The Study In Brief
- Despite having highly similar economies, in banking the experience of the crisis-prone United States contrasts starkly with Canada’s stability.
- For each major US crisis, different reasons have been put forward to explain Canada’s comparative stability in the face of broadly similar shocks, an issue that arose again in the context of the failure of Silicon Valley Bank and its aftermath.
- This Commentary examines whether there is a unifying explanation for these contrasting outcomes and what this implies for Canada’s future financial sector stability. It identifies the changes introduced in the 1890 and 1900 Bank Act revisions that led Canada to manage banking sector problems in a cooperative arrangement between the banks and the authorities. The aim was to address the externalities generated by bank failures while controlling the resultant moral hazard through social networks rather than market discipline.
- Importantly, the system ensured enough competition to be efficient. Drawing on this comparative analysis, the Commentary considers the lessons to be drawn for future financial regulation.
Introduction
Silicon Valley Bank (SVB), an iconic institution serving the US technology sector and the United States’ sixteenth-largest bank by assets, collapsed in a crisis that unfolded with shocking speed between March 8 and 10, 2023 (Chappatta 2023). The collapse sent shock waves through the US and global financial systems.
The context was anything but benign: on March 7, the day before the SVB crisis flared, Jerome Powell, the chair of the US Federal Reserve, in testimony before the Senate Banking Committee, commented that interest-rate increases could be larger and more rapid than previously anticipated. Specifically, Powell stated that “the ultimate level of interest rates is likely to be higher than previously anticipated” and that, if necessary, the Fed “would be prepared to increase the pace of rate hikes” (Schneider and Dunsmuir 2023).
With the US yield curve inverted since mid-2022,
- New York-based Signature Bank, the twenty-ninth-largest bank in the United States, failed two days after SVB (Giang 2023). The Federal Deposit Insurance Corporation (FDIC) seized the bank and sold it to Flagstar Bank, N.A., a subsidiary of New York Community Bancorp, with the latter bank assuming the business of Signature Bank as of March 20, 2023 (FDIC 2023a).
- San Francisco-based First Republic Bank, the fourteenth-largest bank in the United States, received a US$30 billion bank-led liquidity injection to shore up confidence after US$70 billion in emergency loans and other liquidity from the Federal Reserve and JPMorgan Chase had failed to stabilize it (Copeland et al. 2023). Even with this support, First Republic was unable to continue, and was seized by authorities on May 1, with its assets sold off to JP Morgan, which assumed First Republic’s deposit liabilities (FDIC 2023b).
- Zürich-based Credit Suisse’s share price collapsed, forcing a massive emergency injection of funds by the Swiss bank supervisory authorities (Cooban 2023) and subsequently a takeover by UBS (Patrick et al. 2023).
- SVB itself was sold, following a two-week auction process, to North Carolina-based First Citizens Bank, ending its history (Choe 2023). The FDIC estimated the cost of the SVB resolution to its Deposit Insurance Fund at approximately US$20 billion (FDIC 2023c).
The run was in part due to the initial approach by the US authorities to the SVB failure, which was to establish a Deposit Insurance National Bank under FDIC control to provide insured depositors immediate access to their insured funds and to pay out a portion of the funds owed to uninsured depositors through an Advance Dividend, while holding back a portion to help cover any losses to the Deposit Insurance Fund. The prospect of losses triggered a run on uninsured deposits in other banks, including Signature and First Republic.
The authorities (including the FDIC, the Federal Reserve and the Secretary of the Treasury) reacted by invoking the systemic risk exception under the Federal Deposit Insurance Act, which set aside the least-cost requirement to the Deposit Insurance Fund to protect the uninsured depositors in SVB and Signature (Gruenberg 2023).
As well, President Joe Biden sought to reassure markets and depositors to prevent further bank runs, saying “Your deposits will be there when you need them” (Sweet et al. 2023). And analysts emphasized that SVB and First Republic had been outliers in terms of business strategies – in particular, in terms of having asset-liability mismatches – that exposed them unduly to the risks posed by rising interest rates (see, for example, Defend, Mortier, and Germano 2023; Russell and Zhang 2023).
While markets generally discounted the risk of further knock-on events, nonetheless several mid-sized US banks that were judged not to be “too big to fail” – in particular, Los Angeles–based PacWest and Phoenix-based Western Alliance (Hirsch 2023a). Pacific Western was merged out of existence in July 2023 as it could not recover (Nishant and Saini 2023). The share price of Western Alliance did rebound but remains as of this writing well below its pre-SVB moment valuations, which suggests that markets have yet to issue an “all clear” signal.
In tallying up the damage, the assets of the three failed US banks totalled US$548 billion (FDIC 2023d), which is larger in absolute terms than the US$526 billion (inflation adjusted) held by the 25 US banks that collapsed in 2008 at the height of the subprime crisis (Russell and Zhang 2023) and of the same order of magnitude (2.4 percent versus 3.4 percent in the subprime crisis) when the two figures are compared as a share of total banking assets.
The Immediate Impact on Canada
The immediate ramifications on Canada, however, were minor. Canada’s banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), took control of SVB’s Canadian branch, which had started operations in Canada only in 2019 (OSFI 2023b; Punchard 2023) and resumed a practice adopted during the COVID-19 pandemic of a daily check on bank liquidity levels.
As SVB’s Canadian branch was only authorized to lend and not take deposits in Canada, there were no ramifications in terms of depositor risk. Some Canadian technology companies that had established relationships with Silicon Valley did have deposit accounts in SVB, which then became part of the US resolution of the failure.
Canadian analysts hastened to emphasize the limited risk of instability to the Canadian banking sector (see Johnson 2023). Commentaries noted the small direct exposure of Canadian banks to the technology sector and that the main exposure of Canadian banks to US developments was indirect through their US bank subsidiaries.
• TD: 35% of TD’s earnings come from US retail banking (TD 2022), including from TD Bank, America’s Most Convenient Bank, which is the tenth largest US bank, and through its holdings in the Charles Schwab Corporation. See: https://www.td.com/about-tdbfg/corporate-information/corporate-profile/….
• RBC: 25% of RBC’s global revenue comes from the United States. RBC claims to be the leading Canadian investment bank in the United States and the 6th largest wealth manager in the United States (RBC 2023). It also holds LA-based City National, the 35th largest bank in the United States, which focuses on Hollywood.
• CIBC: 11.3% of its global revenue comes from its US operations (CIBC 2022).
And not for the first time, the “Canadian model” for banking was touted: “Not only should the failure of Silicon Valley Bank not have significant negative implications for our banks, but this crisis should actually be viewed as further vindication of the Canadian banking model” (Scotiabank analyst Meny Grauman, quoted in Bickis 2023).
The SVB collapse has been compared to the Bear Stearns moment as the subprime crisis started to unfold (Pollard et al. 2023). This raises the question of whether the system remains exposed to a Lehman moment parallel. Markets generally appear to have drawn a line under the SVB moment but there are reasons to consider the lessons from this incident.
First, while the US policy response to SVB nipped the incipient crisis in the bud, the US banking system remains fragile on a structural basis. As Jiang et al. (2023) note, “prior to the recent asset declines all US banks had positive bank capitalization. However, after the recent decrease in value of bank assets, 2,315 banks accounting for [US]$11 trillion of aggregate assets have negative capitalization relative to the face value of all their non-equity liabilities.” The Federal Reserve Board’s October 2023 Financial Stability Report confirms that “high interest rates continued to depress the fair value of longer-maturity, fixed-rate assets that, for some banks, were sizable.” As well, it notes that “a subset of banks continued to face funding pressures, reflecting concerns over uninsured deposits and other factors” (FRB 2023).
Second, the shadow banking sector, which engages in credit intermediation outside the framework of rules developed to govern banks in this activity, has grown its direct lending very substantially.
Third, while the tech sector exposure has been flagged as a reason to treat SVB as an isolated case, the larger risk for the financial system is rapid technological change driving pervasive structural change in the economy. For example, commercial real estate debt is a source of risk as increased work-from-home drives both reduced demand for office space and the products of the services sector that evolved to serve office workers. Also, it is unknowable what stresses the widespread adoption of artificial intelligence systems will unleash – but stresses there will be.
These structural issues loom large, since further monetary tightening has not been taken off the table as of this writing. Following the Federal Open Market Committee (FOMC) meeting of early November 2023, Fed chair Jerome Powell stated: “We haven’t made any decisions about future meetings…It’s fair to say that the question we’re asking is: Should we hike more?” (cited in Foster 2023). Perhaps even more important, the Fed has indicated that rates will remain high for longer. As can be seen from Figure 2, the subprime crisis did not break out immediately following the monetary tightening of 2006, but rather after an extended period of high interest rates, a situation that now looms for the US economy (note: the grey bars denote recessions).
Accordingly, even though the US money centre banks, which have been the focus of supervisory attention since the subprime crisis, are reportedly well capitalized, it is an open question of whether US authorities are in a position to revert to business as usual on bank closures without tipping the system into yet another crisis.
This is significant because while the SVB crisis has led to consideration of regulatory reforms in the United States,
In this Commentary, I consider what light can be shed on the policy course being taken in the United States from the historical evolution of the Canadian and US financial sectors in terms of financial stability. Where Canada has implicitly prioritized avoiding systemic risk in handling troubled financial institutions and has a remarkable history of stability, the United States has implicitly prioritized moral hazard and has an unparalleled history of financial crises.
The Commentary is organized as follows. The next section provides an overview of this history, documenting the differences in societal costs of the two approaches; the online Appendix reviews this history in greater detail. The following section discusses the many contending explanations for the divergence in historical outcomes. It identifies the tipping point in history where Canadian and US experience diverged given the choice made in Canada early in its history to prioritize prevention of the negative externalities associated with bank failures, while the United States tolerated failures to provide a market discipline on moral hazard. The next-to-last section discusses the implications of these choices for financial sector efficiency and stability and the extent to which there is a trade-off between the two objectives based on tolerance for risk taking. The final section concludes with a discussion of the lessons Canadian policymakers should draw from the SVB failure – and what lessons US policymakers might draw from the Canadian experience.
The Great Divergence
Canada and the United States are highly similar economies, as would be expected given the many common historical influences on economic policy and regulation, similar levels of income and urbanization, the shared geography (each Canadian region is part of a larger North American region with its US neighbour) and the high degree of economic interaction, amplified by more or less free trade since the 1989 Canada-US Free Trade Agreement. Importantly for the present discussion, the agreement removed US banks from the cap on foreign bank assets in Canada, opening up competitive pressure in Canada’s financial markets. The Bank Act reforms that authorized foreign branch banking in Canada further opened up the system to competition on the asset side, although not so much on the funding side.
Deep integration creates incentives for regulatory convergence, which in the North American context essentially means that Canadian standards and regulations tend to follow the rules adopted by the United States, even if they differ in their minutiae (Hart and Dymond 2007).
In the financial sector, however, and particularly in banking, the US model has not been the primary influence on Canada: where the United States has been crisis prone, Canada has a long history of stability. In fact, the two countries arguably occupy the polar extremes of the most and least crisis-prone financial sectors of the major economies.
The Anomalous History of US Financial Crises
The United States is a far outlier in terms of frequency of bank failures and financial crises. In its early history, the United States had recurring financial crises/panics/incipient panics on a decadal-plus basis, resulting in 3,401 banks suspending payments between 1865 and 1914 alone (Davis and Gallman 2001). The Federal Reserve Board was established in 1913 in response to the 1907 panic.
The interwar period featured additional waves of bank failures, including over 9,000 failures during the 1930–33 period alone (Calomiris and Mason 2003). During the Bretton Woods era, the United States had a brief respite from financial crises, but these returned with a vengeance in the 1980s. A partial tabulation of the post-1980 crises and the bailout costs they entailed (prior to the SVB event) is provided in Table 1.
The Sharp Contrast between Canada’s History and US Experience
The contrast between the US experience and that of Canada could not be greater, despite the fact that Canada experienced the same major shocks as did the United States. Since 1900, Canada has had only one significant bank failure (Home Bank in 1923).
Canada, however, had its version of the savings and loan crisis in the early 1980s. In the United States, this crisis was centred in the oil patch, with Texas the epicentre. In Canada, it was centred in Alberta. Canada closed two small banks (Canadian Commercial and Northland) and merged another troubled bank (Bank of British Columbia) out of existence, with financial support from the public purse. No depositor lost a cent and there was no crisis – although, as the Estey Commission underscored, it was the collapse of the Canadian Commercial Bank that undermined the Northland Bank’s “survival tactics” in raising capital (Estey 1986, 6). The cost to the Canadian government amounted to $1.39 billion, of which $875 million was payouts to uninsured depositors, $316 million was losses incurred by the Canada Deposit Insurance Corporation (CDIC), and $200 million injected by the federal government to facilitate the takeover of the Bank of British Columbia by Hongkong Bank of Canada (Chant et al. 2003). It is worth noting that this was the only instance in the history of Canada’s deposit insurance program where the banking system proper required assistance.
Canada also had an echo in its non-bank deposit-taking sector of the extended period of banking sector troubles in the United States from the early 1980s through the mid-1990s. Canada lost 38 trust and loan or mortgage companies insured by the CDIC during this period, including six in 1983. The last deposit-taking institution to fail in Canada was Security Home Mortgage Corporation, in 1996 (although there have been some close calls since). The total amount in deposit repayments or rehabilitation laid down by the CDIC amounted to $10.2 billion, with total losses of about $1.7 billion.
Canada emerged from the Great Financial Crisis of 2007–08 without the failure of a financial institution. To be sure, the Canadian banking system required liquidity support (including from the Federal Reserve) during the crisis due to the closing of global funding markets, but Canadian banks did not need any capital injections from public authorities.
