Canadian bank system gets the balance right (Irish Times)

04 November 2011


The US may have aspired to be a city on a hill, but its neighbour Canada has attracted more attention recently as a paradigm for creating and regulating a banking system that has been stable, and even profitable, through the worst economic crisis since the Great Depression.

Praise has come from many quarters, including Taoiseach Brian Cowen who has promised to create a new regulator that will “build on best international practice, similar to the Canadian model”.

Canada’s reputation for fiscal conservatism may have been boring during boom times, but being boring has left the country’s banking system in a rare position of strength in the financial world.

“It has turned out that boring is good and an excellent attribute of a financial system,” Jim Flaherty, Canada’s minister for finance, told European reporters on a visit to Canada this week.

Gordon Nixon, chief executive of Canada’s biggest bank, Royal Bank of Canada (RBC), prefers being described as “conservative from a risk perspective”, and says the bank will stick to that model.

“The conservative nature of the system has been a source of strength. The big issue is does that create opportunity?” says Nixon.

The reasons for Canada’s sturdy banking system are many and varied: prudent lending and cautious borrowing; a tight government rein over the country’s property and mortgage market; strict capital requirements to ensure banks set aside plenty of capital for the bad times; intensive and constant regulatory spot-checks; and, of course, a national culture of fiscal conservatism.

Nixon says Canadian bank leverage – the ratio of assets to capital – is capped at a ratio of 20 to one, which compares with as high a ratio as 50 or 60 times for some European banks. “It was a combination of strength and less leverage that enabled our operations to earn through a lot of our problems,” he says.

Canadians also have a different mindset. They are less debt oriented and more savings focused, paying larger mortgage deposits, building up equity in their homes and insuring against default if their mortgages exceed 80 per cent of the property’s value, and often even below that level. The maximum mortgage is 95 per cent and the longest term is 35 years, while fixed-rate loans are popular.

Canada’s five biggest banks have hoarded plenty of cash. By law, they must maintain capital above a 7 per cent tier-one ratio – the key measure of reserves held to absorb losses – though these ratios rose above this before the crisis and are currently between 9.6 per cent and 11.5 per cent.

The banks have managed to raise 13 billion Canadian dollars (€8 billion) in equity selling preference and ordinary shares in the market over the past year, illustrating just how secure they are considered by investors.

The banking regulator, Julie Dickson, and her Office of the Superintendent of Financial Institutions, carries out regular lengthy audits, ensuring she knows what is sitting on the banks’ balance sheets and forcing lenders to set aside further capital if risks have gone undetected.

Grant Rasmussen, head of the Canadian division of Swiss bank UBS, traces the strength of the system to 1998 and a decision by former finance minister Paul Martin to refuse a merger of two large Canadian banks. It received a mixed reaction at the time but Martin’s actions prevented any one bank becoming too large and potentially taking on much greater risks overseas. This policy has continued. “We are comfortable with not giving priority to bank mergers and I think it has served us well,” says Flaherty.

The acquisition of a stake larger than 10 per cent in a bank must be approved by government. This keeps overseas predators at bay, while the domestic banks control a large majority of the market.

Others date Canada’s stable banking culture back further. Economist Sherry Cooper at BMO Capital Markets, part of the Bank of Montreal, says a banking crisis in the 1920s helped strengthen the system before the Great Depression. Some 7,000 US banks failed following the Wall Street collapse of 1929 but not one Canadian bank went under, she says, and they have not cut a dividend since 1942.

Canadian investment banks were subsumed by the country’s commercial banks in the 1990s, unlike in the US where high debt levels later forced the collapse of the investment banks.

The banking community has a village feel, with regulators, government and bank executives in close and constant contact about what is best for the good of the lenders and the country. Flaherty says the banks have established themselves as “national institutions”, which means they are not only coast-to-coast banks with a strong retail presence but are owned by a large number of Canadians who enjoy uninterrupted dividends. This keeps the banks in check.

Cooper says that, while Canadian banks are “conservative by requirement”, abiding by stringent regulatory rules, they also follow a principles-based approach that limits rogue behaviour. “No bank would want to be seen to be doing something shady or self-serving. It is more than complying with the regulations – Canadian banks don’t want the spotlight to shine on them.”

The banks have mostly remained profitable. RBC was the first Canadian bank to post a quarterly loss during the crisis. This is its first such loss since 1993, but it says it has enough capital to weather it.

No Canadian bank has received a government bailout through recapitalisation or nationalisation, nor are they expected to – loan losses are rising in line with a shrinking economy this year, but remain near record lows.

The government-owned Canada Mortgage and Housing Corporation (CMHC), with two private state-guaranteed companies, insures two-thirds of Canada’s C$1 trillion mortgage market.

CMHC executive director André Asselin says that, as a result, the banks do not have to set aside as much capital, as they are insulated from defaults on higher-leveraged loans. Lenders also have strong underwriting, making many of the loans high quality and giving the banks a double protection.

Bernard Dorval, head of Toronto Dominion Bank’s global insurance business, says the bank has no external risk department and therefore all staff “own” the risks they take on.

Banks securitise just 30 per cent of their loans, keeping most of the loans on their balance sheets, unlike their US counterparts. This again forces the banks to maintain high standards when underwriting loans.

New housing units vary from 150,000 to 225,000 a year and the CMHC quells development to ensure supply matches demand. This means prices do not rise too high or decline dramatically.

Canada, unlike Ireland, does not subsidise mortgages with tax relief. “Canada has no policy incentives that push people to get into homes,” says Terry Campbell of the Canadian Bankers’ Association, though it has roughly the same level of home ownership (67 per cent of households) as the US.

Grant Rasmussen of UBS says the banking system was once criticised for being over-regulated but now, following the global financial collapse, strict regulation will become essential. “We try to balance extremes,” he says, pointing to Canada’s tradition of seeking compromises. “We are a nation of immigrants – we try to take the best of all the people who come here.”

Why Canada has a stronger system 

- IT HAS a more robust regulatory regime to supervise its banks.

- The banking regulator conducts regular forensic inspections of the banks and continuously demands information.

- Canadian banks have higher capital reserves and must have a minimum tier-one ratio of 7 per cent. Some 75 per cent of this must be held in ordinary shares or common equity.

- The banks are cautious lenders and Canadians are prudent borrowers.

- Customers are not allowed to take on mortgages of more than 80 per cent of a property’s value unless they buy mortgage default insurance from the government- owned Canada Mortgage and Housing Corporation (CMHC) or two state-sponsored private insurers. The minimum deposit is 5 per cent and maximum term is 35 years.

- An investor must seek government approval to acquire more than 10 per cent of a bank.

- Just 30 per cent of bank loans, all insured against default, are sold to investors in securitisation deals. This motivates the banks to ensure they hold high-quality loans.

- The five biggest banks control between 80 and 85 per cent of the domestic market.

- Canadian finance minister Jim Flaherty says bank mergers are “not a priority”. This has stopped any one bank becoming too large.

- The CMHC monitors housebuilding to ensure it does not rise significantly above 225,000 new units a year, suppressing price fluctuations.

- The biggest bank, Royal Bank of Canada, pays bonuses in its capital markets division based on pretax net income rather than revenue.