While the world economy is now recovering from the first global financial crisis since the 1930s, the global debate on how best to present a reoccurrence is anything but settled. Financial reform proposals in the United States, the European Union, Britain and elsewhere present quite different views on how this core sector should be regulated, with the battle over a proposed bank tax being a prominent example. In all this, as a recent Financial Times article observed, “Canada is a real-world, real-time example of a banking system in a medium-sized, advanced capitalist economy that worked. Understanding why the Canadian system survived could be a key to making the rest of the West equally robust.”
Although Canada was hit by the worldwide recession, the Canadian financial system weathered the global financial crisis comparatively well. Canadian financial institutions were not unscathed by the crisis, but none were excessively affected by toxic assets, no public funds were injected into financial institutions, Canadian banks remained profitable and they continued to lend.
The sharp contrast between the Canadian experience and how negatively the financial crisis affected the United States, and much of Europe, reflects different regulatory regimes, as well as different corporate governance systems, financial institution lending practices and different structures. Interestingly, in the halcyon years before the financial crisis, Canadian practices were often criticized in New York and London as being too conservative, too prudent and too unwelcoming of the new financial innovations that were sweeping global balance sheets.
Canada has integrated regulation of banks, insurance companies and large investment dealers. The head of the Office of the Superintendent of Financial Institutions (OSFI), Canada’s regulator, regularly meets the largest financial institutions, to make sure that they are governed so as to be sound and stable. Canada allows securities firms to be bank-owned, and OSFI regulates the banks on a consolidated basis (retail, commercial, investment and wealth activities) worldwide, in contrast to the regulatory silos in the United States. The Canadian regulatory approach is both prescriptive and principle-based. This combination puts the onus on a financial institution to assure itself that it has met the intent of the legislation, in addition to what is explicitly prescribed.
Canadian financial institutions were less highly leveraged than their international peers in the precrisis period. This reflected the fact that Canada has a regulatory cap on leverage at an asset-to-total-capital ratio of 20 to 1. As a result, major Canadian banks had an average asset-to-capital multiple of 18 in 2008, while the comparable figure for many U.S. banks was more than 25, and numerous European banks were well over 30.
Capital requirements for Canadian financial institutions were above international standards, and Canadian banks typically maintained capital above these minimum requirements. Further, Canadian banks rely more on depository funds than on wholesale funding, compared which banks in many other countries, which provides more stability in times of market volatility.
A key asset class that fuelled the global financial crisis was subprime mortgages. The vast majority of Canadians mortgages are originated by banks to be held, thereby providing a “front-line” incentive not to lend where there is a high risk of default; unlike the U.S., where the majority were originated to be sold. In Canada, this is further buttressed by government regulations that require insurance for high-ratio mortgages and higher credit standards on the eligibility for mortgage insurance.
This financial-sector framework has to be overlaid on a Canadian economy with strong fundamentals: a decade of sustained government surpluses, solid corporate balance sheets, low and stable inflation, low net foreign indebtedness (less than the U.S.), the lowest net government debt as a proportion of GDP among the G7 countries, and an actuarially sound national pension plan. Taken together, this combination of macroeconomic management, regulatory systems, corporate governance structures and banking practices has produced what the World Economic Forum rates as the soundest financial system in the world.
As world leaders contemplate global financial reform, there are lessons to be learned from Canada’s experience and principles for reform to be drawn from the Canadian approach.
First, macroeconomic behaviours and microeconomic systems don’t exist in splendid isolation from each other. Prudent, long-term, fiscal and monetary policies are beneficial for financial sectors; conversely, macroeconomic policies that contribute to imbalances will eventually infect financial markets, no matter how sound the regulatory systems.
