This is a piece I received from TD Bank and their Economics group discussing the banking issue in Canada. It sends a strong message that the investment world is happy with the Canadian Banking business.
TD Economics
WHY CANADA’S BANKS HAVE FARED BETTER THAN THEIR
INTERNATIONAL PEERS DURING THE CREDIT CRUNCH
February 24, 2009,
Economic Notes
• There appears to be a more risk adverse culture
in Canada running through government, the
public and banks
• Canadian banks benefited from prudent and
disciplined risk management practices
• Higher capital ratios pre-crisis and the fact that
Canada’s major investment banks were part of a
large diversified financial services institution
also played a role
In the midst of the recent global financial carnage, the
Canadian banking system has weathered the storm far
better than its international peers. Canada has not experienced
the failure of any major financial institution. While
financial losses were incurred and mistakes were made,
as evidenced by the exposure of some Canadian firms to
U.S. subprime paper, the degree of the losses experienced
in Canada have paled in comparison to those recorded in
the U.S. and European banking systems. This outcome
supports the World Economic Forum assessment in October
2008 that Canada had the soundest financial system in
the world, with a rating of 6.8 out of 7. The natural question
is why Canadian banks have fared so much better?
There are number of reasons. The most basic answer
is that Canadian banks pursued more prudent and more
disciplined risk management practices. This can be observed
by a number of trends.
Solid capital ratios
Canadian banks are regulated by the Office of the Superintendent
of Financial Institutions (OFSI). And, OFSI
was one of the first national regulators that signed on to
the Basel II capital framework. The Canadian regulator
requires the banks to have a Tier 1 capital ratio of 7%.
However, the Canadian banks view the regulatory requirement
as a minimum, and in practice the median was well
above the requirement. In December 2007, before the
credit crunch intensified the following year, the median Tier
1 capital ratio of the Canadian large cap banks was 9.6%.
This is a higher capital ratio that in many other countries.
For example, the regulator in the U.S. is the Board of Governors
of the Federal Reserve System (FRB) and it did
not sign on to Basel II. The FRB requires a bank holding
company to have a Tier 1 capital ratio of 4% if it is to be
deemed adequately capitalized. To be considered well
capitalized, a bank holding company requires a capital ratio
of 6%.
However, it should be stressed that many U.S. banks
were well capitalized heading into the financial turmoil and
most U.S. banks well exceeded the minimum require-
ment. Nevertheless, the U.S. capital ratios were below
those in Canada. For example, many of the U.S. large cap
regional and super-regional banks had Tier 1 capital ratios
of around 7.5% in December 2007. Meanwhile, a Time
magazine article from November 2008 reported that European
commercial banks had a Tier 1 capital ratio of 3.3%.
More conservative lending practices
Canadian banks avoided the adoption of the high risk
lending practices being conducted abroad. In 2006,
subprime mortgages accounted for close to 25% of all new
mortgage origination's in the U.S., while in Canada the ratio
was 5% and subprime mortgages only represented 3%
of all outstanding Canadian mortgages. Adjustable rate
mortgages (ARMs) became popular in the United States,
and the interest rate adjustment on these products is a leading
reason for the dramatic increase in mortgage delinquencies
in that country. In Canada, ARMs were never
introduced. Canada did allow greater leverage in the mortgage
market through no money down and extended amortization
mortgages, but the risk profile on these products
was much less than on new U.S. products.
Strong risk management culture
The Canadian banks stuck to their long standing risk
assessment systems. Indeed, the criteria for getting a
mortgage did not change considerably during the real estate
boom. For example, a mortgage borrower taking out
a variable rate mortgage still had to qualify on the basis of
a 5-year fixed mortgage rate. In contrast, the U.S. had a
proliferation of NINJA loans (loans with no demonstration
of income, job or assets) and when mortgage qualification
was being done it was often assessed at the low introductory
rate on the ARM.
Prudent regulatory oversight
The Canadian regulatory system and Government of
Canada policy has also served the nation well. OFSI provided
prudent oversight. Moreover, the Government of
Canada did not push for imprudent lending practices like in
some jurisdictions abroad. In the United States, the Community
Reinvestment Act encouraged higher risk mortgage
lending. Fannie Mae and Freddie Mac, the two U.S. government
sponsored enterprises in the mortgage sector, also
pushed hard to expand home ownership and may have
contributed to higher risk activities. The U.S. government
also allows mortgage interest deductibility, which deters
homeowners from paying down their mortgages as quickly
as possible. It should be noted, however, that mortgage
insurers in Canada did influence lending practices by opting
to insure no-money down and extended amortization
mortgages. But, as mentioned above these were lower risk
than some of the international practices and the Government
of Canada has since eliminated insurance on no money
down and 40-year mortgages.
More risk adverse behaviour by households
Canadian homeowners were also more cautious in the
their activities. Canadians were less inclined than Americans
to draw down on the equity in their homes. The more
conservative behaviour of both lenders and borrowers has
resulted in a more modest rise in mortgage arrears.
Canadian investment banks part of a larger diversified
financial institution
The structure of the Canadian financial system also
provided some important stability. In the late 1980s, the
Government of Canada allowed commercial banks to ac-
quire investment dealers. This set off a wave of mergers
and acquisitions, with the result that no large independent
dealers were left. So, the investment banks in Canada
folded into a larger diversified institution. Investment banking
takes inherently more risk than retail and commercial
banking, so the combination allowed the former to benefit
from the lower risk balance sheets of the latter. In the
United States, some have argued that the U.S. investment
banks were only lightly regulated. The U.S. investment
banks also had very low capital ratios that averaged around
4%. When the dust settles from the recent financial turmoil,
it would appear that independent U.S. investment banks
will be a thing of the past.
Conclusions
These are the results and facts. The practices in Canada
stand in sharp contrast to those in the U.S., Europe and
elsewhere. It is more difficult to pinpoint why. Why has
the regulatory environment been tougher in Canada? Why
have Canadian banks had tougher risk management cultures?
Why have Canadian households chosen to taken on
less leverage? All of these aspects likely intertwine in a
virtuous circle. There appears to be a more risk adverse
culture in Canada running through government, the public
and banks. One feeds off another. It may be instrumental
that Canadian banking is relatively dominated by a fairly
small number of large banks that have been in business for
a very long time – most dating back in one form or another
since prior to Confederation. Perhaps this long history deters
actions to boost short-term profits at the expense of long term
risk.
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