Know Thy Neighbor: What Canada Can Tell Us About Financial Regulation

Policy-makers in the Obama administration and Congress are designing a new regulatory architecture for the nation’s financial system. As they toil on this daunting project, they might consider taking a page or two from a model next door—Canada. Before pursuing this idea, we, the authors of this paper, owe readers two disclaimers. First, neither of us is an economist nor do we claim deep expertise in financial regulation. Our observations perforce will be elementary. Second, notice that we said take “a page or two”—not every page. For not everything above the 49th parallel is to be emulated, and much that might be praiseworthy is not politically feasible down here.

Good Show

The Canadian banking system has long been regarded by the IMF as a paragon of international best practices. The World Economic Forum recently ranked it the soundest in the world. And it looks better with every passing day. As during the Great Depression, when only a few inconsequential banks failed in Canada, the overall system has remained solvent and solid amid the current global crisis. Indeed, unlike several large U.S. banks these days, the sustained profitability of Canada’s is startling. While shares of Citigroup and Bank of America were trading at lows of around $2 to $4 in February, shares of Royal Bank of Canada and of Toronto-Dominion Bank were in the range of $24 to $37. Canada’s “Big Five” banks had recorded substantial profits last year. Since the credit crunch began in 2007, write-downs taken by Canadian banks have represented a negligible fraction of the total recorded by banks and brokerage houses worldwide. In 2008, Ottawa had made available to the banks a comparatively modest $125 billion mortgage purchase program. But so healthy are Canada’s institutions, last month they announced that they no longer needed to use any of it.

A Few Misapprehensions

What accounts for the extraordinary performance by our northern neighbor?

Small, hence presumably more manageable, scale is not a sufficient explanation. Ranked by assets, four of the top ten banks in North America are Canadian, according to a recent Bloomberg report. Contrary to a misimpression harbored by some casual observers on this side of the border, Canada’s big banks are not mere local lenders focused on commercial banking activities for a limited domestic market; they are full-service financial firms, engaged, like our biggest banks, in corporate and investment banking, and complex securitization of loans with a global reach. These far-flung enterprises could have wound up as over-extended and relatively under-capitalized as some of ours. But they didn’t.

Some might conjecture that because Canada’s banking sector is led by five major banks, it is a concentrated industry with limited competition and comfortably cushioned by oligopolistic profits. The trouble with this thesis is that by most measures of consumer welfare—service fees, credit card costs, interest spreads on intermediated credit, and so on—customers in Canada hardly seem disadvantaged. On the contrary, their experience appears to compare favorably with those of citizens in other advanced countries, including the United States.

Nor does it seem very plausible that the Canadian banking establishment is neo-protectionist. Plenty of foreign companies—including Bank of America, Capital One, Credit Suisse, ING, and Deutsche Bank, among many other foreign subsidiaries and branches—do business in Canada.

Further, although one could stipulate that a banking industry organized around a few huge companies is less likely to experience major liquidity problems than a system built around smaller, regionally based firms with shallower equity pools, the opposite can also be true. It is the banking giants in the United States that are now in trouble, while, as Fed Chairman Ben S. Bernanke noted not long ago, the nation’s extensive lower-tier of community banks are the lenders that still appear robust enough to make new loans. Put another way, if Canada’s financial conglomerates had been mismanaged, Canadians could have ended up in worse shape than Americans. With fewer local banks to come to the rescue and relying on a handful of behemoths “too big to fail,” Canadian taxpayers might have had to cough up bailouts proportionately even larger than ours.

Canadian Regulation

That Canadian banks are more closely, or carefully, regulated is fairly well-known. The specifics, however, deserve more attention.

The Canadian regulatory edifice is more centralized. There is no provincial equivalent to America’s state-chartered banks. All of Canada’s banks are federally chartered and overseen by federal agencies. One government-owned entity—the Canada Mortgage and Housing Corporation (CMHC)—plays a dominant role in shaping mortgage default-insurance policy. It and five other government bureaus in Ottawa—the Department of Finance, the Canada Deposit Insurance Corporation, the Bank of Canada, the Financial Consumer Agency, and importantly, the Office of the Superintendent of Financial Institution—set standards, coordinate the overall regulatory structure, and enforce it with sanctions. The Superintendent, for instance, has the power to remove miscreant bank directors and senior officers.

Three additional features of the edifice stand out. For starters, over-leveraging is discouraged. The ceiling on leverage ratios (assets to capital) for Canada’s financial institutions is capped well below the U.S. norm (an average of 18:1 compared to over 25:1, respectively).

Second, the requirements for mortgage loans are relatively stringent. Down payments of at least 20 percent are ordinarily required, unless the bank obtains mortgage insurance through the Canada Mortgage and Housing Corporation. The CMHC exerts a prudential influence over mortgage underwriting. Banks rely extensively on it for default insurance, which is conditioned on comparatively strict criteria for creditworthiness. (Private insurers operate as well, but they, too, are held to relatively exacting standards since they benefit from a partial government guarantee.) Sub-prime mortgages are not unheard of in Canada, but the stiffer standards for lending have kept them to a minimum. In 2006, for example, sub-primes amounted to less than five percent of the country’s total mortgage originations, compared to over 20 percent in the United States.