That record has been maintained since, including through the SVB crisis, notwithstanding some close calls along the way.
Duelling Explanations
Canada and the United States provide a “natural experiment” for studying the impact of alternative financial sector regulatory and supervisory polices (see Bordo, Rockoff, and Redish 1994). Canadian officials have promoted the “Canadian model” – for example, through Canada’s Global Risk Institute in Financial Services) – researchers have tried to tease out just what about that model accounted for its apparent relative success and some countries (such as Ireland) have set out to imitate it. Nonetheless, the reason for the difference in outcomes is tantalizingly difficult to pin down.
Different Crises, Different Explanations
A first major challenge in identifying the source of Canada’s relative stability is that, for each US crisis, differing aspects of the “Canadian model” have been singled out as the key explanatory factor.
For example, it is generally argued that, in the Great Depression, Canada’s regionally diversified national banking system enabled it to avoid the waves of bank failures experienced in the US unit-bank-dominated system. As many analysts have pointed out, however, regional diversification breaks down as a risk-management measure when all regions of a country are subject to a common shock, as was the case in the Great Depression. Moreover, by the time of the subprime crisis, US banks had become regionally diversified, and the largest bank to fail in US history to that point – Washington Mutual – had as impressive a branch network as any of the major Canadian national banks.
When the United States had its savings and loan crisis, Canada largely avoided the problems because of a timely liberalization of interest rates in the late 1960s, prior to the inflationary surge of the 1970s, thus avoiding the disintermediation suffered by the US savings and loans institutions that was a major contributing factor to the crisis in the United States.
When the United States again lurched into crisis as a result of the subprime mortgage debacle, Canada’s system emerged largely unscathed despite many similar contextual developments. Some of the differences noted to explain the difference in outcomes in this latter incident include:
- statistically significant differences in particular balance-sheet ratios – for example, capital and liquidity ratios or the share of liabilities generated by retail versus wholesale deposits, as Rostnovski and Huang (2009) emphasize;
- the concentrated Canadian banking system (Bordo, Redish, and Rockoff 2011);
- differences relevant to the mortgage market, including the lesser run-up in housing prices in Canada, the fact that mortgage interest is not tax deductible in Canada, which works to constrain speculation, and the fact that Canadian mortgage loans are not non-recourse loans as is the case in many US states, (features emphasized by Dodge 2011);
- the consolidation of supervision of Canada’s federally supervised financial institutions under the Office of the Superintendent of Financial Institutions, which contrasted with the fragmented US regulatory framework;
Formal reviews of the functioning of Canada’s prudential regulatory and supervisory system also emphasize the effectiveness of interagency cooperation in Canada between OSFI, the Bank of Canada, the CDIC and the federal Department of Finance through formally established bodies such as the Senior Advisory Committee, which considers systemic issues, including crisis preparedness, and the Financial Institution Supervisory Committee, which addresses institution-specific problems, including early intervention into troubled financial institutions. More generally, Canada gets good marks for the collegial culture of information exchange and cooperation among the agencies with a formal role in financial system governance. See IMF (2019) for a detailed discussion of these issues and the division of responsibilities among Canada’s federal agencies for dealing with systemic-risk issues, including the overarching responsibility of the minister of finance for financial system stability, and the Bank of Canada’s responsibilities as lender of last resort and manager of the payments system. and - Canada’s innate conservatism in running the financial sector and stronger prudential requirements – for example, capital requirements over and above the Basel Accord requirements and limits on the role of innovative forms of capital in Tier 1 capital, points emphasized by Jackson (2013) in a Congressional Research Service report.
For example, in their exegesis of the subprime crisis, Bordo, Redish, and Rockoff (2011) attribute Canada’s escape from crisis to the fact that the concentrated Canadian banking system had absorbed the key sources of systemic risk that exploded in this crisis – namely, the mortgage market and investment banking – and was tightly regulated by one overarching regulator. By contrast, in the United States, a weaker fragmented banking sector had resulted in the evolution of a strong financial market that featured a large shadow banking system, multiple competing regulatory authorities, and a “labyrinthine set of regulations for financial institutions.” In the US system, the shadow banks were largely outside the regulatory umbrella and the risks that they took were therefore not well understood or monitored. While Canada had its version of the shadow banking crisis in the form of the meltdown of the non-bank asset-backed commercial paper (ABCP) market, this activity was relatively small in Canada compared to the United States (see, for example, Chant et al. 2003).
To be sure, the Canadian financial sector reforms in the early 1990s – which replaced the “four pillars” framework based on the separation of banking, trust, investment underwriting and insurance with an integrated financial sector model under one supervisory institution – explicitly targeted many of the risks that blew up in the United States in the subprime crisis.
Moreover, the risk-management rules both Canada and the United States adopted are broadly consistent with the global standards that have emerged through decades of work through international organizations such as the Bank for International Settlements (BIS) and the International Organization of Securities Commissions (IOSCO). Regulatory convergence has also gained impetus from international competitiveness concerns.
Paralleling the official processes, individual financial institutions have developed mathematically sophisticated techniques to manage risk, mining the massive databanks that have been developed on financial markets and instruments. Although individual institutions in Canada and the United States might have superior systems, it is hard to see why Canadian banks as a whole should consistently have more effective internal controls than do US banks.
To illustrate the difficulty of untangling this particular web, both Canada and the United States adopted a major financial sector reform prior to the subprime crisis, allowing banks into investment underwriting. In Canada, this was done through the “mini big bang” of 1987. In the United States, the reform was the repeal of the Glass-Steagall Act in 1999, a move that has been blamed explicitly for contributing to the subprime crisis. In Canada, the mini big bang was motivated by the desire to protect the banking system from disintermediation by a nascent shadow banking system – as signalled by the institution of the “bought deal” by Gordon Capital in the mid-1980s. Such a system would have created a dynamic problem of adverse selection as the banks’ best clients moved into direct financing, given that, at the time, they had as good or better credit ratings than the banks, which were saddled with non-performing sovereign loans associated with the Latin debt crisis. In one country, deregulation is said to have led to the crisis; in the other, the same deregulation can be argued to have prevented the crisis.
The Simultaneous Failure of Multiple Lines of Defence
The second major challenge in trying to nail down specific regulatory or supervisory features as responsible for Canada’s record of stability lies in the fact that, in managing their affairs, financial institutions have multiple lines of defence against failure: internal risk-monitoring management systems, internal auditors, boards of directors’ audit committees, boards of directors themselves, external auditors, and the disciplines generated by scrutiny from interested shareholders, market analysts and credit-rating agencies. Supervisory oversight and regulatory rules of the road are thus only one line of defence, and not necessarily the most important.
Given the various lines of defence, following every major financial debacle, of which we now have had four and counting in the span of a quarter-century – the Asian crisis, dot-com, subprime and now SVB – recriminations are levelled at each layer: the managers (and their pay/incentive packages), the directors, the auditors, the rating agencies, the market analysts, the risk models and the technicians who build them and, of course, public sector rules and the supervisory authorities.
For example, examining the subprime crisis, the Financial Crisis Inquiry Commission (FCIC 2011) seemingly apportioned equal blame to the “captains of finance and the public stewards of our financial system” who “failed to question, understand, and manage evolving risks” in the financial system, while commenting disapprovingly on households that “borrowed to the hilt.” The Commission listed its major findings as follows:
- The financial crisis was avoidable: it was the result of “human action and inaction, not of Mother Nature or computer models gone haywire” (FCIC 2011, xvii).
- There were failures in financial regulation and supervision: “The sentries were not at their posts, in no small part due to the widely accepted faith in the self-correcting nature of the markets” (FCIC 2011, xviii).
- There were “dramatic failures of corporate governance and risk management at many systemically important financial institutions” (FCIC 2011, xviii).
- There was “excessive borrowing, risky investments, and lack of transparency” (FCIC 2011, xix).
- The government was “ill prepared for the crisis, and its inconsistent response [allowing some institutions to fail but bailing out others] added to the uncertainty and panic in the financial markets” (FCIC 2011, xxi).
- There was a “systemic breakdown in accountability and ethics” (FCIC 2011, xxii).
More generally, the Commission blamed the collective “we” for allowing the development of a shadow banking system that lacked all the safeguards built around the formal banking system to prevent recurrence of the crises of the 1930s; in Biblical tones, the Commission concluded, “We had reaped what we had sown” (FCIC 2011, xx).
In the case of the subprime crisis, the chain of failure was multiplied many times over because of the multiple players involved in the generation of the derivative instruments at the heart of the crisis. As Baily, Litan, and Johnson (2009, 8) observe,
What is especially shocking...is how institutions along each link of the securitization chain failed so grossly to perform adequate risk assessment on the mortgage-related assets they held and traded. From the mortgage originator, to the loan servicer, to the mortgage-backed security issuer, to the CDO issuer, to the CDS protection seller, to the credit rating agencies, and to the holders of all those securities, at no point did any institution stop the party or question the little-understood computer risk models, or the blatantly unsustainable deterioration of the loan terms of the underlying mortgages.
The Asian crisis elicited a similar litany of recriminations of failure at every step in the line of defence: Where were the auditors? Where were the credit-rating agencies? Where were the risk models?
These recriminations are being reiterated at present in the SVB crisis (Barr 2023). For example, in the review of the SVB failure, it was noted that supervisory officials had warned SVB about the risk that higher interest rates posed to its balance sheet as far back as November 2021; SVB failed to address the concerns, however, exposing it to the deposit run that took it down (Son 2023) and exposing the supervisors for not having acted on their own warning.
That should give pause for reflection.
A theme that has received prominent discussion as a causal factor in financial crises is fraud. In the case of the subprime crisis, it was noted that none of the executives of the major failures went to jail: “Too big to fail, too powerful to jail?” is a question raised by Pontell, Black, and Geis (2014) in assessing why there were no major prosecutions – although hundreds of lower-level participants in the mortgage origination process were prosecuted (Nguyen and Pontell 2010). In a retrospective, Griffin (2021) identifies from a survey of the literature what he terms “a cohesive narrative that conflicts of interest and the malfeasant features it generated played a central role in the financial crisis.” Nguyen and Pontell (2010) describe the fraud as “built into” the financial system – that is, the system is structurally fraudulent in that “lax lending policies, poor underwriting standards, inadequate regulatory structure, and government oversight…entails significant amounts of fraud at various institutional levels.”
From the perspective of the present author, there are three major problems with assigning fraud a key role in the subprime or other financial crisis. First, fraud is a routine part of economic activity and is subject to routine monitoring and prosecution. For example, the US Mortgage Bankers Association estimated that, in 2006, mortgage fraud cost the industry between US$946 million and US$4.2 billion (cited in Nguyen and Pontell 2010). For its part, the FDIC issues a regular “Mortgage Loan Fraud Industry Assessment Based on Suspicious Activity Report Analysis.” The January 2017 report highlighted that the frequency of suspected frauds had risen substantially in the previous year (FDIC 2007).
The real issue, however, is not individual misrepresentations on mortgage applications by applicants who intend to repay, but “fraud for profit” – the latter is systematic (FBI 2007). That leads to the second point, which is that an allegation of fraud as a critical factor means “fraud for profit,” which then indicts the entire system – the “built-in” argument noted above. Fraud then becomes all-encompassing, and its role in “causing” the subprime crisis and, by extension, the longer history of US banking sector crises becomes inherently an “American-exceptionalism” argument – which is uncomfortable to rely on.
Finally, this fails to explain the failure of the entire system of controls all at once but only episodically. In short, fraud will always be found, will always be a contributing factor to the scale of the losses, but fails as a critical explanatory factor and, a fortiori, as a predictive factor.
Where the “fraud” explanation implicitly argues that the system was fine but there were bad apples in the barrel, a diametrically opposite explanation is to argue that the players were fine but risk models could not keep up with financial innovation.
Securitization is hardly new: it dates back to the 1800s, and the modern era, driven by securitization of mortgages, dates back to at least the 1970s (Kaplan 2014), if not the 1920s (Goetzmann and Newman 2010). The evolution of the overall financial system in terms of the relationships among the various types of intermediaries, their relative scale and so on would, of course, modify the system’s behaviour. For example, Gorton and Metrick (2010) point to the role of repurchase agreements in maturity transformation as the real culprit – although they acknowledge that all explanations remain controversial. In the big picture of long history, specific innovations become a digression in a footnote.
Canada Has the Bugs but Not the Disease
In light of the above, it is interesting, from the perspective of a comparative US-Canada analysis, to review the list of causal factors the CDIC lists in its own analysis of failures of Canadian financial institutions (CDIC 1997):
Mismanagement:
• lack of business plans and coherent strategies.
• excessive risk taking in expanding market segments.
Control system
• inadequate control systems to ensure compliance with internal policies and supervisory rules.
• inadequate credit analysis and loan review procedures.
Poor asset quality
• excessive concentration in a single sector.
• excessive loan growth in relation to management, control systems and funding sources.
• overlending (high loan-to-debt serviceability ratio).
Poor liquidity
• lack of cash to ensure the continuation of operations, caused by mismatch of loans and short-term assets and liabilities.
Capital adequacy
• inadequate capital to meet all applicable regulatory requirements and/or operating losses.
Fraud and concealment
• material fraud, which generally includes the intent to deceive and/or an attempt to conceal insider abuse in self-dealing.
Parent (or group contagion)
• difficulties caused by problems elsewhere in the group.
This list would not be out of place in any analysis of the US system. And yet, Canada’s system is stable and the US system is not. The bugs that are blamed for the disease of instability are present in Canada, but the disease is not. And this too gives pause for reflection.
