First published in the Financial Post - https://www.law.utoronto.ca/blog/faculty/canadas-banks-conservative-nature
By: Anita Anand
In a recent interview with a major U.S. news network, Prime Minister Stephen Harper touted the fine regulatory balance that underpins the strength of Canadian financial institutions. Without question, Canadian banks have been relatively insulated from the economic turmoil that has crippled their U.S. counterparts. But why is this case? What characteristics particular to the Canadian economy and corresponding legal regime have protected Canada’s financial institutions?
If we look deeply, we see that Prime Minister Harper is partially right: The regulatory regime is an important factor to consider. Yet other considerations, including a conservative mentality that pervades our financial system and its players, are also relevant in the analysis.
Under Canada’s Bank Act, Schedule 1 and Schedule II banks are both investment banks and deposit-taking institutions. They therefore have a steady, secure stream of (cheap) capital. Under the U.S.’s Glass Steagall Act, American institutions were prohibited from engaging in investment banking as well as commercial banking. Arguably, the U.S. investment banks that failed were holdovers from Glass Steagall (despite the fact that the U.S. legal regime changed in 1999). They did not have this retail base of cheap capital. Indeed, there are no more stand-alone investment banks in the U.S., as even Goldman Sachs and Morgan Stanley were forced to become bank holding companies in order to survive the turmoil in the capital markets that Lehman’s bankruptcy set in motion. Thus, there is in the structure of the banking regime a partial explanation for the relative stability of the big five Canadian banks.
In addition, we need to consider that Canada’s banking system has proven to be well-regulated by the Office of the Superintendent of Financial Institutions (OSFI). Unlike the United States, where regulatory jurisdiction is fragmented, OSFI has jurisdiction over a broad list of financial institutions including banks, trust and loan companies, insurance companies and other financial institutions. While OSFI’s mandate is “to ensure that financial institutions are regulated … so as to contribute to public confidence in the Canadian financial system,” it leaves the management of the financial institution to individual boards of directors and management of the institution itself. (Perhaps this is what Prime Minister Harper means when he describes Canada’s regime as interventionist but with a non-“micro-manager” mentality). Thus, in understanding why Canadian banks have been relatively successful, it is also important to examine approaches to systemic risk at the bank level.
Throughout the credit crisis, Canadian banks have remained well capitalized, being not only Basel II compliant but also maintaining high Tier 1 ratios relative to banks in other countries. For example, at the end of the third quarter in 2008, these ratios ranged from 9.47% to 9.81% compared to other global banks that were in the 6%, 7% and 8% range. Thus, it is unsurprising that Julie Dixon, superintendent of OSFI has stated that, “[t]he first lesson is capital, capital, capital. We have seen how strong capital cushions have paid off to the benefit of our institutions and overall financial system.” In addition to relatively high capital levels, the quality of the Tier 1 capital is also said to be high in Canada with banks common equity representing a greater portion of their regulatory capital relative to banks in other jurisdictions, which have a greater reliance on preferred shares and other hybrid forms of capital such as trust-preferred securities. Thus, both the level and quality of capital have placed Canadian financial institutions on a strong footing vis-à-vis their counterparts in other countries.
While it is clear that levels of capital are relevant, one may question why the quality of capital matters. Where capital injections are in the form of preferred shares, these shares often have a redemption feature that undermines the capital’s overall permanence. In OSFI’s view, “permanence is a critical element for OSFI to consider something as Tier 1 capital.”
The Canadian government has not made capital injections of this sort into the banking system. Rather, the level of its intervention has been relatively limited, e.g., purchasing $125-billion of insured mortgages (thereby increasing banks’ capacity to make new loans). The point about permanence is a broader one that speaks to the importance of the quality of the banks’ assets. Hindsight now tells us that there were loans that should not have been made: loans with no covenants, leverage ratios that were sky high, and sub-prime loans that could barely cover the asset values at their peak. Capital adequacy is significant but it only takes us so far in understanding the issue. The quality of capital is crucially important.
To understand further the stability of Canadian banks, we also need to examine risk management. Though difficult to document, there appears also to be a more conservative understanding of, and protection against, systemic risk within Canadian banks. The approach to the housing sector is instructive as Canadian banks (and brokers) have exhibited more restrictive mortgage lending practices than their U.S. counterparts. They did not rely on third party brokers/originators to the same extent or succumb to ninja and liar loans with the result that the likelihood of defaults on their mortgage portfolios remained, and continue to remain, relatively low.
As a general rule, Canadian banks did not vary the standard mortgage model (e.g., no loans with 50-year amortization periods or negative amortization). While U.S. banks sold a large portion of their mortgages, Canadian banks did not. In fact, Canadian banks tended to keep the mortgages on their balance sheets and therefore were more diligent in their credit assessment of their borrowers. Even now with federal aid available, Canadian banks are choosing to refrain from selling mortgages to the government under the $125-billion plan if they do not need to.
Without question, Canadian financial institutions have been well-regulated. However, in addition to strong regulation, Canadian banks have survived because a more conservative culture pervades all aspects of banking business, from lending to trading. With the United States and other countries turning to examine the Canadian financial system in redesigning their own regulatory regimes, it is important to remember that prudence and conservatism do not emanate from law (or at least from law alone). Rather, they are cultural phenomena particular to this country and this economy. They highlight for us that law can only do so much.