Our so-called genius banks

Is Canada’s banking system really so smart, writes Andrew Coyne, or have we just been lucky?

Our so-called genius banksOne 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 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 restrain-ed 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.

Yet 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.




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Our so-called genius banks

  1. Of course it’s mostly luck! It always is why do you think they call it a fortune when you get one (from the word fortunate) it’s luck being at the right place at the right time and making the right decision! The same can be said for every major invention in human kind. Never once was it a well planned and thought out endeavour with a good business plan – NEVER – it’s always a so and so was there doing this when that happened and they did the other thing – this is an ancient principle called serendipity and to ignore it is to live in a dream land. The fact remains though through a series of decisions (always made for other reasons) a few people (always the ones you never thought about) were somewhere at the exact time when soomething happened and they mad the right call – now some people call this skill or intuition or some other such non sense because it just happned and the call they made was the right one ask Bill Gates, Isaac Newton or Zeno it doesn’t matter it’s always the same even Obama – think about it. It wasn’t all skkill, savvy planning and nice orderly well thought out process that got him elected. It was a series of serendipitous events all lined up and he made the right call in otherwords he was lucky!

  2. You don’t like J.M. Barrie? Aren’t all those Geniuses at the G-20 wearing their G’s big on their shoulders right now? lol. and isn’t they o’erlookin all them theirs bankin’ regulations, as you pointed out…”Revise Tax Code…2 pm…”. Now I know AC has a sense of humour, so it must be the diligent macleansians deleting my comments.. push push push…the unwelcome…the welcome…

  3. Coyne makes a compelling argument that the soundness of Canadian banks is somewhat overrated, but, as he concedes several times in the column, the positive reputation of Canadian banks is based in reality. I’m sure that luck had something to do with the fact that our banks had only $20 billion or so in write-downs, but it was also due to the unique attributes of the Canadian system.

    Few Canadians have ever heard of OSFI, but I have a hunch that the OSFI regulatory model will eventually be adopted by other countries.

    • What is the source on the $20B – this is a higher number than I’m familiar with – does anyone have it? And is this including provisions for credit losses or is it over and above?

  4. Only Coyne could make the soundness of the Canadian banking system seem like a negative, or at the very least, like nothing to brag about.

  5. 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

    Surely, Andrew, you know the difference between a creditor and a borrower? Or are you just making stuff up?

    • Oh jeepers. Brain cramp. Of course I meant borrowers.

      • Some copy editor needed more caffeine. It’s pretty obvious from the context you meant the opposite of what you said. (That’s the beuty of prallel construction.)

        • Sheesh. “beauty of parallel construction”

          • See? Everyone makes mistakes. ;-)

    • Tedious and unedifying, Coyne.

  6. I think one conclusion should be made from Coyne’s cautious assessment of the Canadian system. So far, so good, but you can’t be complacent and maybe it works until it doesn’t.

  7. The only reason Canadian banks are ‘sound’ is that they are tremendously uncompetitive. This is not a virtue. It means that our potential for economic prosperity is severely limited by our lame financial institutions.

    • Right, Canadian banks are uncompetitive compared to all those “competitive” yet unsound banks that have failed, and are currently being bailed out by national governments to the tune of hundreds of billions of dollars. Perhaps you fail to grasp the magnitude of this calamity.

      • Not at all. But when you never take a risk as a bank, not only do insulate yourself from failure, you insulate yourself from success. Just ask anybody who runs a small business in this country what it’s like to try to get finance to expand. What happened in the United States with subprime mortgages and their associated derivatives was driven in part by the very competitive nature of their banks. Unfortunately, the other side of that equation, the ‘Greenspan put’, meant that they could just go on being crazy because they knew that the government would bail them out. And it did. That’s not even capitalism anymore, I don’t know what you would call it other than an unmitigated disaster.

        • Mulletaur – I’m not saying I disagree but could you provide some evidence – aside from “asking anyone who runs a small business” – on how our banks are uncompetitve? It’s a big assertion to make without an argument.

          • “It’s a particularly odious form of argumentation that demands evidence for everything, especially the stunningly obvious,”

            Weep for humanity.

          • Hey.. you know some other things that are stunningly obvious?