The Tipping Point: Where Canada and the US Diverged
If we look to history for the answer, we need to focus on developments in Canada when its experience started to diverge. This was 1900. Prior to that date, Canada’s financial institutions failed as routinely as those in the United States. After that date, they did not. In 1900, Canada had a decennial revision of its Bank Act. For reasons that are probably completely buried in the sands of time, Canadian policymakers gave a prime role in resolving bank problems to the Canadian Bankers Association.
Here it is salient to note that the first Canadian banks were founded by Scots, and there are many parallels between Canadian banking history and Scottish banking history. Scotland had a history of banking stability that contrasted sharply with the tendency of the English banking system to lurch into crises. In their magnum opus to explain banking sector fragility as a “game of bank bargains,” Calomiris and Haber (2014) go into great depth in describing England’s troubled history but spend little time on Scotland, despite noting the distinctly different history. Nor do they unpack Canada’s similar divergence from its southern neighbour’s experience, despite Canada’s shared banking tradition with Scotland.
But there is a hook here on which to hang a theory. The implicit “model” that explains the sharp improvement in Canadian banking sector stability comes originally from the role of the Canadian Bankers Association. Bankers are strongly averse to instability because of the negative spillovers of such failures on their own banks and on the value of their bank charters. Any need for reinforcement of this perspective was provided by the fallout from the Home Bank failure in 1923. And thereafter, Canada handled incipient bank problems through mergers and acquisitions, not through allowing failures (see the Appendix for examples of how Canadian banks resolved incipient problems). The Canadian bankers controlled moral hazard through what we would refer to today as “social networks.” The United States, by contrast, prioritized the role of market disciplines in controlling moral hazard.
This, along with the historical accident of decennial revisions that prompted regular reform between crises rather than driven by crises, allowed the Canadian system to address the externalities generated by bank failures directly rather than indirectly through market discipline, while adapting to changing societal needs and technological conditions on a timely basis. Importantly, the system ensured enough competition to be efficient, as concluded by studies explicitly focused on this point conducted over many years (see the online Appendix for an elaboration and citations).
Following the SVB failure, Canada finds itself in a familiar position of observing a simmering financial crisis in the United States driven by a factor common to both countries – in this case rising interest rates due to monetary tightening – and facing similar factors in the risk environment, including commercial real estate and the increased potential rapidity of bank runs due to the digital transformation. Again, the United States is driven to consider a range of reforms in the wake of a crisis, while Canada is not.
Discussion and Conclusions
There are several takeaway points from the consideration of the comparative history of Canadian and US financial sector stability.
First, the US response in the SVB crisis balanced concerns about stability with concerns about longer-term efficiency from a possible heightening of moral hazard risk. In this regard, the US approach to SVB was much more in line with Canadian historical practice and does not necessarily create the risk of future crisis since, as Canada has demonstrated, moral hazard risks can be addressed between crises. The most comparable episode to SVB in US financial history is the Latin debt crisis, when the US authorities, alongside their international counterparts in this instance, exercised regulatory forbearance and avoided a US banking crisis on that account. That is encouraging for the prospects of avoiding a banking crisis in the present moment given the continuing vulnerabilities in the US banking system and the unknown risks in the shadow banking system.
Second, while US authorities are subject to the political necessity to be seen to be taking action, Canadian authorities are not. Nonetheless, OSFI was quick off the mark to monitor liquidity in the Canadian banking system, given that the SVB failure was triggered by a liquidity crisis, and the Canadian Bankers Association, although no longer armed with the powers conferred on it by the 1900 Bank Act, was similarly quick to issue a statement asserting the stability of the Canadian banking system. Forewarned is forearmed.
Third, while history tells us there is no parallel between the United States and Canada in terms of banking crises, the same history shows that Canada’s stability advantage was not quite as clean as it might appear. In this regard, see for example: the shrinkage of Canada’s bank branches in the Great Depression, which roughly matched the number of US bank failures; the litany of trust and loan company resolutions paralleling the US S&L and banking crises of the 1980s-1990s; and the collapse of Canada’s ABCP market during the subprime crisis in parallel with the collapse of similar instruments in the United States. Moreover, Canada's comparative stability also arguably owes something of a debt to serendipity – for example, the timely deregulation of interest rates for reasons unrelated to the benefit that Canada enjoyed as a result when accelerating inflation massively escalated the US savings and loan crisis. Accordingly, there is no basis for complacency. The present paper does not make the case for Canada to pat itself on the back. The SVB moment is, after all, the first such crisis in the age of social media, online banking and an unprecedented disruption that is unfolding in terms of the way we work flowing from the changes wrought by the pandemic and that are to come in the age of artificial intelligence.
Finally, while the evidence strongly argues that Canada did not buy stability through a grand trade-off with efficiency, since the US propensity for crisis has little to do with economic efficiency gains from optimizing competition in financial markets, this is not to argue that there is no trade-off at all between these objectives. Working within a regulatory/supervisory model that gives appropriate weight to the many and often destabilizing negative externalities of allowing financial institutions to fail and that acknowledges the de facto impossibility for depositors to judge the soundness of a bank from the quality of the marble in its foyers or the implications of the footnotes in its annual reports, it is possible to craft a financial sector policy that nudges the system toward greater efficiency while courting some additional margin of risk.
For example, the major Canadian banks reported Common Equity Tier 1 (CET1) ratios well above the regulatory minimum in 2022 (Rush 2023). From the perspective of the banks, this might reflect the need to maintain buffers above regulatory minima for risks not captured by the formal regulatory framework, including, for example, various uncertainties facing the economy, such as the historically high ratio of debt to income in Canada. From the perspective of the economy, however, it might reflect excessive prudence, as reflected in the fact that the margin between the prime business lending rate and the rate to small and medium-sized enterprises has tended to be the highest in the OECD (Kronick and Bafale 2022). In light of the narrative in this Commentary, one would be hard pressed to attribute the gap reported by Kronick and Bafale (2022) between the average spread for Canada (2.26 percentage points) and the United States (0.26 of a percentage point) to the treatment of moral hazard concerns in dealing with troubled institutions.
An informed reading of our own history – including reflecting on the Porter Commission’s advocacy for bank entry into conventional mortgage lending despite the mismatch in terms of assets and liabilities that this entailed – suggests that Canada has the margin to push for greater efficiency in its financial institutions policy. And, as also informed by its own history, this margin might be credited to the fact that, a century ago, in response to the last major bank failure in Canada, the collapse of Home Bank in 1923, Canada took the right decision about how to deal with the negative externalities of bank failures. The rest is history.
Canada has avoided its own banking crises over the past century, but it has not escaped the macroeconomic consequences of US banking crises. Nor would Canada escape the macroeconomic consequences of any knock-on financial trigger in the wake of the SVB failure, whether in the formal banking system or in the shadow banking system. The main takeaway lesson from Canada’s experience, when compared to that of the United States, is that there is no grand trade-off between economic dynamism and efficiency and instability. Instability is a choice made by prioritizing moral-hazard concerns over the negative externalities that come from bank failures. Moral-hazard issues are addressed far more effectively through regulatory design formulated in quiet periods rather than in the heat of a crisis. Economic efficiency can be pursued by fine-tuning the scope for risk taking through competition and regulatory design.
References
Allen, Jason, and Walter Engert. 2007. “Efficiency and Competition in Canadian Banking.” Bank of Canada Review, Summer, 33–45.
Allen, Jason, Walter Engert, and Ying Liu. 2007. “Are Canadian Banks Efficient? A Canada-U.S. Comparison.” Financial System Review. Ottawa: Bank of Canada.
Ames, Daniel, Chris S. Hines, and Jomo Sankara. 2014. “Credit Union Failures: Why Liquidate Instead of Merge?” Academy of Business Disciplines Journal 6 (1): 32–63.
Andrews, Edmund L. 2008. “Greenspan concedes error on regulation.” New York Times, October 23. https://www.nytimes.com/2008/10/24/business/economy/24panel.html.
Baillie, Charles. 1998. “Remarks to the House of Commons Standing Committee on Finance,” cited in The Standing Committee On Finance, Twelfth Report, https://www.ourcommons.ca/documentviewer/en/36-1/FINA/report-12/page-24
Baily, Martin Neil, Robert E. Litan, and Matthew S. Johnson. 2008. “The Origins of the Financial Crisis.” Washington, DC: Brookings Institution, Initiative on Business and Public Policy.
Bank of Canada. 2023. “Financial System Review 2023 – In Brief.” https://www.bankofcanada.ca/2023/05/financial-system-review-2023/.
Barr, Michael S. 2023. “Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank.” Board of Governors of the Federal Reserve System, April 28. https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf.
Bean, Mary Ledwin, Martha Duncan-Hodge, William R. Ostermiller, Mike Spaid, and R. Steve Stockton. 1998. Managing the Crisis: The FDIC and RTC Experience, Washington, DC: Federal Deposit Insurance Corporation. https://www.fdic.gov/bank/historical/managing/v.
Bernanke, Ben S. 2012. “Some Reflections on the Crisis and the Policy Response.” Remarks at the Conference on “Rethinking Finance: Perspectives on the Crisis.” Russell Sage Foundation and the Century Foundation, New York, April 13.
Bernanke, Ben, Mark Gertler and Simon Gilchrist. 1996. “The Financial Accelerator and the Flight to Quality,” The Review of Economics and Statistics 78(1), February: 1-15.
Bickis, Ian. 2023. “Silicon Valley Bank collapse presents low risk for Canadian sector: analysts.” Canadian Press, March 13. https://www.ctvnews.ca/business/silicon-valley-bank-collapse-presents-low-risk-for-canadian-sector-analysts-1.6311098.
BIS (Bank for International Settlements). 2004. “Bank Failures in Mature Economies.” Working Paper 13, Basel: BIS.
Boone, Peter, and Simon Johnson. 2010. “Canadian Banking Is Not the Answer,” The New York Times, 25 March. https://archive.nytimes.com/economix.blogs.nytimes.com/2010/03/25/canadian-banking-is-not-the-answer/
Bourque, Michelle. 2014. “CDIC’s New Role as Canada’s Resolution Authority,” Speaking Notes for CDIC President and CEO, Michele Bourque, CD Howe Institute, 9 June. https://www.cdic.ca/wp-content/uploads/Speech_MBourque_CDHowe_jun2014.pdf
Bordo, Michael D. 1986. “Financial Crises, Banking Crises, Stock Market Crashes and the Money Supply: Some International Evidence, 1870–1933. In Financial Crises and World Banking System, ed. Forrest Capie and Geoffrey E. Wood, 190–248. New York: St. Martin’s Press.
———. 1990. “The Lender of Last Resort: Alternative Views and Historical Experience.” Federal Reserve Bank of Richmond Economic Review, January/February, 18–29.
———. 1995. “Regulation and Bank Stability: Canada and the United States, 1870–1980.” Policy Research Paper 1532. Washington, DC: World Bank.
Bordo, Michael D., Hugh Rockoff, and Angela Redish. 1994, “The U.S. Banking System from a Northern Exposure: Stability versus Efficiency.” Journal of Economic History 54 (2): 325–41.
Bordo, Michael D., and David C. Wheelock. 1998. “Price Stability and Financial Stability: The Historical Record.” Federal Reserve Bank of St. Louis Review, September/October, 41–62.
Borio, Claudio. 2003. “Towards a Macroprudential Framework for Financial Supervision and Regulation?” BIS Working Paper 128. Basel: Bank for International Settlements.
Brandenburger, Adam M., and Barry J. Nalebuff. 1996. Co-opetition: A Revolution Mindset that Combines Competition and Cooperation. Crown Business.
Calomiris, Charles W. 2007. “Bank Failures in Theory and History: The Great Depression and Other ‘Contagious’ Events,” NBER Working Paper No. 13597, November. https://www.nber.org/system/files/working_papers/w13597/w13597.pdf
Calomiris, Charles W., and Gary Gorton. 1991. “The Origins of Banking Panics: Models, Facts, and Bank Regulation,” Chapter 4 in R. Glenn Hubbard (ed.) Financial Markets and Financial Crises, University of Chicago Press: 109-174.
Calomiris, Charles W., and Stephen H. Haber. 2014. Fragile by Design: The Political Origins of Banking Crises & Scarce Credit. Princeton, NJ: Princeton University Press.
Calomiris, Charles W., and Joseph R. Mason. 2003. “Fundamentals, Panics, and Bank Distress during the Depression.” American Economic Review 93 (5): 1615–47.
Canada. 2006. “2006 Financial Institutions Legislation Review: Proposals for an Effective and Efficient Financial Services Framework.” Ottawa: Finance Canada. https://publications.gc.ca/collections/Collection/F2-178-2006E.pdf.
Carlson, Mark. 2006. “A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response.” Finance and Economics Discussion Series. Washington, DC: Federal Reserve Board, Divisions of Research & Statistics and Monetary Affairs.
Carr, Jack, Frank Mathewson, and Neil Quigley. 1995. “Stability in the Absence of Deposit Insurance: The Canadian Banking System 1890–1966.” Journal of Money, Credit, and Banking 27 (4): 1137–58.
Chant, John. 2008. “The ABCP Crisis in Canada: The Implications for the Regulation of Financial Markets.” Paper prepared for the Expert Panel on Securities Regulation.
Chant, John, Alexandra Lai, Mark Illing and Fred Daniel. 2003. “Essays on Financial Stability,” Bank of Canada Technical Report No. 95, September.
Chappatta, Brian. 2023. “SVB’s 44-hour collapse was rooted in Treasury bets during pandemic.” Bloomberg, March 10. https://www.bloomberg.com/news/articles/2023-03-10/svb-spectacularly-fails-after-unthinkable-heresy-becomes-reality?leadSource=uverify%20wall.
