Canada’s Great Escape

by Jerry O’Driscoll

There has been an earlier discussion of why Canada didn’t suffer a banking crisis.  The Financial Times asked the same question in its January 30/31 issue. The answers provided by the FT may not satisfy all, but here they are:  Old-fashioned prudential regulation is singled out: capital requirements, quality of capital and leverage ratios. Other major Western countries, particularly the US, were all relaxing them while Canada was tightening them. The regulators worked in tandem and there were no regulatory gaps to exploit.  

Additionally, bank regulation in Canada is principles-based, rather than rules-based.  That obviates legalistic circumvention of safety-and-soundness regulations.  “The message in the US is it’s your responsibility to meet our rules.  In Canada, the responsibility is to run the institution right.”  

Finally, there were no trendy innovations in the mortgage market, and securitization was much less common.  

In other words, banking and supervision done the old-fashioned way: safety first.

34 thoughts on “Canada’s Great Escape

  1. The article quotes the CEO of the Royal Bank of Canada saying that residential real estate was the strongest asset class. Maybe too strong? Yesterday’s WSJ had an interesting front pager “Housing Rebound in Canada Spurs Talk of a New Bubble.” Sub-prime “liar loans” weren’t a factor in inflating that bubble, which might put the kabosh on the idea that they were (much) of a factor in inflating its southern neighbor’s real estate boom.
    Another front pager, “Fed to Bare Tightening Plan,” made the point that “slow, predictable increases helped fuel the borrowing boom that led to the financial crisis.” A former Fed research director is quoted saying “The predictability of the rate hikes was a problem for some of us.”
    Adaptive expectations?

  2. I think you should also look into the intrusive role of state guarantees in the Canadian system. They may not have such conflict-ridden hybrids like Fannie and Freddie, but they certainlly do have the Canadian Mortgage & Housing Corporation which, as this recent letter to the FT points out, has been a vehicle for vast intervention and a co-ordinated bail-out.

    “A Crown corporation – the Canada Mortgage and Housing Corporation – dominates the domestic mortgage insurance market. It also guarantees the vast majority of residential mortgage-backed securities issued by Canadian banks, which account for almost 30 per cent of outstanding mortgage credit in the country. Since 2001, those banks have been able to use the federal government’s own special purpose trust to repackage their mortgage-backed securities (MBS) with more marketable terms and the crucial government guarantee.

    Finally, in the past 16 months, the CMHC has purchased nearly $70bn of Canadian MBS with money borrowed from the federal government. It is true that the Canadian government did not bail out our banks in 2008 or 2009. But it is also true that the government provides them with insurance and guarantees on mortgages and MBS worth hundreds of billions of dollars, all of which lower their capital requirements, reduce their cost of funds and ensure a stable supply of money for residential mortgage loans.”

  3. Canada certainly has a mixed economy. And governments can’t seem to stay out of housing finance.

    But the Candain banking system came through all of this unscathed. The FT article rebuts the claims of apologists for US policy that nothing could have been done.

  4. One problem with principles-based regulation here in Canada is that when the Federal government starts to bully Canadian banks, the banks have no explicit rules to fall back on.

    In terms of mining foreign banking systems for good examples, I always like Australia. No deposit insurance, and no government housing authority.

  5. There’s an issue I’ve been wondering about for some time and I wonder if there’s a connection here. Oil prices experienced a steady run-up in the years prior to the financial crisis. Consumers, especially low-income consumers, saw a larger portion of their incomes eaten up by fuel prices. This caused problems among the least able to pay their bills, possibly setting off the mortgage crisis. Auto lending was suffering similar problems at the same time. Canada’s economy, meanwhile, benefitted from this drive-up in oil prices. It is the largest supplier of oil to the world’s biggest user. I’m just wondering if we’re putting too much emphasis on the crisis in the financial sector and not asking if the real culprit wasn’t the commodities market.

  6. Commodity prices might be a supporting story. One would need to look at timing to make that case.

    Home prices really peaked in 2006. Refinancings kept the mortgage game going for a while. The first sign of trouble in the subprime market came in Feb. 2007.