            The sun revolves around the earth.
            Heavier things fall faster than light things.
            Hair and fingernails continue growing after death.
            Water drains backwards in the southern hemisphere because of the earth’s rotation.

            Unfortunately, when evidence is gathered, it seems they’re all wrong. I give your assertion equal chances.

          • I am looking for reliable quantitative evidence and will respond in due course.

          • Actually, Mulletaur, now that you’ve expanded on your original comment, I agree with some of your points. Canadian banks have been excessively cautious with some of their lending (e.g. loans to small businesses and entrepreneurs) and yet commendably cautious with other financial activities.

          • Mulletaur – I’m not sure I would use total lending as a proxy for competitiveness but I take your point. That said total shareholder return, profitability, efficiency ratios, deposit base, AuM, etc. etc. etc. etc. are all pretty relevant when assessing a bank’s competitiveness. Even Tier 1 capital ratios.

            I agree though that our banks generally have a much lower risk appetite. And I partially attribute that to the fact that it’s easy money in the Canadian oligopoly.

  8. 44

  9. Our bankers are not that bright and they’re not that virtuous. BMO tried an end run around Paul Martin to merge with RBC in 1998. Martin put a knife in it.

    Shortly after, BMO tried it again, this time with Scotiabank. Who could have guessed that Martin would knife that one too.

    Then the best and brightest walked face first into Enron. Our brilliant bankers coughed up billions in legal settlements.

    Now our banks are sitting with tens of billions in derivatives on their balance sheets. Are there any bank execs that really know what’s in those scary looking numbers? I worry because if there’s an idiot scheme out there it seems they’ll fall for it.

    We have too few big banks. There is way too much destructive power in way too few hands.

  10. Don’t you just hate it, Coyne. Canadian banks have been the subject of scorn by the self-appointed elite in the media for so long they just can’t stand the accolades for their objects of jealousy. The headline clearly spells out your jealousy and contempt for the banking system. You would have loved the Freddie Mac/Fannie Mae fiasco–until it came crashing down around YOUR ears.

  11. Ah, the wisdom of bankers and their federal overlords … or is it the other way ’round, I forget.

    Being something of an XXL sized banana republic economy, the rest of the world would not spend a lot or invest a lot in Canada, except as needed to secure vital commodities like wheat, coal, lumber, potash, etc. Nobody was much interested in bidding the price of our real estate up to the moon or lending provinces the money to pay for unlimited drunken-sailor deficit orgies like say, Calif. or Mass.

    The Scotch weren’t cheapskates because they inherited a prudent gene, it’s because nobody would lend them any damn money. “Show me the mutton, Jock!” (“Show me the natural gas, Hoser!”)

    But stay tuned. All the bubbles have not burst, all the derivatives have not been unwound, and all the rotten pension funds have not been exposed. The worldwide banking system is based on the premise that, yes sir, there IS a free lunch, as long as you can put it on credit, and then keep rolling over the credit forever. “Sure we borrow a lot, but we make it up on volume!”

    If Canadians aren’t directly caught with their pants down, they’ll get caught anyways when the price of bananas drops through a hole in the floor.

  12. The only reason our Canadian banks survived the meltdown is because our Federal Government did not allow them to “directly” leverage their balance sheets up to their US counterparts. Trust me, they would have if they could. By default, they are superstars and collected their $5mln plus wages.

  13. Seems to me the only reason they survived as well as they did was decent, rigorous government regulation to ensure they didn’t run amok like sailors on shore leave like the rest of them. Hmm… what does that tell me? That at least in this case, government worked and business didn’t.

  14. Oh, and by the way, before we all get too sanctimonious about how “genius” our banks are, one may well ask why they are trying to ease the “mark to market” accounting rules for some debt instruments :

    http://www.theglobeandmail.com/servlet/story/LAC.20090408.RACCOUNTING08ART1943/TPStory/?query=Banks+push+for+adoption+of+U.S.+accounting+rule

    If our banks don’t want to mark to market, it means they are holding garbage and are afraid to take the write downs. So far they have taken the hit to the tune of $20 billion. I am certain that the real situation is much worse than this (i.e. they are holding a lot more bad ABCP from the United States than they are letting on) but Canadian banks have been under no pressure to bring their books in line with market reality. I am wondering what really took place during that crisis meeting Flaherty had a while ago with the heads of all the major banks. Not much news came out of it, but meetings like that don’t happen for nothing.