Choe, Stan. 2023. “Deal to buy Silicon Valley Bank calms bank fears, for now.” Associated Press, March 27. https://ottawa.citynews.ca/national-business/deal-to-buy-silicon-valley-bank-calms-bank-fears-for-now-6762165
Clarfelt, Harriet, Martha Muir, Leo Lewis, and William Langley. 2023. “US bank shares rebound after rout sparked by SVB failure.” Financial Times, March 14.
CNN. 1998. “Fed cuts key interest rates.” October 15. https://money.cnn.com/1998/10/15/economy/fed/.
Cooban, Anna. 2023. “Credit Suisse got its lifeline. Investors are unconvinced.” CNN News, March 17. https://www.cnn.com/2023/03/17/investing/credit-suisse-shares-drop-despite-lifeline/index.html.
Copeland, Rob, Lauren Hirsch, Alan Rappeport, and Maureen Farrell. 2023. “Wall Street’s biggest banks rescue teetering First Republic.” New York Times, March 16. https://www.nytimes.com/2023/03/16/business/first-republic-bank-sale.html.
Cotis, Jean-Philippe. 2006. “Benchmarking Canada’s Economic Performance,” International Productivity Monitor 3 (Fall): 1–20.
Ciuriak, Dan. 2013. “Canadian and US Financial Sector Stability Differences over Long History: Is There a Unifying Explanation?” Working Paper, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2246150
__________. 2016. “Book Review: ‘Fragile by Design: The Political Origins of Banking Crises & Scarce Credit’ by Charles W. Calomiris and Stephen H. Haber,” 24 June 2016. Available on SSRN, http://papers.ssrn.com/abstract=2797098
__________. 2023. “The Silicon Valley Bank Failure: Historical Perspectives and Knock-on Risks.” Working Paper. Available at SSRN: https://papers.ssrn.com/abstract=4392931
Curry, Timothy, and Lynn Shibut, 2000. “The Cost of the Savings and Loan Crisis: Truth and Consequences.” FDIC Banking Review, December, 26–8.
Curtiss, C. A. 1948. “Banking,” in W. Stewart Wallace (ed.), The Encyclopedia of Canada, Vol. I, Toronto: University Associates of Canada: 151-164.
Davis, Lance E., and Robert E. Gallman. 2001. Evolving Financial Markets and International Capital Flows: Britain, the Americas, and Australia, 1865–1914. Cambridge: Cambridge University Press.
Defend, Monica, Vincent Mortier, and Matteo Germano. 2023. “No systemic risk from SVB failure, but watch out for areas of vulnerability.” Amundi Investment Talks, March 14. https://research-center.amundi.com/article/no-systemic-risk-svb-failure-watch-out-areas-vulnerability.
Dimand, Robert W., and Robert H. Koehn. 2009. “Canada in Two World Financial Crises: Why No Canadian Banks Failed or Were Bailed Out in the 1930s or 2000s,” Paper Presented at the IVth Bi-Annual Conference on The Financial and Monetary Crisis: Rethinking Economic Policies and Redefining the Architecture and Governance of International Finance, University of Bourgogne, Dijon, December 12.
Dodge, David. 2011. “Public Policy for the Canadian Financial System: From Porter to the Present and Beyond.” In New Directions for Intelligent Government in Canada: Papers in Honour of Ian Stewart, ed. Fred Gorbet and Andrew Sharpe, 81–100. Ottawa: Centre for the Study of Living Standards.
Dowd, Kevin. 1999. “Too Big to Fail? Long-Term Capital Management and the Federal Reserve.” Briefing Paper 52. Washington, DC: Cato Institute.
Escobar, Sabrina. 2022. “First Horizon stock surges on deal to be bought by TD Bank.” Barron’s, February 28. https://www.barrons.com/articles/first-horizon-stock-price-td-bank-acquisition-51646051475.
External Advisory Committee on Smart Regulation. 2004. Smart Regulation: A Regulatory Strategy for Canada. Ottawa: Privy Council Office. http://epe.lac-bac.gc.ca/100/206/301/pco-bcp/committees/smart_regulation-ef/2006-10-11/www.pco-bcp.gc.ca/smartreg-regint/en/08/rpt_fnl.pdf.
FBI. 2007. “Mortgage Fraud Report 2006.” Washington, DC: Federal Bureau of Investigation, May. https://www.fbi.gov/stats-services/publications/mortgage-fraud-2006.
FCIC (Financial Crisis Inquiry Commission). 2011. The Financial Crisis Inquiry Report. Washington, DC: US Government Printing Office.
FDIC (Federal Deposit Insurance Corporation). 1997. An Examination of the Banking Crises of the 1980s and Early 1990s, Volume 1. Washington, DC: FDIC. http://www.fdic.gov/databank/hist80.
———. 2007. “Mortgage Loan Fraud Industry Assessment Based on Suspicious Activity Report Analysis.” Financial Institution Letter FIL-4-2007, January 16.
———. 2023a. “Subsidiary of New York Community Bancorp, Inc., to assume deposits of signature Bridge Bank, N.A..” Press Release, March. 19. https://www.fdic.gov/news/press-releases/2023/pr23021.html.
———. 2023b. “JPMorgan Chase Bank, National Association, Columbus, Ohio assumes all the deposits of First Republic Bank, San Francisco, California.” Press Release, May 1. https://www.fdic.gov/news/press-releases/2023/pr23034.html.
———. 2023c. “First–Citizens Bank & Trust Company, Raleigh, NC, to Assume All Deposits and Loans of Silicon Valley Bridge Bank, N.A., from the FDIC.” Press Release, March 26. https://www.fdic.gov/news/press-releases/2023/pr23023.html.
———. 2023d. “Bank Failures in Brief – 2023.” https://www.fdic.gov/bank/historical/bank/bfb2023.html.
Federal Reserve Bank of St. Louis. n.d. “10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity.” https://fred.stlouisfed.org/series/T10Y3M.
———. n.d. “Total Assets, All Commercial Banks, Billions of U.S. Dollars, Weekly, Seasonally Adjusted.”
FOMC (Federal Open Market Committee). 1998a. “Minutes of the Federal Open Market Committee, September 29, 1998.” Federal Reserve Board. https://www.federalreserve.gov/fomc/minutes/19980929.htm
———. 1998b. “Minutes of the Federal Open Market Committee, November 17, 1998.” Federal Reserve Board. https://www.federalreserve.gov/fomc/minutes/19981117.htm.
Foster, Sarah. 2023. “Will the Fed raise interest rates one more time this year? Some economists aren’t convinced.” Bankrate, November 8. https://www.bankrate.com/banking/federal-reserve/how-much-will-fed-raise-rates-in-2023/#money.
Freedman, Charles. 1998. “The Canadian Banking System.” Paper delivered at the Conference on Developments in the Financial System: National and International Perspectives, Jerome Levy Economics Institute of Bard College, Annandale-on-Hudson, NY, April 10–11.
Friedman, Milton and Anna J. Schwartz. 1963. A Monetary History of the United States, 1867-1960. Princeton University Press.
Financial Stability Board. 2011. “Shadow Banking: Scoping the Issues: A Background Note of the Financial Stability Board.” Basel: Financial Stability Board, April 12. https://www.fsb.org/2011/04/shadow-banking-scoping-the-issues/.
———. 2012. “Global Shadow Banking Monitoring Report 2012,” Basel: Financial Stability Board, November 18.
FSRA (Financial Services Regulatory Authority of Ontario). 2023. “History of Closed Insured Institutions.” Toronto. https://www.fsrao.ca/consumers/credit-unions-and-deposit-insurance/find-credit-union-or-caisses-populaires-ontario/history-closed-insured-institutions.
GAO (General Accounting Office). 1997. “Financial Crisis Management: Four Financial Crises in the 1980s.” Staff Study GAO/GGD-97-96. Washington, DC.
Geithner, Timothy F. 2008. “Reducing Systemic Risk in a Dynamic Financial System: Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve Bank of New York, at The Economic Club of New York, New York, 9 June 2008.” BIS Review 74.
Giang, Vivian. 2023. “Banking turmoil: What we know,” New York Times, March 15. https://www.nytimes.com/article/svb-silicon-valley-bank-explainer.html.
Gelzinis, Greg. 2019. “Strengthening the Regulation and Oversight of Shadow Banks.” Washington, DC: Center for American Progress, July 18. https://www.americanprogress.org/article/strengthening-regulation-oversight-shadow-banks/
Goetzmann, William N., and Frank Newman. 2010. “Securitization in the 1920's.” NBER Working Paper 15650. Cambridge, MA: National Bureau of Economic Research. http://www.nber.org/papers/w15650/.
Gorton, Gary B. 2010. “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007.” In Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007, chap. 2. New York: Oxford University Press.
Gorton, Gary B., and Andrew Metrick. 2010. “Regulating the Shadow Banking System.” Brookings Papers on Economic Activity, Fall, 261–312.
Griffin, John M. 2021. “Ten Years of Evidence: Was Fraud a Force in the Financial Crisis?” Journal of Economic Literature 59 (4): 1293–321.
Grossman, Richard S., and Hugh Rockoff. 2015. “Fighting the Last War: Economists on the Lender of Last Resort.” NBER Working Paper 20832. Cambridge, MA: National Bureau of Economic Research. http://www.nber.org/papers/w20832.
Gruenberg, Martin J. 2023. “Remarks by Martin J. Gruenberg, Chairman, FDIC, on The Resolution of Large Regional Banks – Lessons Learned.” Federal Deposit Insurance Corporation, August 14. https://www.fdic.gov/news/speeches/2023/spaug1423.html.
Guardian. 2007. “When the music stops.” November 6. https://www.theguardian.com/commentisfree/2007/nov/06/comment.business.
Hart, Michael M. 2006. Taking Charge of Canada-US Regulatory Convergence. Commentary 229. Toronto: C.D. Howe Institute.
Hart, Michael, and William Dymond, 2007. “Trade Theory, Trade Policy, and Cross-Border Integration.” In Trade Policy Research 2006, ed. Dan Ciuriak, 103–58. Ottawa: Foreign Affairs and International Trade Canada.
Haubrich, Joseph G. 1990. “Nonmonetary Effects of Financial Crises: Lessons from the Great Depression in Canada,” Journal of Monetary Economics 25 (2): 223–52.
———. 2007. “Some Lessons on the Rescue of Long-Term Capital Management.” Policy Discussion Paper 19. Cleveland: Federal Reserve Bank of Cleveland, April.
Hirsch, Lauren. 2023a. “Bank turmoil is paving the way for even bigger ‘shadow banks.’” New York Times, May 6. https://www.nytimes.com/2023/05/06/business/dealbook/bank-crisis-shadow-banks.html.
———. 2023b. “Small banks rush to reassure investors as shares plunge.” New York Times, May 4. https://www.nytimes.com/2023/05/04/business/pacwest-stock.html.
Hughes, Stephanie. 2023. “TD Bank and First Horizon call off US$13.4-billion merger deal.” Financial Post, May 4. https://financialpost.com/fp-finance/banking/td-bank-first-horizon-terminate-merger.
IMF (International Monetary Fund). 2019. “Canada: Financial System Stability Assessment,” IMF Country Report 19/177. Washington, DC: International Monetary Fund.
Independent. 1998. “Bear Stearns’ $500m call triggered LTCM crisis.” September 26.
Jackson, James K. 2013. “Financial Market Supervision: Canada’s Perspective.” CRS Report to Congress R40687, April 4. Washington, DC: Congressional Research Service.
Jiang, Erica Xuewei, Gregor Matvos, Tomasz Piskorski, and Amit Seru. 2023. “Monetary Tightening and U.S. Bank Fragility in 2023: Mark-to-Market Losses and Uninsured Depositor Runs?” NBER Working Paper 31048. Cambridge, MA: National Bureau of Economic Research. https://www.nber.org/papers/w31048.
Johnson, Daniel. 2023. “After Silicon Valley Bank’s collapse, what would happen if a Canadian bank failed?” BNN Bloomberg, March 15. https://www.ctvnews.ca/business/after-silicon-valley-bank-s-collapse-what-would-happen-if-a-canadian-bank-failed-1.6314618.
Kaplan, Cathy M. 2014. “Securitisation: A Brief History and the Road Ahead.” Who’s Who Legal, August 8. https://whoswholegal.com/features/securitisation-a-brief-history-and-the-road-ahead.
Kronick Jeremy M., and Mawakina Bafale. 2022. “Deepening Canadian Capital Markets.” Intelligence Memo. Toronto: C.D. Howe Institute, 26 July. https://www.cdhowe.org/intelligence-memos/kronick-bafale-deepening-canadian-capital-markets.
Kryzanowski, Lawrence, and Gordon S. Roberts. 1993. “Canadian Banking Solvency, 1922–1940.” Journal of Money, Credit, and Banking 25 (1): 361–76.
———. 1998, “Capital Forbearance: Depression-era Experience of Life Insurance Companies.” Canadian Journal of Administrative Sciences 15 (1): 1–16.
———. 1999. “Perspectives on Canadian Bank Insolvency in the 1930s.” Journal of Money, Credit and Banking 31 (1): 130–6.
Lam, Eric. 2009. “CIBC ranked 15th in largest global bank losses for 2008.” Financial Post, July 2.
Macdonald, David. 2012. “The Big Banks’ Big Secret.” Report, Canadian Centre for Policy Alternatives, April. https://policyalternatives.ca/sites/default/files/uploads/publications/National%20Office/2012/04/Big%20Banks%20Big%20Secret.pdf
Macmillan Commission. 1933. Report of the Royal Commission on Banking and Currency in Canada. Chair, Lord Macmillan. https://publications.gc.ca/collections/collection_2014/bcp-pco/CP32-129-1933-1-eng.pdf.