  7. Would Jeremy want to deposit his money in a bank that wasn’t examined regularly? I suggest he read Daniel Klein’s book on Trust.

    In situations with assymetric information, potential customers look to trusted third parties for verification of vital information. The problem is not unique to financial services. But it is understandably of central concern in that industry.

    Some of the needed third-party verification can and has been supplied by private institutions through markets. In financial services, it has largely, though not compeltely, been taken over by governments.

  8. Oil prices did boom during this period, but so did other commodities, including the metals (e.g., gold, copper, platinum) and agricultural commidities. This was caused partly by increased growth in the developing countries, especially the BRICs, but it was also caused by what The Economist a year or so ago called the biggest credit boom in history. Oil’s peak price of $147/barrel was not based on fundamentals.
    The credit bubble inflated prices of other asset classes besides housing and commodities; private equity boomed, as did stock and bond markets, and the art market. These markets have mostly had big declines (and partial retracements) since their peaks, although the bond market appears to be awaiting its Waterloo.

    Jerry O’Driscoll is right on the timing of the housing market. The stocks of the home builders peaked in the third quarter of 2005, about six months or so before the housing market itself peaked, and a few months after I sent an email to mutual fund manager and home building stock poster boy Ron Mullenkamp (“bring me fresh money and I’ll invest them in the builders” was his oft-repeated mantra) opining that they were headed for a bear market and should be shorted. At the peak he had something like half his fund in the builders; and his shareholders sat through a decline of something like 80% of the fund’s NAV.
    Why the Keynesians don’t understand the causal relationship between credit bubbles and asset price bubbles has always been a mystery to me. It was none other than Paul Krugman who called for the Fed to inflate a housing bubble, which it had already been doing.

  9. Why, whatever do you mean, Gene? I was agreeing with the kind professor.

    But seriously, I think there’s room to make fun of praise for regulation on a forum such as this, even given that I understand the relative spirit in which it was given. What I don’t understand, however, is the point.

    Let the WSJ speculate about what package of regulation destroys less wealth and encourages less recklessness. It’s not clear why TM’s readers should be concerned.

  10. Gene, what really are the facts? Regulation creates a problem, so we bring in MORE regulation to solve it. How libertarian. Seriously, what is going on here?

    Why not have a discussion about actual “market” solutions? They could be feasible, or practical, or pragmatic, whatever you like. This direction, look at how great the canucks can regulate, is quite counterproductive.

  11. The price system and markets are a self-regulating system that produce an overall order. They are enveloped in a rule of law. Economic and political freedom depend on, indeed are inextricably linked with, lawful behavior.

    The question is from where do the laws and regulations come. That is the question Hayek focused on much of his professional life, culminating in Law, Legislation and Liberty.

    The idea you can have a financial system w/o outside oversight is simply laughable. Again, how much can be from markets and how much from a coercive authority is the crucial question. I prefer the maximum from markets.

    GIVEN the state has taken over most — not all — regulation of banks, who did a better job: the US or Canada? I don’t think it’s even a close contest (as it was not in the Great Depression, when no Canadian bank failed against many thousands in the US).

  12. Sapienza ought to realize that “private” isn’t equivalent to “free market.” And “regulation” is a misleading word. The American financial system wasn’t (and isn’t) “unregulated.” Sure, firms were free to concoct and trade all sorts of “innovative” products at will. They were free to cook their books in doing so. And they were encouraged in this activity with all sorts of implicit and explicit government guarantees, plus cheap credit. When it all fell apart, the better connected players were rescued at taxpayer expense, confirming the implicit guarantees. Some “unregulated” system. It’s closer to mercantilism than free market.

    Good luck to Pete in getting a pure free market fix to this mess; it would take abolishing the Fed, abolishing all government deposit insurance, utterly eliminating all ability of government to bail out TBTF banks. In the meantime, if someone suggests a more sensible set of regulations that would help reduce control fraud, systemic risk, and intentional robbery of the taxpayer, it isn’t anti-libertarian. A limit on bank size, a separation of trading vs. deposit firms, and transparent audits by genuinely arms-length third parties would be a good start.

