Mark T. Williams is author of Uncontrolled Risk: Lessons of Lehman Brothers and How Systemic Risk Can Still Bring Down the World Financial System. He also teaches finance at Boston University's School of Management and is a former trading floor executive and Federal Reserve Bank examiner.
At the G-20 meeting that concluded yesterday and will resume in the fall, we were reminded that Canada is uniquely positioned to share with other global leaders the lessons of how it kept its banks financially sound. Since the Great Credit Crisis of 2008, more than 200 American banks have failed while no Canadian banks have done so.
Canadian banking is in an enviable position with healthy institutions, no need for multibillion-dollar taxpayer bailouts, and no necessity for financial regulatory overhaul. And there is no secret to the nation's formula for success -- Canadian regulators and bankers are more boring than their Wall Street cousins when it comes to taking risk.
Strong regulatory constraints
Since the repeal in the 1980s of the Canadian equivalent of the Glass-Steagall Act, banking laws and oversight has not been loosened, in stark contrast to the regulation-light approach in America. Canada has embraced a universal banking model, and its top five banks represent approximately 90 percent of its banking business. The United States has more than 7,000 banks. In the world economy, its vast number of commercial banks is an anomaly.
In Canada, big banks are chartered by the federal government and diversify risk by conducting business in every province. As part of the 1980s' Canadian banking reform, most investment-banking activities have been performed within major commercial banks, which are required to comply with higher standards for capital and oversight.
Significantly, unlike the United States, Canada has only one bank regulatory body, the Office of the Superintendent of Financial Institutions (OSFI), which prevents banks from being able to shop regulators. A single regulatory voice also ensures consistency in how banks manage risk.
The OSFI sets regulatory standards that are higher than Basel II requirements, and banks are asked to set internal capital targets to provide a cushion against unexpected losses. Such higher capital standards are not mandated by the Federal Reserve or the Office of the Comptroller of the Currency. The OSFI requires a Tier 1 and Total Capital Ratio of 7% and 10%, respectively. In contrast, Basel II requires only that commercial banks retain 4% and 8% for these same ratios.
During the financial crisis, all major Canadian banks maintained capital levels in excess of minimum regulatory requirements. Tier 1 capital, the most liquid buffer against financial losses, averaged almost 10%. Their American counterparts averaged approximately 7%. Canadian banks tend to maintain asset-to-capital, or leverage, ratios of 18-to-1 while at the market peak some American banks were at 26-to-1.
Tighter regulator constraints paid off. Unlike in America, no Canadian banks needed government TARP-like capital injections. At minimum, Canadian regulators and policymakers appear better at managing their financial system.
Mortgage market
Mortgage securitization also played a smaller role in Canada. In the U.S., it was typical for banks to securitize at least half of their originated mortgages, while in Canada this figure remained at about 25%. Given that Canadian banks held more of the loans they made, there was a built-in incentive to make better loans.
Underwriting standards also were higher in Canada. Historically, when lending in the residential home market, Canadian bankers require down payments of 20% to 25%. No- or low-money-down loans never caught on in Canada.
Unlike in the United States, home loans in Canada are full-recourse, meaning that a default allows the bank to go after other borrower assets to meet payment obligations. Borrowers thus have an added incentive to fulfill their contractual obligation. Moreover, mortgage loans are typically issued for longer fixed-rate periods or reset only after five years. Canada's mortgage market was therefore insulated from the risk associated with shorter-term, adjustable-rate mortgage products that might initially make it cheaper to buy a home but cause financial havoc if interest rates spike.
In this more conservative lending environment, subprime lending was kept to a minimum in Canada. Fewer than 7% of mortgage portfolios were subprime, while for American banks, subprimes made up more than 20%. Canadian borrowers were less likely to get mortgages they couldn't afford.
When the housing bubble popped, the United States saw prices drop by as much as 25%; Canada experienced a drop half as much. One explanation was that Canada's tax code does not provide interest deductions and added incentive for overconsumption.
Last, there are no government-sponsored enterprises in Canada, such as Freddie Mac or Fannie Mae, used to support the market and encourage broader homeownership. Despite having no explicit social policy to promote greater homeownership, 68% of Canadians own their home, similar to the number in America.
It's not just that Canadian bankers have a more conservative appetite for risk, but it appears that their customers also are risk-averse. Unlike America borrowers, 70% of Canadian credit card holders pay off their balances monthly. In the U.S. it's less than 60%.
Should we have Canadian-style regulatory reform?
From a risk perspective, Canadian bankers and regulators passed a real-life stress test. They proved that, as in a 15-round boxing match, taking a more cautious strategy and protecting themselves against excessive risk prevented a knockout. And when the final bell rang and the financial crisis had subsided, they had won.
A decade ago, no Canadian banks made North America's top-10 list. Today, there are four on it: Royal Bank of Canada (NYSE: RY), Toronto Dominion (NYSE: TD), Bank of Nova Scotia (NYSE: BNS) and Bank of Montreal (NYSE: BMO). It's notable that Canadian banks didn't move up in the North American ranks from growing massively in asset size (or risk-taking). In the past few years, the top banks have grown by only 8%. The real change was that their competition -- American banks -- lost more than $350 billion in assets, with many going bust.
The major takeaway is that "boring" and "banking" should be spoken in the same sentence. When that can be said again for American banks, we will be on the right track toward meaningful reform.