McCulley, Paul. 2009. “The Shadow Banking System and Hyman Minsky’s Economic Journey.” In Insights into the Global Financial Crisis, ed. Laurence B. Siegel, 257–68. [n.p.]: Research Foundation of CFA Institute.
McDade, Susan E. 1989. “Latin American Debt Crisis and the Canadian Commercial Banks.” ISS Working Papers 53, General Series. The Hague: Erasmus University, International Institute of Social Studies.
Mor, Federico. 2018. “Royal Bank of Scotland Bailout: 10 Years and Counting.” Insight, House of Commons Library, October 12. https://commonslibrary.parliament.uk/royal-bank-of-scotland-bailout-10-years-and-counting/.
Nguyen, Tomson H., and Henry N. Pontell. 2010. “Mortgage Origination Fraud and the Global Economic Crisis: A Criminological Analysis.” Criminology and Public Policy 9 (3): 591–612.
Neufeld, Edward P. 1972. The Financial System of Canada. Toronto: Macmillan of Canada.
Nishant, Niket, and Manya Saini. 2023. “PacWest stock soars on $1.1 billion buyout deal with Banc of California.” Reuters, July 26. https://www.reuters.com/markets/deals/pacwest-stock-soars-11-bln-buyout-deal-2023-07-26/.
Noiseux, Marie Hélène. 2002, “Canadian Bank Mergers, Rescues and Failures.” PhD thesis, Concordia University.
Ontario Securities Commission. 2009. “In the Matter of the Securities Act R.S.O. 1990, c. S.5, as Amended and Coventree Inc., Geoffrey Cornish and Dean Tai: Statement of Allegations.” Ontario Securities Commission, December 7.
OSFI (Office of the Superintendent of Financial Institutions). 2022. “Who We Regulate.” https://www.osfi-bsif.gc.ca/Eng/wt-ow/Pages/wwr-er.aspx.
———. 2023a. “Foreign Bank Branches.” https://www.osfi-bsif.gc.ca/Eng/fi-if/dti-id/fbb-sbe/Pages/default.aspx.
———. 2023b. “Superintendent of Financial Institutions takes temporary control of Silicon Valley Bank’s Canadian branch.” Press Release, March 12. https://www.osfi-bsif.gc.ca/Eng/osfi-bsif/med/Pages/nr20230312.aspx.
PacWest. 2023. “Banc of California and PacWest announce transformational merger and $400 million equity raise from Warburg Pincus and Centerbridge.” Company Release, July 25. https://www.pacwestbancorp.com/news-market-data/news/news-details/2023/Banc-of-California-and-PacWest-Announce-Transformational-Mergerand-400-Million-Equity-Raise-from-Warburg-Pincus-and-Centerbridge/default.aspx.
Patrick, Margot, Ben Dummett, Dana Cimilluca, and Patricia Kowsmann. 2023. “UBS agrees to buy Credit Suisse for more than $3 billion.” Wall Steet Journal, March 19. https://www.wsj.com/articles/ubs-offers-1-billion-to-take-over-credit-suisse-bfac51fa.
Perino, Michael. 2012. “Crisis, Scandal and Financial Reform during the New Deal.” Legal Studies Research Paper Series 12-0004. Jamaica, NY: St. John’s School of Law. May.
Poapst. J.V. 1956. “The National Housing Act, 1954.” Canadian Journal of Economics and Political Science 22 (2): 234–43.
Pollard, Amelia, Giulia Morpurgo and Reshmi Basu. 2023. “SVB Isn’t a ‘Lehman Moment’ – But Could It Be a ‘Bear Stearns’ One?” Bloomberg, 14 March. https://www.bloomberg.com/news/newsletters/2023-03-14/what-s-the-next-banking-crisis-after-svb-analysts-say-it-won-t-be-last
Pontell, Henry N., William K. Black, and Gilbert Geis. 2014. “Too Big to Fail, Too Powerful to Jail? On the Absence of Criminal Prosecutions after the 2008 Financial Meltdown.” Crime, Law and Social Change 61: 1–13.
Punchard, Hilary. 2023. “OSFI takes permanent control of SVB’s Canadian branch assets.” BNN Bloomberg, March 15. https://www.bnnbloomberg.ca/osfi-takes-permanent-control-of-svb-s-canadian-branch-assets-1.1896031.
Rappeport, Alan. 2023. “F.D.I.C. proposes broadening bank insurance for businesses.” New York Times, May 1. https://www.nytimes.com/2023/05/01/business/fdic-bank-insurance-proposals.html.
Ratnovski, Lev, and Rocco Huang. 2009. “Why Are Canadian Banks More Resilient?” IMF Working Paper WP/09/152. Washington, DC: International Monetary Fund. July.
RBC. 2023. “Royal Bank of Canada Investor Presentation, Q3/2023.” https://www.rbc.com/investor-relations/_assets-custom/pdf/irdeck2023q3.pdf.
Ricks, Morgan. 2016. The Money Problem: Rethinking Financial Regulation. Chicago: University of Chicago Press.
Rowe Jr., and James L. “How a bank lent itself to disaster.” Washington Post, July 29. https://www.washingtonpost.com/archive/politics/1984/07/29/how-a-bank-lent-itself-to-disaster/ccff5657-af6b-4045-bc63-de6100e7dc07/.
Rubinstein, Mark. 2000. “Comments on the 1987 Stock Market Crash: Eleven Years Later.” Risks in Accumulation Products, Society of Actuaries: 1–6.
Rush, Geoff. 2023. “Banking in Transition: Fiscal Year 2022 Results Analysis: Analysis of the Six Major Canadian Banks’ Year-End Financial Results for 2022.” KPMG. https://kpmg.com/ca/en/home/insights/2023/01/banking-in-transition-fiscal-year-2022-results-analysis.html.
Russell, Karl, and Christine Zhang. 2023. “3 failed banks this year were bigger than 25 that crumbled in 2008.” New York Times, May 1. https://www.nytimes.com/interactive/2023/business/bank-failures-svb-first-republic-signature.html.
Sanati, Cyrus. 2010. “Prince finally explains his dancing comment.” New York Times, April 8. https://archive.nytimes.com/dealbook.nytimes.com/2010/04/08/prince-finally-explains-his-dancing-comment/.
Santomero, Anthony M., and Paul Hoffman. 1998. “Problem Bank Resolution: Evaluating the Options.” Wharton School Working Paper Series 98-05-B. Philadelphia: University of Pennsylvania, Wharton School.
Schneider, Howard, and Lindsay Dunsmuir. 2023. “Fed’s Powell sets the table for higher and possibly faster rate hikes.” Reuters, March 8. https://www.reuters.com/markets/us/feds-powell-hill-appearance-update-views-status-disinflation-2023-03-07/.
Scholes, Myron S. 2000. “Crisis and Risk Management.” American Economic Review 90 (2): 17–21.
Shaw, C.J. 2006. “Big Bank Merger Review in Canada.” Journal of International Banking Law and Regulation 8: 474-486.
Shearer, Ronald A. 1977. “The Porter Commission Report in the Context of Earlier Canadian Monetary Documents.” Canadian Journal of Economics 10 (1): 34–49.
———. 1978. “Proposals for the Revision of Banking Legislation.” Canadian Journal of Economics 11 (1): 121–36.
Sidel, Robin, David Enrich, and Dan Fitzpatrick. 2008.“WaMu is seized, sold off to J.P. Morgan, in largest failure in U.S. banking history.” Wall Street Journal, September 26. https://www.wsj.com/articles/SB122238415586576687.
Smialek, Jeanna. 2023. “Fed slams its own oversight of Silicon Valley Bank in post-mortem.” New York Times, April 28. https://www.nytimes.com/2023/04/28/business/economy/fed-silicon-valley-bank-failure-review.html.
Son, Hugh. 2023. “SVB customers tried to withdraw nearly all the bank’s deposits over two days, Fed’s Barr testifies.” CNBC, March 28. https://www.cnbc.com/2023/03/28/svb-customers-tried-to-pull-nearly-all-deposits-in-two-days-barr-says.html.
Sprague, O.M.W. 1910. History of Crises under the National Banking Act. Washington, DC: US Government Printing Office.
Sweet, Ken, Christopher Rugaber, Chris Megerian, and Cathy Bussewitz. 2023. “U.S. government races to reassure that banking system is safe.” CTV News, March 13. https://www.ctvnews.ca/business/u-s-government-races-to-reassure-that-banking-system-is-safe-1.6310632.
TD. 2022. Annual Report, 2022. htps://www.td.com/document/PDF/ar2022/ar2022-Complete-Report.pdf.
———. 2023. “TD Bank Group reports third quarter 2023 results: Report to shareholders, three and nine months ended July 31, 2023.” https://www.td.com/document/PDF/investor/2023/2023-Q3_Report_to_Shareholders_F_EN.pdf.
Tedesco, Theresa, and John Turley-Ewart. 2009. “Canadian Banks: A Better System.” National Post, April 5. https://nationalpost.com/news/canadian-banks-a-better-system.
Todd, Tim. 2010. “Integrity, Fairness and Resolve: Lessons from Bill Taylor and the Last Financial Crisis.” Federal Reserve Bank of Kansas City. https://www.kansascityfed.org/AboutUs/documents/6510/integrityfairnessandresolve.pdf
Turley-Ewart, John. 2004. “The Bank That Went Bust.” The Beaver, 1 August. https://www.canadashistory.ca/explore/business-industry/the-bank-that-went-bust
Wagster, John D. 2009. “Canadian-Bank Stability in the Great Depression: The Role of Capital, Implicit Government Support and Diversification.” Unpublished manuscript, Wayne State University.
Walter, John R. 2005. “Depression-Era Bank Failures: The Great Contagion or the Great Shakeout?” Federal Reserve Bank of Richmond Economic Quarterly 91 (1): 39–54. https://www.richmondfed.org/-/media/RichmondFedOrg/publications/research/economic_quarterly/2005/winter/pdf/walter.pdf.
Wells, Donald R. 1987. “Banking Before the Federal Reserve: The U.S. and Canada Compared.” The Freeman, Ideas On Liberty: 231-235.
Wicker, Elmus. 2001. “Banking Panics in the US: 1873–1933.” Net Encyclopaedia. Economic History Association. https://eh.net/encyclopedia/banking-panics-in-the-us-1873-1933/.
Wighton, David. 2017. “What we have learned 10 years after Chuck Prince told Wall St to keep dancing.” Financial News, July 14. https://www.fnlondon.com/articles/chuck-princes-dancing-quote-what-we-have-learned-10-years-on-20170714.
Witmer, Jonathan, and Lorie Zorn. 2007. “Estimating and Comparing the Implied Cost of Equity for Canadian and U.S. Firms.” Bank of Canada Working Paper 2007–48. Ottawa: Bank of Canada. https://www.bankofcanada.ca/2007/09/working-paper-2007-48/.
Online Appendix
US and Canadian Experiences, Regulatory Policies, and Tipping Points
The United States has a unique history of frequency of financial crises and financial institution failures. In its early history, the United States had recurring financial crises/panics/incipient panics, including in 1797, 1815, 1819, 1825, 1833, 1837, 1839, 1857, 1860–61, 1873, 1884, 1890, 1893, 1897, 1907 (the event which prompted the formation of the Federal Reserve System) and 1914.
The interwar period featured additional waves of bank failures. In particular, there were numerous failures in the agricultural states in the 1920s – although these were not associated with panic-type bank runs but rather reflected shocks to the real economy (Walter 2005) – followed by a total of over 9,000 failures nationwide during the 1930–33 period, which witnessed four separate episodes of bank panic (Calomiris and Mason 2003).
Following an extended period of relative calm from the 1940s through the 1970s, US bank failures surged between 1980 and 1994, including in the mutual savings bank sector, the commercial bank sector and the savings and loan sector.
The mutual savings bank problems surfaced early. Between late 1981 and year-end 1985, the Federal Deposit Insurance Corporation (FDIC) conducted 17 assisted mergers or acquisitions of mutual savings banks with total assets of nearly US$24 billion, at a cost estimated at about US$2.2 billion (FDIC 1997, chap. 6). Subsequently, 58 more savings banks with combined assets of about US$60.8 billion failed, including some that had been restructured in the first wave, at a cost to the public purse of US$6.6 billion (FDIC 1997, appendix table 6-A.1), bringing the overall total of savings bank failures during this period to 75, with total assets of US$85 billion, and generating a cost to the public of US$8.8 billion.
A much bigger problem erupted in the commercial bank sector. Between 1980 and 1994, more than 1,600 banks insured by the FDIC were closed or received FDIC financial assistance, with a total cost to the taxpayer estimated at US$36.3 billion (FDIC 1997, chap. 1). Prominent events in this period included the failure of an Oklahoma bank, Penn Square, in 1982 during the oil patch downturn; this had significant ripple effects due to loan participations it had sold to other banks. The Penn Square closure represented the largest bank failure in which uninsured depositors suffered losses up to that point in the FDIC’s history (FDIC 1997, chap. 3). Shortly after, in 1984, Continental Illinois collapsed, in part due to its connections to Penn Square. Continental Illinois was at the time the seventh-largest bank in the United States, the largest US commercial and industrial lender and one of the most highly regarded by the market in the year that preceded its collapse (see, for example, Rowe Jr. 1984). This crisis, featuring an electronic bank run by wholesale depositors, cost the FDIC US$1.1 billion in resolution costs and gave rise to the sobriquet “too big to fail,” as well as a debate about “nationalization” of banks due to the public capital injected to keep them from failing (FDIC 1997, chap. 7). These incidents, however, turned out to be just the prologue: at the height of the banking crisis in 1988–92, during the bust in the commercial real estate market, on average one bank failed in the United States every day.
