunately learned the lessons of the world banking crisis at lower costs than others. The strong performance of the Canadian financial institutions through the crisis resulted from a combination of forces: the structure of the banks, the nature of their business, the design of the regulatory framework, and the authority’s approach to regulation.
I. The business of Canadian banking
The Canadian banking system has been historically dominated by a few large banks that have been sheltered from competition by formidable barriers to entry. Over time, the barriers have been relaxed.
The entry of foreign banks was first permitted in 1980 and eased over time, while the powers for other deposit-taking financial institutions have been progressively expanded. Still, the six largest banks account for more than 75 per cent of the assets of deposit-taking institutions.
The banks have never faced any restrictions on branching and have always been able to use nationwide branch networks to gather deposits. An International Monetary Fund study found that their dependence on this stable source of funding allowed the banks to withstand the financial crisis better than banks that depended on wholesale funding.
II. The regulatory framework
As in other countries, the regulator has been established as an independent agency. The regulator’s independence has been further strengthened through its approach to staffing. Senior staff members of U.S. agencies are often political appointees drawn largely from the financial and associated industries who move through a revolving door following government changes.
Staff members in Canada tend to be career civil servants with much less movement back and forth with the financial industry.
Independence also applies to the development of financial rules. Legislation in the U.S. is developed in Congress and in its committees where members are targets for vigorous lobbying and reap substantial campaign contributions from the financial industry. Legislators offer amendments that cater to special interests in return for their overall support for the legislation.
In Canada, such influences are minimized: The ministry of finance develops legislation and presents it to parliament with assured support from the governing party.
The Canadian regulatory environment has also clearly defined responsibility and accountability. The federal government has sole jurisdiction over Canada’s major financial institutions and vests its authority in a single financial regulator.
That regulator has only one objective: protecting the rights and interests of depositors, policyholders, and creditors of financial institutions. The assignment of authority to a single agency firmly establishes its responsibility and the assignment of a single objective to that agency makes clear whether failure to achieve its goal resulted from tradeoffs with other goals or just poor performance.
In addition to their duties for monetary policy, the central banks of the U.S. and U.K. share responsibility for financial regulation. This consolidation of responsibilities has been justified for allowing information derived from one activity to be used for the other.
Canadian authorities have instead tackled the problem by requiring agencies to share information relevant to the supervision of financial institutions through an interagency committee, an arrangement that has worked well according to the government auditor.
III. Approach to regulation
Experience shows that financial markets can change quickly and regulators must be able to respond nimbly to market developments to keep up with the regulated. The Canadian approach gives the regulators the capacity to respond in a number of ways. At the operational level, regulators issue guidelines based on principles, rather than set rules, that can be quickly adapted to changing conditions.
This flexibility allowed the regulator to raise bank capital requirements against credit lines committed to ABCP issuers well before problems emerged in that sector.
This step discouraged Canadian banks from offering liquidity to non-bank conduits and let them avoid the cost of that market’s collapse. This flexibility to adapt guidelines quickly contrasts with the processes in the U.S., where it took years to draft regulations based on the 2010 Dodd-Frank Act.
The use of guidelines is also much simpler than prescriptive rules. Canada’s Guideline B-4 dealing with securities lending consists of only four pages with five sections, whereas the comparable U.S. Regulation U rule uses 23 pages for 32 sections and is itself supplemented by Regulation X. The Canadian approach gives financial institutions themselves the leeway to manage security lending whereas the U.S. approach specifies numerous minute details. (see sidebar)
Guidelines may not always be sufficiently specific to deal with every issue. In these cases the regulator has resorted to some rules. Still this simple, predominantly principles-based approach has the benefit of saving the cost of compliance for financial institutions and lowering the enforcement costs for the regulator by allowing them to focus on essentials.
Further flexibility arises from the distinctive sunset clauses that require renewal of financial legislation every five years. These renewals have often led to thorough reviews of the financial system that have influenced the subsequent evolution of financial legislation and regulation. This flexibility has allowed the regulatory framework to keep in step with financial market developments.
Canadian authorities have a track record of using their flexibility to go beyond international capital standards by requiring deposit-taking institutions to maintain more capital than the Basel II standards and to hold more shareholder equity in their capital.
They also subjected deposit-taking institutions to an asset-to-capital ratio that limited their leverage. Both these measures contributed to the Financial Stability Board’s praise for policies that exceeded minimum international standards. The regulator has now announced that the six largest banks designated as being of domestic systemic importance will need to meet a capital surcharge well before the Basel III target of 2019.
IV. Stability and other objectives: Was there a tradeoff?
Canada’s approach to regulation has done well in preserving the soundness of financial institutions. Regulation, however, affects other aspects of economic performance including efficiency and economic growth. Has Canada’s emphasis on soundness come at the expense of other goals?
On the whole, the Canadian broadly principles-based approach minimizes the impact of regulation on efficiency. While legislation does restrict banks to the business of providing financial services, the respective acts specify a host of permitted activities.
The manner in which institutions perform these activities is generally governed by broad guidelines directed toward assuring practices that are compatible with safety and soundness, leaving institutions with broad scope for their business practices.
Recently, however, a former governor of the central bank has expressed concern that emphasis has been shifting away from principles toward more prescriptive rules and greater complexity. With the adoption of the Basel III, the documentation for capital requirements in the U.S. and U.K., for example, has mushroomed from the less than 20 pages for Basel I to over 1,000 pages, significantly increasing the costs of compliance.
These costs could be justified if they were necessary for the safety of the financial system. Evidence suggests, however, that simpler leverage ratios, as adopted in Canada, protect stability more effectively than complex capital ratios found in Basel III.
Available measures suggest Canadian financial institutions do fairly well with respect to lending to the private sector. In contrast to most foreign financial institutions, they maintained their private sector credit throughout the period of financial stress and have expanded it ever since.
They also perform quite well with respect to the cost of credit.
As far as the difference between lending rates and the costs of government borrowing is concerned, Canada ranks third lowest among eight high-income countries, following only Japan and the U.K.
The Canadian financial system has gained much praise for its performance during the recent financial crisis. But each financial crisis is different and survival in one does not assure survival in the next. The soundness of Canadian financial institutions predates the crisis by more than 100 years and builds on a solid framework governing financial regulation.
The framework assigned a single objective, the soundness of financial institutions, to a single financial regulator; allowed the banks to develop national branch networks that gave them stable deposit funding; and it offered the regulator flexibility to respond to changes in financial markets.
The regulator responded with foresight and determination to ensure Canadian financial institutions could weather the crisis. The banks did not escape unscathed but they fared better than most others.