  13. Well, Jerry, we both know that Hayek (and Mises before him) wrote a book that explained the crisis long before the 70s. The idea that you could have a financial system without government oversight, is both practical and superior to our current system. However, I am willing to set that aside for a moment.

    Given that the state has taken over the banking system, should we give them the best possible advice? The best advice is surely not emulate Canada or adopt “smarter regulation.” Why aren’t we talking about reducing the problems by market based reform, like reducing the amount of FDIC insurance to 25k per PERSON or suggesting banks offer 100% reserve deposit accounts that would be a safe haven for those with cash they did not put at risk? Simple ideas such as this would force bank depositors to take responsibility and reduce the availability of capital to overly risky banks.

    This obviously ignores the Fed’s role in all of this which the “regulation” crowd is more than happy to gloss over.

  14. “…as it was not in the Great Depression, when no Canadian bank failed against many thousands in the US.”

    But that wasn’t due to the Canadian regulator’s superior ability to supervise. It was because Canada had a long history of branch banking, and therefore had large national banks capable of withstanding crisis, whereas the US was composed of small unit banks.

  15. And because Canada wasn’t stuck with a central bank until 1935.
    I think we should debate what to do with the constable. I’d like to turn him into a snow man.

  16. I agree with Charles Steele, Bill Stepp and others. Let’s distinguish positive analysis from normative. For whatever reason, Candian banks did better than US.


    It is true that Canada had nationwide branching and US not. That was the product, however, of law and regulation in both countries.

  17. When you compare Canada and the US you must start with accepting that Canada is an export-oriented economy, while the US is a consumption driven economy (or was). That means that capital rather flows out of the country than in the economy and therefore does not stimulate a bubble. It also means that there are is a savings surplus.

    On the other hand, incentives for a real estate bubble are not obvious, e.g. mortgage interest rates are not tax-deductible. Thus it is harder to buy housing and people may want to get rid of mortgages rather than collecting debt.

    For the banks, they are the soundest banks in the world. Canadian banks have lower risk and leverage ratios than Swedish banks which are considered very sound as well. This may be due to the fact that they are less active in investment banking. Further they stick more in their local market (as opposed to banks in Germany that lost heavily (accept of savings banks) in the crisis). Even the Swedbank lost a ton of money in the Baltics and so forth.

    In their Canadian market they seem to be well diversified, meaning that they usually are present in every state. If a branch goes belly up in one state due to default in crisis, they have a balance because in other states there was no artificial boom. That is like a Mundell (1973) risk sharing mechanism in a monetary union – even though on a completely different scale.

    But if you ask me, the main reason is that Canadian banks are more conservative as Jerry put it (and maybe Canadians are less risk-friendly and therefore save more). It is their luck that this hindered banks from competing to become the world’s biggest players and from losing Canadian savings in the US mortgage market gamble.

  18. I appreciate Andreas’ intervention and find his analysis persuasive. The “conservatism” he mentions is a kind of cultural explanation. I don’t dispute it, but one always prefers an incentives-based argument.

    Certainly Canadian banks have traditionally had a substantial presence in U.S. markets. The opportunity was there.

  19. Andreas,

    The tax deductibilty of mortgage interest by American mortgage holders shouldn’t produce real estate bubbles (contrary to what I gather is your implicit assumption and to claims in the financial press), because they would be capitalized in home prices and the discounted cash outflows to home buyers from these higher (but non-“bubbleized”) prices would be more or less offset by the discounted cash inflows they realize from their reduced tax “bills.”

    I pointed this out at a motley fool discussion board three years ago, and it generated some heated replies. The consensus was that my point was correct.

  20. Jerry,

    I think you gave the correct incentives-based argument already. While in the US regulation is much stronger, financial institutes may rather try to get around regulation and search for holes to get through. At the same time they feel save in general as regulators approve their doings.

    In Canada, on the contrary, regulation should not be as strict. Therefore you have a more serious and conservative culture in banking. They actually look for their own risks. From this perspective it could be a moral hazard problem of US banks.