Unfolding concurrently with the commercial banking crisis, the US savings and loan crisis resulted in the closing of 1,043 thrifts holding US$519 billion in assets, the insolvency of the Federal Savings and Loan Insurance Corporation, the federal insurer for the thrift industry, and a public bailout cost of US$123.8 billion (Curry and Shibut 2000).
(Todd 2010).
US capital markets then generated in short order several additional bouts of financial stress that threatened the banking system and pressured the Federal Reserve to make significant adjustments to monetary policy to avert systemic risks. The stock market crash of 1987 brought the US financial system to the point of breakdown and raised fears of a widespread credit crunch, requiring the Federal Reserve to inject liquidity into markets and to prompt commercial banks to extend credit to securities firms, despite any concerns they might have had about the size of their exposure (Carlson 2006; GAO 1997). Through contagion, the effects spread worldwide and prompted new regulatory initiatives (such as circuit breakers). To this day, the event remains poorly understood despite the fact that it provoked extensive study because of the spanner it threw into the workings of conventional finance theory.
The collapse of Long Term Capital Management (LCTM) in 1998 at the tail end of the Asian/emerging market crisis of 1997–98 also elicited a massive intervention organized by the Federal Reserve based on its judgment that the hedge fund’s bankruptcy would pose a systemic threat. A consortium of 14 institutions with outstanding claims against LTCM infused new equity capital into the firm and took over its management at a meeting chaired by William McDonough, head of the New York Federal Reserve Bank. According to one of the principals of LCTM, Myron Scholes, although the Fed facilitated the refinancing, it did not bail out LTCM, as all the funds came from private creditors and, in any event, LCTM was liquidated (Scholes 2000). As Myron Scholes explains, the Fed’s initiative was prompted by the threat of holdup actions by creditors claiming they had priority claims on LCTM assets; such actions would have forced LCTM to file for bankruptcy. Press reports at the time suggested a bankruptcy would have forced an unwinding of as much as US$100 billion, resulting in cascading losses through the international financial system.
The intervention “ … encourages more calls for the regulation of hedge-fund activity, which may drive such activity further offshore; it implies a major open-ended extension of Federal Reserve responsibilities, without any congressional authorization; it implies a return to the discredited doctrine that the Fed should prevent the failure of large financial firms, which encourages irresponsible risk taking; and it undermines the moral authority of Fed policymakers in their efforts to encourage their counterparts in other countries to persevere with the difficult process of economic liberalization” (Dowd 1999).
Notably, the firms participating in the LCTM rescue included Bear Stearns and Lehman Brothers, whose failures a decade later unleashed the subprime crisis.
Although this crisis did not result in further major financial instability, it did prompt new regulatory initiatives such as the Sarbanes-Oxley Act to address scandalous practices, and focused attention on macroprudential aspects of financial regulation.
As regards the subprime crisis, Ben Bernanke (2012) provides a good retrospective, including a good sense of the (apparent) bewilderment of the protagonists in this drama in trying to understand how something as relatively minor and prosaic in the grand financial scheme as aggregate losses on subprime paper on the order of US$1 trillion could upset the whole system: “By way of comparison, it is not especially uncommon for one day’s paper losses in global stock markets to exceed the losses on subprime mortgages suffered during the entire crisis, without obvious ill effect on market functioning or on the economy” (Bernanke 2012, 2). Bernanke explains the difference in terms of concentration of losses:
In the case of dot-com stocks, losses were spread relatively widely across many types of investors. In contrast, following the housing and mortgage bust, losses were felt disproportionately at key nodes of the financial system, notably highly leveraged banks, broker-dealers, and securitization vehicles. Some of these entities were forced to engage in rapid asset sales at fire-sale prices, which undermined confidence in counterparties exposed to these assets, led to sharp withdrawals of funding, and disrupted financial intermediation, with severe consequences for the economy. (Bernanke 2012, 6.)
Once confidence in these weak nodes unravelled, the crisis then unfolded as a “classic financial panic,” the kind that had been eliminated in retail banking by deposit insurance (Bernanke 2012, 11), but that in this case had flared up in a non-traditional context: the shadow banking system.
The Canadian experience was quite different. The number of chartered banks formed in Canada early in its history was relatively small compared that in the United States. Canada’s first chartered bank, the Bank of Montreal, started business in 1817. The number of Canadian banks peaked at 51 in 1875 before a period of consolidation through failure and merger brought the number down to 22 at the end of 1914. During this period, 46 banks failed or had their charter revoked, and an additional 23 disappeared through merger (Neufeld 1972). But notwithstanding the fact that, cumulatively, Canada lost nearly half the chartered banks that ever opened their doors prior to World War 1, Canada did not have recurring systemic crises as did the United States during this period (Calomiris 2007).
In addition to chartered bank failures, Canada also experienced numerous failures of private banks and near-banks in its early history, which is often overlooked. In the early history of Canada, numerous private banks sprang up to provide financial services in areas underserviced by the chartered banks. Neufeld (1972) lists 147 private bankers in operation in 1885, of which 80 were operating in centres not served by a chartered bank. Many of these private banks, which operated without any regulatory oversight whatsoever, failed, inflicting significant losses on the small communities they served, as brought out in debates in the House of Commons at the time (Neufeld 1972, 173–5). Similarly, the early building societies in Canada mostly ended badly.
In the interwar period, Canada had exactly one bank failure, Home Bank in 1923, which led to the establishment of the office of the Inspector General of Banks in 1924. Due to a continued steady pace of consolidation through merger, however, Canada entered the Depression years with just 11 banks in operation.
The consolidation wave continued through the Depression. There was only one major acquisition – that of the Weyburn Security Bank with its 30 branches by the Canadian Imperial Bank in 1931. The archival evidence clearly shows that this acquisition was facilitated as a pre-emptive move to avert Weyburn’s failure (Carr, Mathewson, and Quigley 1995). The main action in terms of consolidation was through closure of branches, which had essentially the same effect as unit bank failures in the United States in terms of reducing banking capacity, but without the disruptions to creditor-debtor relations that are attendant on failures. From a peak of over 4,600 branches in 1920, the Canadian bank branch system shrank to about 3,600 in the 1940s. Some of this was due to the merger wave of the 1920s, some due to reduction of capacity during the 1930s. Canada exited the Depression with 10 banks still standing.
During the troubled 1980s, Canada lost three small banks: two to failure (Canadian Commercial Bank and the Northland Bank, both based in Canada’s oil patch) and one through an assisted merger (Bank of British Columbia, which was taken over by Hong Kong Bank of Canada). No depositor lost a cent and there was no crisis. The cost to the federal government amounted to $1.39 billion, of which $875 million was payouts to uninsured depositors, $316 million losses incurred by the CDIC and $200 million injected by the federal government to facilitate the takeover of Bank of British Columbia (Chant et al. 2003). This understates somewhat the full extent of the reduction of banking supply capacity in Canada at the time because a number of foreign-owned banks also exited the Canadian market.
Canada’s trust and loan companies, the successors to the building societies, also experienced a series of failures in the troubled 1980s and early 1990s. Of the 40 trust and loan company failures the CDIC lists since it came into existence in 1967, 38 of them occurred between 1980 and 1996, coinciding with the years of heightened rates of bank failure and the savings and loan crisis in the United States. The last deposit-taking institution to fail in Canada was Security Home Mortgage Corporation in 1996, although there were some near-misses later.
No depositor lost money, and the failures did not trigger a crisis – although Chant et al. (2003) list them as a “borderline crisis.” The handling of the failure in 1992 of Central Guaranty Trust Company (CGT), Canada’s fourth-largest trust company with $12 billion in financial assets and the largest financial institution to fail in Canada’s history, was described by CDIC president Michelle Bourque in a speech to the C.D. Howe Institute in 2014 as follows: “CGT closed at midnight on December 31, 1991, and was reopened a minute later as a part of Toronto-Dominion Bank. Depositors did not have to lose a minute of sleep, nor did they lose a single dollar of their money. The cost of the failure was recouped through premiums collected from our member institutions” (Bourque 2014). The total amount in deposit repayments or rehabilitation laid down by the CDIC amounted to $10.2 billion, with total losses of about $1.7 billion (based on a compilation from CIDC annual reports).
The Canadian banking system sailed through the various bouts of market turbulence from the late 1990s through the subprime crisis without systemic crisis – apart from liquidity support during the subprime crisis when global funding dried up – or major financial institution failures.
To be sure, the stark differences in the above accounts are at least somewhat misleading. The great number of US bank failures reflects in good measure the fact that the US system had evolved for much of its history with unit banks. By contrast, Canada, like most other countries, had branch-banking systems (on the significance of this difference, see, for example, Bordo 1995). Accordingly, Canada had far fewer banks than the United States, while the number of branches of Canadian banks was generally similar to the number of unit banks in the United States on a per capita basis. For example, in 1910, when Canadian bank-branch density reached what proved to be a relatively stable level of about one per every 3,000 Canadians, there was one bank for every 3,770 Americans (Davis and Gallman 2001).
Considered in this light, the failure of Home Bank in 1923, which involved the closure of over 70 branches,
Also, it is important to note that many crises were averted by problems having been “swept under the rug,” so to speak. During the 1930s, the federal government bailed out Newfoundland, Manitoba and Saskatchewan, which indirectly staved off problems for the Canadian banks that were heavily exposed to them (Dimand and Koehn 2009). During the Latin debt crisis, the Inspector General of Banks exercised “regulatory forbearance” to avoid triggering action when the entire banking system was technically insolvent due to excess exposure to non-performing sovereign debt.
“The ABCP note typically had a maturity of 30, 60 or 90 days and were backed up by liquidity arrangements that would enable the conduits to meet their repayment obligations under specified conditions, which for third-party conduits were dependent on a ‘general market disruption.’ The assets held by third-party conduits were divided between traditional assets (29 percent) and synthetic, or derivative, assets (71 percent). Of the derivative assets, $17.4 billion (59 percent of total assets) were Leveraged Super Senior Swaps through which the conduits provided protection for others against credit losses. In addition to the sponsors and their conduits, credit rating agencies and investment dealers and their sales representatives were critical to the market’s development. Credit rating agencies provided the rating that exempted ABCP from prospectus requirements and made it an eligible investment for many investors. Investment dealers and their sales agents distributed and marketed ABCP to financial institutions, pension funds, governments and their agencies, corporations, individuals and other investors” (Chant 2008).
Fortunately for Canada, the scale was too small to bring down the system.
In a similar vein, this narrative does not delve into the experience of the credit union movement in the two countries, where the experience appears to be more similar than dissimilar, as both systems emphasize amalgamations and purchases of troubled credit unions over costly liquidations.
In summary, while Canada’s record is not quite as clean as it is often made out to be, its financial sector did show much greater stability overall than did the US system, at least after its early years – and without any significant penalty in terms of efficiency (Allen and Engert 2007; Bordo 1995; Witmer and Zorn 2007). The difference in the performance of the Canadian financial sector thus appears to have deep roots. Several key factors that influenced the evolution of the Canadian system in a way that might have accounted for this difference are examined below. This understanding is important for the evaluation of transportability of the Canadian “model” to other jurisdictions.
The Evolution of Regulatory Policies
The main elements of Canada’s early banking regulation from a prudential perspective reflected instructions from the British Treasury issued in 1833 (Curtiss 1948). Almost two centuries later, these elements read remarkably well in terms of establishing a sound basis for the operation of a financial institution:
- banks had to make return or statement of affairs, which as early as 1856 was to be made on a monthly basis and made public (thus providing for transparency);
- shareholders were liable for the amount of their shares, which amounted to “double liability” in the event of a failure (thus providing a discipline against undue risk taking);
- issue of banknotes – which represented Canada’s currency before the Bank of Canada took over the role on an exclusive basis – was regulated with reference to paid-in capital;
- provision was made for a sufficient reserve fund;
- banks were required to remain lenders, and not allowed to become partners in the businesses to which they lent (thus separating banking and commerce); and
- limitations were placed on loans to officers and directors, and a ban placed on banks’ investing in their own stocks or lending on the security of these stocks (that is, no “self-dealing”).
The concern with financial soundness and the protection of bank creditors seems to have been internalized by Canadian authorities from the beginning. As Shearer (1977, 6) notes “the very first enquiry – the 1868 Select Committee on Banking and Currency of the Dominion – was motivated by a concern that [as Hansard recorded] ‘for both circulation and deposits there should be the fullest measure of security given to the public.’”
With two notable exceptions – the reforms prompted by the 1964 Porter Royal Commission’s investigation into banks and banking and the comprehensive 1987–92 reforms – the Canadian system subsequently evolved through a gradual accretion of amendments rather than as the result of any grand design. In part, this was due to a series of ad hoc legislative developments at the time of Confederation, which resulted in the life of the banks’ charters being established on a uniform basis at 10 years in the 1870 Bank Act. Periodic revisions of the Act were needed to extend individual banks’ charters – the first decennial revision took place with the 1880 Bank Act – and provided an opportunity to make timely adjustments as circumstances dictated, with adequate time for preparatory analysis and reflection (Shearer 1978). At the same time, the regular reviews prevented the build-up of issues that would have warranted major overhauls, at least for banks: Canada’s federal non-bank financial institutions legislation was not regularly updated until the introduction of the five-year review cycle for all federal financial institutions in the 1992 reforms.