Last but by no means least, CMHC, working alongside the banks, transparently plays a role in circumscribing residential mortgage securitization. Indeed, the great bulk of all lending in Canada takes place within the banking system itself, not through a largely unsupervised secondary market for bundles of loans and securities supposedly backed by other bundles of loans and securities—the “shadow banking system” that has burgeoned in the United States.

Systemic Differences

Canadians may be right to showcase a good deal of their regulatory regime. But one wonders how much of it would succeed were it not for other fundamentals in the Canadian story.

It may be, for example, that the “culture” in Canada’s financial sector is inherently more risk-averse than in the United States. As individuals, Canadians have long been known to be greater savers than Americans, although the spread between the two countries has narrowed over the past few decades. As businessmen, Canadian financiers have tended to steer clear of the chanciest investments, not just in North American real estate but in various other kinds of global gambles, such as certain Latin American bonds.

Contrary to what Americans might think, Canadian executives are handsomely compensated. (Anticipating the growing consternation about outsized bonuses on both sides of the border, the CEO of Toronto-Dominion Bank took more than a 40 percent pay cut, though his compensation remained in the multiple millions of dollars. He was not alone among bank CEOs.) Still, Canadians don’t appear to countenance the ultra-lavish packages that go out of their way to encourage short-term risk-taking on Wall Street.

To an extent Canada may have avoided a hyper-risky mortgage market because, ironically, policymakers there seem less preoccupied with promoting ownership of “affordable” housing. Which is not to say that Canadian policy, at both the national and provincial levels, hasn’t furnished an ample supply of low-cost housing. To the contrary, so much is available at low rents that households may actually be less inclined to buy their dwellings whether they can afford to or not. Whereas almost half of all American households in the lowest income quintile own their own homes, the home-owning share for the lowest quintile in Canada is just over 38 percent.

Perhaps even more important is the fact that macro-level fiscal policy in Canada differs rather fundamentally from America’s. It restrains the demand side more than does the U.S. national tax structure, which arguably rewards consumption while mostly dunning incomes and saving.

Although housing prices in Canada’s major urban centers (notably Vancouver and Toronto) have increased markedly since the 1980s, the country did not experience a U.S.-style housing bubble. In the Greater Toronto area, for example, the average selling price of houses dropped only seven percent between the months of March of 2008 and 2009, compared to 29 percent in Miami, 25 percent in Los Angeles, and 13 percent in metropolitan Chicago.

Mortgage interest is not tax-deductible in Canada. The result, not surprisingly, is to induce less private investment in housing than there has been in the United States, where mortgage lending is exceptionally tax-advantaged. Further, the federal tax system in Canada includes the functional equivalent of a VAT. This national impost, supplementing provincial sales taxes, is levied on most goods and services including newly constructed homes. Although buyers of such homes may qualify for partial rebates, on net, the tax treatment of home buying is, again, considerably less favorable to consumers than it is on this side of the border. Indeed, consuming in general is a bit less of a great national pastime in Canada, in part, because it is more heavily taxed.

Limits of the Canadian Lesson

Clearly, there is something to be said for studying Canada’s more centralized, and apparently better-coordinated, regulatory bodies. America’s assortment of financial watchdogs, jealously guarding their turfs and leaving gaping holes unmonitored, appears in dire need of correction. But let’s not kid ourselves: Even Canada’s seemingly comprehensive arrangements almost certainly fall far short of constituting a “systemic risk regulator,” capable of foreseeing and averting every imaginable form of financial excess. The Canadian system seems to have done a commendable job managing risk in one sector—mortgage lending. Given that the world’s financial meltdown originated with the U.S. sub-prime bust, the way Canada dodged it was no small accomplishment. Whether Canadian regulators and financial companies will remain as unscathed by crises begot from other sources, including novel mutations of financial assets likely to be invented in the future, remains very much an open question.

Also, here’s another caveat: In retrospect, cautious Canadian-style risk-management looks highly desirable. Yet before the crash, that same prudence might have seemed like too much of a good thing. In fact, financial systems such as Canada’s, which are less reliant on versatile non-bank capital markets, could seem insufficiently entrepreneurial. With twenty-twenty hindsight, we now know that Wall Street’s risk-takers were reckless. But during the boom, few of us were as skeptical of the borrowing binge they facilitated. Rather, their innovative financial instruments were mostly deemed creative ways of leveraging and deepening scarce capital. In other words, it is not too much to say that when times are rotten, we wistfully look to exemplars of moderation. When times are good, moderation often looks like a virtue only in moderation.

In any event, much of what helps support the Canadian model is probably beyond the grasp of the American political process. Eliminate mortgage-interest deductions? Forget it. Temper the pursuit of what the Left calls “affordable” homeownership, or what the Right calls the “ownership society”? Fat chance. Shift more of the tax burden’s target from earnings to consumption? Don’t hold your breath.