    However these are just suggestions.


    oh, I did not mean to say that they produce real estate bubbles by themselves. I thought they would give ONE incentive to stay indebted. As there were also other government incentives and low interest rates at the same time, this cumulation of incentives should lead to rising demand in housing in the US.

  21. Andreas,

    Yes, moral hazard combined with regulatory arbitrage and regulatory capture (Prof. Stigler’s Travels on the Ship [“USS Wall Street”] of State) is a very toxic brew.

    What we need is anarchy in the creation of law (Benson, D. Friedman, Rothbard), money and banking (free bankers).

  22. Steele ought to pay attention to my main message — TM is not influencing policy. Given this, it is devoted exclusively to theorizing and moral questions and told-you-sos. And therefore, I see no point in pointing out Canada’s superior controls on business in this forum.

    From the rest of your comment, I see you somehow think that I am under the impression that the US banking system, or any other part of our economy, operates in a free market. I hereby disabuse you of that contention by denying it explicitly.

  23. Jerry O’Discroll wrote:

    It is true that Canada had nationwide branching and US not. That was the product, however, of law and regulation in both countries.

    I am not entering the discussion of whether it was smart regulation or some other factor that explains Canada’s relative health during the recent housing boom/bust. But as far as the Great Depression, Milton Friedman made a pretty strong case that it was clearly (state) government intervention that rendered US banks so fragile. So yes, the health of the Canadian system during the Great Depression was the product of “law and regulation” in both countries, but in the same sense that Chicago gangland murders, before and after Prohibition, was the product of “law and regulation” in both time periods.

  24. I’m on two minds about regulations.

    I think that a decentralized system such as a market requires private responsibility, and when strong safety nets and activist countercyclical policies exist, the dynamics of a decentralized system is “shared responsibility is no responsibility”, i.e., a tragedy of the commons.

    In these conditions free markets are dysfunctional and regulated markets can be better, mainly because regulations reduce the possibilities of exploiting the fake profit opportunities created by moral hazard.

    The problem with regulations is that they hamper the market ability to exploit both fake profit opportunities and real profit opportunities, thus reducing efficiency. Activist policies create a trade-off between efficiency and stability, which may not exist in an unhampered market.

    I do believe that safety nets and regulations are a schizophrenic policy: the latter solves the problem created by the former, and it does this by hampering market efficiency. It would be better to introduce total market responsibility, but, as long as a safety net exists, prudential regulations can be useful (some sort of a second best theory).

    I think that an analysis of sources of moral hazard would show that the US have been more aggressive than Canada, and so systemic risk more likely to be the end result of these policies in the US than in Canada. The US have been more aggressive in manipulating interest rates (and as a commenter said last week, probably also had a higher natural interest rate), and have had strong countercyclical interventions in the last 20-30 years (Canada had fairly high interest rates even in the early 90s, if I remember well).

    For what concerns Fannie and Freddie, semi-public semi-owners of 50% of the US mortgage market, a comparative analysis with the Canadian equivalent should be performed. Then I would look into the details of deposit insurance schemes, and I have no idea of what I would find, and in the history of Fed-sponsored “private” bailouts (such as LTCM).

    Moral hazard has many dimensions and many causes, I have probably forgot some of them, and in general I don’t have enough data, and knowledge, to make an institutional and policy comparison between the US and Canada.

    There may be some scope of moral hazard even without state intervention, but I believe that moral hazard occurring among privates can be more easily and fully taken care of, so I guess it’s a minor problem (provided that private parties have incentives to internalize these costs).

  25. Three points:

    Financial markets will inevitably, even with the freest of markets, be subject to third party monitoring because of trust issues. If the word “regulation” offends, call it banana.

    The issue is how much can be done through market mechanisms. To pick a different industry, trust issues about the safety of electrical products lead to UL.

    As Pietro correctly observes, with safety nets, financial markets become dysfunctional. It’s great to say we shouldn’t have them. Many. Then what is the correct policy?

  26. This is way after everyone has left the discussion, but here is an example of the problems with Canadian regulation of banks.

    Ad hoc and sudden changes to capital requirements, secrecy, and no explicit rules by the regulator (OSFI) expose Canadian banks and investors to high degrees of uncertainty.

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