While the early history of Canada’s bank regulation emphasized prudential concerns, it also featured substantial pushback from Canadian financial institutions against regulatory intervention. As Shearer (1977) noted, the proposal by Canadian authorities in the late 1860s to introduce measures already adopted in the United States that required banknotes in circulation to be backed by government securities was “vigorously opposed by the banking interests and ultimately withdrawn … leading to the resignation of Canada’s first minister of finance.” Similarly, there was resistance from the chartered banks to the introduction in the (delayed) 1913 revision of the Bank Act of a more rigorous shareholders’ audit pursuant to the recommendations of a Commission of Enquiry into the failure of the Farmers Bank of Canada. The Commission had determined that the bank’s failure resulted from “gross extravagance, recklessness, incompetency, dishonesty and fraud” on the part of management (Porter Royal Commission, quoted in Shearer 1977).
Canada did not establish a banking supervisory office until 1925 (introduced pursuant to the 1924 Bank Act revision).
Canada did not establish a central bank until 1935,
It might be tempting, given this record, to infer that the greater stability of the Canadian system might have reflected the absence of deposit insurance or government supervision, and thus was due to more prudent behaviour by financial institutions instilled by market discipline, in the context of generally sound, if minimalist, rules of the road. There are many claims to this effect. Wells (1987) uses this argument in a comparison of the early Canadian and US banking histories; Bordo (1990) summarizes the perspective of “free-banking” advocates on the disutility of government regulation of banks, an issue revisited below.
Following the early changes to tighten regulation, subsequent reforms in Canada started to move in the direction of promoting competition and expanding the supply of financial services to the Canadian economy. A major reason for this shift in emphasis was the phasing out of banknotes issued by the chartered banks as circulating currency with the 1934 Bank Act revision. With this reform, the function of issuing banknotes was vested with the Bank of Canada following its establishment in 1935.
Many of the measures introduced in Canada in this more recent history parallel those that have come under fire in the United States as contributing factors to the US subprime crisis.
In the immediate postwar period, concern about the supply of housing led to initiatives such as the establishment of Canada Mortgage and Housing Corporation
The 1967 Bank Act revisions, which followed the first ever in-depth review of the micro structure of Canada’s financial sector (Shearer 1977) by the 1964 Porter Royal Commission, continued in this vein. As Shearer noted, “Porter was much less concerned with ‘soundness’ and more concerned with efficiency and innovativeness than was traditional.” Notably, in this regard, the 1967 revisions relaxed the restriction on bank mortgage lending by permitting non-insured, conventional mortgage lending.
Nonetheless, two measures introduced in the 1967 Bank Act revision proved to be particularly valuable in preserving stability in Canada’s financial sector, although for reasons unrelated to the prime motivations behind the measures.
First, regulations on bank lending rates were removed to level the playing field for the banks vis-à-vis near-banks that were not subject to interest-rate regulation.
Second, the 1967 Bank Act revision introduced a restriction on ownership of chartered bank shares to 10 percent. This was ostensibly for antitrust reasons (Shearer 1978), although the measure was prompted largely by the perceived threat of foreign takeovers in the wake of Citibank’s interest in a non-bank financial institution in Canada. In time, this measure came to be seen as a primary regulatory bulwark against related party transactions – since widely held banks had no related parties through shareholding structures – and involvement in commercial, non-banking activities through upstream related parties.
The 1980 Bank Act was notable primarily for bringing the Canadian activities of foreign banks, which had been conducted through a variety of non-bank mechanisms, under the Act. This measure, which required the establishment of separately capitalized foreign bank subsidiaries, had overt prudential aspects: ensuring adequacy of capital in Canada to cover liabilities in Canada, which insulated the solvency of the subsidiary from the foreign parent. It also had competitive aspects, mostly in terms of restricting competition. First, limits were placed on the size of loans made by the foreign banks based on ratios of the loans to the capital in their Canadian subsidiary, rather than to the parent’s worldwide capital. In practice, this was more a nuisance factor than a constraint given the flexibility that lenders have to organize loan syndicates, which could of course include their parents – Canada’s having a wide-open capital account. Second, new branches of the foreign bank subsidiaries were subject to approval; this hardly deterred the expansion of foreign banks in Canada, however, as no application for branching was ever denied. Third, total foreign bank assets were subject to a ceiling based on a percentage of total banking system assets in Canada. Even this widely criticized measure had no real effect since the ceiling was never actually binding, as it was raised when approached. With the Canada-US free trade agreement, US banks were no longer subject to the asset ceiling;
The closest thing to the implementation of a grand regulatory design in Canada’s financial sector regulatory system was the overhaul in the late 1980s and early 1990s. These reforms started with the intent to modernize the non-bank financial institutions statutes, which had not had a thorough updating since the early 1900s. With the approach of the scheduled 1990 Bank Act revision, however, the reform initiative expanded to include the Act. Based on an extensive review of the formal barriers that up to that time had existed between banking, trust, insurance and securities dealing, the reforms replaced the “four pillar” framework with what was essentially a universal financial services model, albeit one that required these various activities to be conducted through separate affiliates.
Nominally, the reforms extended powers of the financial institutions considerably; however, the review that preceded these reforms had concluded that the fungible nature of financial instruments had already allowed considerable functional competition across the formal regulatory barriers. For example, life insurance companies had started to issue short-term, daily interest, deferred annuities that competed directly with deposits. Securities dealers had introduced the “bought deal,” in which securities underwriters took on large corporate issues on their own books before distributing them to final purchasers through jobbers; previously, underwriters had lined up their distribution beforehand. With this innovation, securities dealers were able to sharpen competition with banks’ commercial loan facilities. Banks, meanwhile, were acting like insurers, building up contingent liabilities by issuing guarantees to gain fee business while minimizing capital requirements. To a good extent, therefore, the universal financial services omelette had already been made de facto; the reforms simply acknowledged and regularized these developments.
While extending the business powers of financial institutions, these reforms were also informed by the lessons learned from the failures of banks and non-bank financial institutions in Canada, by the lessons from the US savings and loan crisis, by the contemporaneous development of international standards for capital requirements and the financial market trends and innovations of the day. Accordingly, the reforms were more in the sense of re-regulation than de-regulation.
- Business barriers that might expose individual financial institutional groups to disintermediation at particular points in the business/credit cycle were eliminated.
- In terms of balance-sheet regulation, there was a review of risk-related capital requirements, risk-diversification requirements, restrictions on active involvement in non-financial businesses and “matching” requirements between assets and liabilities in terms of appropriate security, yield and term.
- A hard look was taken at related-party transactions (especially with majority shareholders in the non-bank financial institutions); attempts were made to tighten controls on conflicts of interest.
- Various proposals were considered to improve the functioning of boards of directors; some were eventually adopted (requirements that audit committees be composed of outside directors to ensure effective oversight by the board), while many were dropped as impractical.
Various proposals were made to improve internal governance that were not ultimately adopted, but are noteworthy for the extent of the review conducted. For example, consideration was given to setting higher standards for boards, including to raise the standard of care from that expected from the “ordinary prudent person” to that of an “experienced business person qualified to be a director of a regulated financial institution”; in the end, the standard “prudent person” rule was adopted. Other proposals aimed at improving the functioning of boards of directors that did not make it into the legislation included limits on the size of boards to increase their effectiveness, attendance requirements to ensure a high level of diligence, limits on interlocking directorships and greater responsibility and greater authority for audit committees. Consideration was also given to increasing the standards for, and independence of, internal auditors, to increase their access to the audit committee (in a “whistle-blowing” sense) and to increase interaction with supervisory authorities. - Attempts were made to enhance external scrutiny by increasing disclosure requirements and by requiring a 35 percent public float of the shares of otherwise closely held companies in order to involve securities markets and rating agencies in analyzing performance.
- An extensive debate was conducted on the role that deposit insurance and implicit guarantees to large institutions that are “too big to fail” might have in heightening moral hazard, and consideration was given to various means of potentially limiting such moral hazard (for example, risk-related premiums for deposit insurance).
- The supervisory agencies were consolidated to facilitate supervision of financial conglomerates – for example, to address practices such as “kiting” of assets between linked institutions to keep problems about the balance one step ahead of supervisors – although the Estey Commission’s recommendation to merge the Office of the Inspector General of Banks with the CDIC was not adopted.
- Many of the problems raised when supervisory officials take control of institutions were addressed, including the criteria to use in deciding to step in – that is, when the institution is insolvent on a net worth basis based on assets marked-to-market versus when it is unable to pay bills as they come due (the operational definition of insolvency).
Interestingly, these reforms included the introduction in Canada of one of the factors that is often argued to have been responsible for the US financial system meltdown – namely, the 1999 repeal of the Glass-Steagall separation of investment and commercial banking. Canada anticipated the US action a dozen years earlier in its 1987 “mini Big Bang,” which echoed the “Big Bang” regulatory reforms in the City of London in 1986. Accordingly, one would have to appeal to contextual factors that would have made the Glass-Steagall repeal particularly dangerous in the United States, whereas a similar reform in Canada proved to be innocuous to sustain this argument. Notably, the Canadian reforms were introduced just months ahead of the October 1987 stock market meltdown. The chartered banks were given a six-month head start in acquiring securities firms and might have bought high, but the system emerged from the meltdown unscathed.
The 1997 reforms, which were introduced in Bill C-82, An Act amending certain laws relating to financial institutions, focused on consumer privacy and coercive tied selling. Amendments to the regulatory framework in the 2000s relaxed, rather than tightened, regulatory controls. Interestingly, even as the US mortgage system was about to tank, Canada was modifying its regulations to allow its institutions to follow the US lead, including in areas such as mortgage lending rules.
To summarize, Canada did many things well in the area of financial regulation but was generally more concerned in recent decades with competitiveness than with soundness. In searching for the secret of Canada’s financial sector stability, one has to go beyond the role of rules and their enforcement.
The Tipping Points and Contributing Factors
Interbank Cooperation: The Scottish Model
Given the tribulations of the Royal Bank of Scotland in the subprime crisis (Mor 2018), it is ironic to note that one of the seminal factors in Canada’s tradition of stability was that, although banking regulation was initially laid down by the Crown, Canada’s early banks were founded and managed in the Scottish tradition, which featured a high degree of interbank cooperation and employed what one would now term social networks to discipline behaviour. Bankers are strongly averse to instability because of the negative spillovers of such failures on their own banks and on the value of their bank charters. The tradition established in Scotland whereby the largest banks would step into the breach in times of crisis was transferred to Canada with the Bank of Montreal, which also acted as the government’s banker and lender of last resort to troubled banks.
The US system was also exposed to the same influences. Calomiris and Gorton (1991), in a study that deserves more attention, documented the differences across US states in banking failures depending on the extent of interbank cooperation arising out of the clearing houses established for interbank payments purposes. The private banking associations established for this purpose provided ready-made institutions for coordinating member banks’ responses to panics, including through the provision of lender-of-last-resort loans, the issue of bankers’ notes that circulated as money and implicit deposit insurance.
The banks were mutual competitors but also cooperated. In this sense, the system featured not unadulterated competition but a blend of cooperation and competition – which might be termed “co-opetition.” This hybrid concept has been promoted by Brandenburger and Nalebuff (1996) who emphasize that, although business strategies are often described in terms of game theory, business is not a game in which someone has to lose – profitability of one enterprise, as they note, does not require that others must fail. In banking, the massive externalities that flow from one bank’s failure have long made it apparent that it is in the interest of all that none fails – thus overriding ambitions on each other’s market shares.
Confederation and the Choice of Branch Banking versus Unit Banking
Perhaps the single most obvious difference between the Canadian and US banking sectors – and one that is front and centre in all analyses of the difference between the two countries in terms of financial sector stability – is the prevalence of branch banking in Canada and of unit banking in the United States. In Canada’s very early history, pre-Confederation, individual banks were started principally by provincial charters, which were individual acts of the legislature. Unit banking was nonetheless introduced in Canada by the 1850 Free Banking Act, “An Act to establish freedom of Banking in this Province, and for other purposes relative to Banks and Banking. 10th August, 1850.” This was enacted by the province of Canada (which resulted from the merger of Upper and Lower Canada); the provisions were modelled directly on the nascent US unit-banking system. Unit banking failed to take root in Canada, however: only a few small banks were formed under the Act and the legislation was repealed by the new Dominion of Canada in 1880 (Curtiss 1948). This clearly was the first important tipping point.
The reason unit banking failed to take off appears to have been Confederation. The British North America Act vested regulatory jurisdiction over banks and banking unambiguously with the federal government because the chartered banks issued the currency of the land. This legislative outcome resulted in provincial bank charters becoming in effect Dominion charters as of 1867 (Curtiss 1948). In turn, this empowered the existing banks to operate in all provinces of the new Dominion of Canada. With both options available, the Canadian system “chose” branch banking, and the free-banking option withered on the vine. The regulation of other financial matters, including insurance, trust and contracts, remained with the provinces as part of the property and civil rights head of power.
Many analysts have concluded that Canada’s branch-banking system allowed it to escape the wave of bank failures experienced by unit banks in the United States during the Great Depression (and earlier) because of portfolio diversification and efficiency gains from economies of scale (see, for example, Bordo 1995; Friedman and Schwartz 1963). However attractive this theory might be at first blush, there are many nagging doubts.
First, Canada’s record on bank failures pre-1900 was far from stellar. In part, this reflects the fact that, notwithstanding their branch-based structure, Canada’s chartered banks were not then all that well diversified regionally (see Davis and Gallman 2001). After 1900, regional diversification was of little benefit in the face of nationwide shocks, such as the Depression (Wagster 2009).