  15. In my opinion, it boils down to just three factors, both of which happened somewhat by luck, in order of decreasing relevance:

    1. Lack of competition in the retail market. Canadian banks don’t go on crazy, exotic, risky missions to make slightly more profit, because their RoE for their retail business (50% of their revenue, for most of them) is so damn high. Mid 20% high. Why ratchet up the risk, so you can recreate a huge American like investment bank and only make 15%, when the core of your business is making way more than that with so little risk? Our investment bankers were as dumb (and still are as dumb) as any other investment banking group was, they just weren’t allowed to roam free like others were.

    2. OSFI. Principals based regulation means than when OSFI tells you to jump, you ask how high, and then thank them for the pleasure of jumping for them, OR ELSE. Rules based regulation means that when one of the branches of the Federal Reserve or SEC tells you to jump, you hop, then send a team of your best analysts to find a way to make sure you can keep doing what you are doing but dot the i’s, cross the t’s, and make the regulator go away forever. The difference between the two approaches is huge.

    3. Decoupling of pay to performance. Canadian banks never tried, for the most part, to compete with the Goldman Sachs’ of the world. If some hot shot associate wanted a 1mil bonus because he took absurd amounts of risk but was thus absurdly profitable, most MD’s would just go tell him to move to New York or London. That type of thing didn’t fly too often on Bay St, except for the exceptionally talented. Thus, the incentive to risk blowing up your firm to get that 1mil was never really was there. Better to blow up an American firm, instead. And oh boy, did they ever.

  16. And to expand on my first point in my above post, I don’t necessarily think these are GOOD things.

    We can preach to the world about the stability that lack of competition brings, but they can preach right back at the stagnant knowledge economy, stifled investment, and complete inability of anyone anywhere to get financing in Canada, all due to the uncompetitive, 25% RoE nature of our banking system.

    Basically, are you an entrepreneur? Have a great idea? Do yourself a favour. Move to California. Don’t worry, you’ll find hordes of other Canadians just like you. For all the faults of the decentralized banking system, it puts more money into more hands. Yes, it’s more unstable, but it also generates more growth.

    • Yeah, I agree with almost all of that. We need to find new and innovative forms of financing which do not involve banks lending money or underwriting share issues if we want to lift our level of prosperity to Yankee levels, because our banking system sure as hell ain’t deliverin’ on that one.

      • But doesn’t that assume that the Yankee levels of prosperity are at all sustainable? Why should we want to rush after them to recreate a system that, from all appearances, simply can’t work over the long term?

        • On average over the long term they do better than us. There are lots of reasons for this, but their banking system is definitely one of them.

  17. This is going to change…quickly.

    It may be touted as the world’s soundest banking system, but in fact it is merely the “world’s soundest FIAT CURRENCY SYSTEM.”

    Our currency is not backed by anything more than the high-grade air that currently backs all other FIAT currencies of the world today, incuding the US Dollar.

    When the US dollar collapses–and I believe that all indications are pointing towards such a collapse, including the obviously “closing society” that the US has become over the last few years–suddenly, the realization that all major companies in Canada are foreign owned, and that the vast majority of those are from the United States…does anyone honestly believe that the Mighty Empire will choose to keep Canadian plants open in favor of the job losses of their own people?

    Are Canadians so short sighted that they can’t see the obvious crosshairs that our government has allowed us to be placed into?

    Surely someone other than myself is capable of seeing the rather brownish looking fan staring back at us from that dark corner noone usually looks towards?

  18. It’s true that Canada has allowed foreign ownership of a very high percentage of its companies unlike many other companies such as Japan or France. The jury is still out regarding the consequences of this. One consequence seems to be that both Japan and France are major creditor nations rather than the reverse.

  19. So the banks are solvent?
    Is that helping our economy?
    Not a bit !
    The economy is still tanking. Too much said about the banks, auto industry, big business in general. Thats not the economy. The economy is me, the consumer. And as long as my money is under my matteress the economy will go nowhere. Less taxes and lower prices and I may start to buy again. Untill then, wallow in the muck.

  20. With respect to the ABCP crisis, it was the international banks that balked at lending against their obligations. Not the Canadain banks. You are mistaken.

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