Second, turning to the US experience, over the years the US system has made significant strides in the direction of nationwide branch banking. This has occurred as the result of state-level regulatory reforms since the 1970s that have eased restrictions on intrastate branching, reciprocal state-level legislation permitting interstate branching and banks’ circumvention of the restriction on interstate branching through the development of holding companies (Bordo, Rockoff, and Redish 1994). Indeed, the failure of Washington Mutual during the subprime crisis, the largest bank failure in US history, involved a bank with 2,239 branch offices in 15 states – a branch network as impressive as that of any major Canadian bank (Sidel, Enrich, and Fitzpatrick 2008). Simply put, regional diversification is of little help when a crisis results in correlation of previously uncorrelated risks.
That being said, the branch-banking character of the Canadian banking system was clearly instrumental in facilitating reduction of banking system capacity in a non-disruptive fashion through consolidation of non-viable branches of individual banks or absorption of branch networks of the least viable banks by stronger banks through mergers. For example, the intervention into the Weyburn Bank, in which 30 branches were absorbed, was accomplished in one regulatory process involving one set of shareholders and one set of senior managers. A comparable process in the United States, scaled up for size of the institution, would have been substantially more transaction intensive, as it would have involved the absorption of some 300 individual banks.
Decennial Revisions
Because the charters of Canadian banks are issued for a limited time, there is a built-in requirement for Parliament to pass new legislation to extend them. This requirement, which occurs every ten years (the length of the original charters), provides a natural opportunity for the government to address any issues that have arisen in the meantime. Importantly, the arbitrary timing of the charters’ expiry means that reforms introduced at these times are not driven by immediate crisis. Many Canadian observers have commented on the importance of this feature. In the 1992 reforms, the ten-year review period was shortened to five years and extended from the Bank Act to all federally regulated financial institutions statutes. Interestingly, the first US banks were also federally chartered with time-limited charters – in this case 20 years. But this did not result in a Canadian-style regular review – the US system chose a different path.
As the account above makes plain, however, although a number of the changes introduced in decennial revisions proved in hindsight to have been very important in mitigating risks to the system – particularly the removal of interest-rate regulations in 1967 before the acceleration of inflation that wreaked havoc with regulated interest rates – there is little evidence of prescience in terms of reforms anticipating problems. The interest-rate deregulation, for example, was introduced for reasons of financial sector industrial policy, not prudence; and the consolidation of the banking and insurance supervisory bodies into OSFI was driven by the de facto integration of Canada’s insurance and deposit-taking sectors, not by concern over banks’ off-balance-sheet liabilities, nor did it prevent individual Canadian banks from taking a bath in the subprime mortgage debacle.
It could be, of course, that Canada simply had a lucky run, in which case its regulatory authorities should become ultra-conservative since such runs of luck inevitably end. This suspicion, however, should not cause us to suspend the search for deeper reasons for the difference between Canada and the United States in terms of financial sector stability.
The 1890 and 1900 Bank Act Reforms
The point in time at which the Canadian system began clearly to demonstrate greater stability can be identified quite exactly: with the passage of the 1900 Bank Act. Previously, most bank disappearances took place through failure; afterward, the vast majority occurred through mergers, many – if not most – effected under circumstances in which the acquired bank was under some duress.
The 1900 Bank Act revision facilitated the merger of chartered banks by transferring approval from the legislature to the cabinet, and conferred on the Canadian Bankers Association particular duties in respect of failed banks and banknotes in circulation. The latter measure followed the introduction pursuant to the 1890 Bank Act of a redemption fund for notes in circulation issued by failed banks. The chartered banks had to subscribe 5 percent of the value of their own banknotes in circulation to this fund, which was managed by the government. This made the chartered banks mutual guarantors of the money they put into circulation (Curtiss 1948), which gave them an important incentive to deal with troubled banks early. With the facilitated merger provisions in the 1900 Bank Act, the banks adopted that route with alacrity.
This is not to go as far as to assert that the acquiring banks were engaged in charitable exercises, taking on losses at their own expense to avert losses to creditors of failing banks. Carr, Mathewson, and Quigley (1995) point to evidence that target banks were weak but not yet insolvent at the time of their takeover. This evidence includes the fact that takeover prices paid by the acquiring bank for stock in the target were consistent with or even above market prices; as well, correspondence among various parties to the deals attests to the adequacy of paid-in capital, reserves and double liability obligations of shareholders to cover the obligations of the target bank. Carr, Mathewson, and Quigley (1995) argue that market forces account for the mergers: that the assets of the weaker, smaller banks were more valuable to the shareholders of the larger banks, which could take advantage of economies of scale and superior technology. There is no compelling reason to believe, however, that these market advantages asserted themselves only after 1900 and not before. The sharp change in systemic behaviour at the dawn of the twentieth century suggests that it was the federal government working hand-in-glove with the Canadian Bankers Association in facilitating mergers to pre-empt risks to the stability of the system that was responsible for the sharp reduction in the rate of failures.
This contrasts sharply with the US situation, where closing a unit bank was a routine affair. Thus, where the United States became proficient at closing banks, Canada became proficient at avoiding closures. It is hardly surprising, therefore, that moral hazard, an argument that justifies bank closures, figures so prominently in US thinking about financial regulatory issues, while Canada has tended toward an approach that de-emphasizes hard and fast rules – which, of course, affords greater latitude for regulatory forbearance, an important feature of a system that leads administrators to seek to buy time to work things out quietly.
“The other systemic strength of the Canadian system is camaraderie between the regulators, the Bank of Canada, and the individual banks. This oligopoly means banks can make profits in rough times – they can charge higher prices to customers and can raise funds more cheaply, in part due to the knowledge that no politician would dare bankrupt them. During the height of the crisis in February 2009, the CEO of Toronto Dominion Bank brazenly pitched investors: ‘Maybe not explicitly, but what are the chances that TD Bank is not going to be bailed out if it did something stupid?’ In other words: don’t bother looking at how dumb or smart we are, the Canadian government is there to make sure creditors never lose a cent. With such ready access to taxpayer bailouts, Canadian banks need little capital, they naturally make large profit margins, and they can raise money even if they act badly.”
For a positive take on this issue see Chant et al. (2003, 100–01): “[OSFI’s] mandate emphasizes the importance of early intervention in the affairs of troubled institutions…With a formal process for early intervention there is a greater likelihood of averting institutional failures by providing incentives for institutions to conduct their business prudently.”
It is important to underscore in making this argument that the CBA no longer has the roles assigned to it in the 1900 Bank Act. The significance of the 1900 legislation is that it served as a tipping point, implying a path dependence in the evolution of the institutional culture for Canadian banking regulation.
The Role of Regulatory Forbearance
Regulatory forbearance
Although this early record of regulatory forbearance is disputed,
Interestingly, perhaps the only major financial crisis that the US system has dodged was the developing country debt crisis – because, for once, the US authorities exercised regulatory forbearance, an action that has been openly acknowledged in the United States. According to US observers, banks with heavy loan exposure to developing countries were not required to set aside reserves to fully cover non-performing sovereign debt. This forbearance was necessary because seven or eight of the ten-largest banks in the United States might then have been deemed insolvent, which would have precipitated an economic and political crisis (FDIC 1997, chap. 5).
Regulatory forbearance by government regulators can be readily understood as the transporting of bankers’ private self-regulatory interest in avoiding a mutually damaging failure of one of their number into public regulatory practice. Arguably, this is not an independent reason for Canadian banking sector stability, but a direct consequence of the early tipping points that drove its evolution down the path it ultimately took.
The Role of Ownership Restrictions
Another aspect of Canada’s banking system that deserves more than passing mention with regard to the history of stability in the more recent era is the ownership limit that became part of the Bank Act in 1967. As is clear from the late date of the measure, it was not responsible for the history and legacy of stability, but one can argue that it was (fortuitously) an added bulwark during the recent period of global financial instability. How it did this was precisely for the reason that the measure is typically vilified in the more fundamentalist economic commentary: it insulated Canadian banks from hostile takeovers, thus easing the market pressures to which bank executives are exposed and which can lead to greater risk taking – recall in this context the famous statement from Citi’s Chuck Prince about having to dance when the music is playing!
This is a factor that cuts two ways, of course: market pressures can also drive efficiency, and for most of the past four decades this latter consideration has tended to dominate the mostly negative commentary on Canada’s system.
“The size of the financial sector in Canada, defined as total loans to the private sector and security market capitalization relative to GDP, is not much more than half that of its US counterpart. Canada in 2000-03 had the fourth lowest share of cross-border loans in total domestic borrowing among OECD countries and foreign banks have low penetration of the domestic loan market ... [Although] foreign ownership ownership restrictions in the banking sector were eliminated in the mid-1990s. ...there are domestic constraints limiting concentration of ownership and maintaining a political step in the process of approving bank mergers. This works against large new players, foreign or domestic, entering the market. Hopefully, both these issues will be carefully examined in the upcoming review of the Bank Act” (Cotis 2006).
But the Canadian banking system is in fact highly efficient – even though it might not be at the frontier for that measurement at any particular point in time. For example, Allen et al. (2007) find that (a) Canadian bank labour productivity is as high as or higher than that in the United States in generating assets and net operating revenue; (b) cost-inefficiency for Canadian banks averages about 6.5 percent, much less than for US bank holding companies (about 14 percent); and (c) Canadian banks have moved closer to the efficiency frontier over time, and in fact their technological progress exceeds that of US banks. Although Allen, Engert, and Liu (2007) find that Canadian banks still have not exploited economies of scale fully, there is no evidence for a productivity or efficiency gap vis-à-vis US banks. In short, there is no particular empirical evidence for an efficiency-instability trade-off – Canada does not buy its stability through efficiency-choking regulation.
To the extent there is such a trade-off, however, Canada’s banking system history shows that, in a dynamic system, staying away from that frontier is vital for the longer-term health of the system, given the significant role of externalities in system stability. Market purists will not like this analysis, but the principle is there to be seen in probably most spheres (I am tempted to say all spheres) of human endeavour. Efficiency is a good thing, for example, but redundancy is vital to robustness. Complex systems have “sweet spots” that balance opposing tensions.
Big Shall Not Buy Big
One of the idiosyncratic curiosities that emerged from the 1992 financial sector reforms was the policy of “big shall not buy big.” This was not part of law or regulation; it was simply announced, although that should not be taken as a sign of its relative importance (or lack thereof).
The background to this policy is as follows. As the financial reform package was being put together, it was foreseen that the removal of the restrictions on formal linkages between banks, trust, insurance and investment dealers would result in a wave of mergers and acquisitions. The potential for a reduction of competition was obvious; at the same time, the potential for gains from economies of scope and scale was also thought to be significant. Canada, it was concluded, would get the best of both worlds by allowing industry consolidation – but only up to a point. That point was set by the policy: “big shall not buy big.” In Canada’s financial system, it was easy to do the arithmetic: if the five major banks, the two large mutual life insurance companies, and the odd investment dealer and trust company created diversified financial groups, the system would have a critical mass of competition – especially with Canada’s strong cooperative credit system serving as a vital check and balance.
This was industrial policy. Students of Japan’s MITI/METI policies over the postwar period – when Japan promoted industry consolidation, but only up to a point, such that Japanese industry would benefit from fierce domestic rivalry while at the same time its companies would be viable international competitors – will have no trouble seeing the family resemblance in the policies. Even the essentially informal approach – not adopted through formal regulation or legislation – has echoes of Japan’s industrial policy approach.
This policy came into play when four of the five Canadian chartered banks announced in 1998 their plans to amalgamate, in violation of their undertakings at the time the 1992 reform package was put together. Famously (or notoriously, depending on one’s perspective), Finance Minister Paul Martin rejected the mergers.
Again, the government’s policy decision was vilified. Charles Baillie, Chairman and Chief Executive Officer of Toronto Dominion Bank, in addressing the House of Commons Standing Committee on Finance, referenced this policy in a pejorative manner:
The other road is to say no to mergers, to say that big shall not buy big ... to say that our institutions are big enough for Canada, and to rule out our competing effectively in world markets. Canadian financial institutions would also see their domestic market shares dwindle, squaring off against much larger foreign-owned competitors. That would be a valid choice, if your vision for Canada does not encompass excellence. Such a choice would not be catastrophic. It would not be a crisis. The decline of our influence as institutions, and Canada’s position as a global financial centre, would be gradual. Our major banks and insurance companies and mutual fund companies are large enough to continue to operate profitably, and to develop strategies to operate in a narrower range of businesses, in order to generate acceptable returns for shareholders. But what of the long term – where would we be? Certainly, with consolidation continuing elsewhere – and make no mistake, bank mergers are a worldwide phenomenon – we would gradually lose our place at the table. There would be certain areas and businesses in which we simply could not compete; consolidation elsewhere results in our major institutions ranking further and further from the top tier, farther and farther from the table. (Baillie 1998.)
Baillie’s perspective was, of course, not borne out by history. Canada’s banking sector did not dwindle, thwarted by policies that prevented “excellence” – which is to be read as emphasizing one particular element of the system to the extreme, in exclusion of all others. “Big shall not buy big” turned out to be a pragmatic, intuitively conceived policy that balanced competing imperatives. A fan of either of the competing imperatives necessarily will see the policy as badly flawed. Only an appreciation of the critical nature of a “sweet spot” in complex dynamic systems that is attained when valid imperatives compete with one another and the ideal outcome is a compromise, a draw, an unsettled tension, allows an understanding of why this policy was in fact ideal.
As a footnote and a segue back to the present, the policy of “big shall not buy big” may have prevented the Canadian banks from taking excessive risks in a North American acquisition strategy predicated on successful mergers in the run-up to the subprime crisis. This approach foreshadowed TD Bank's escape from its planned merger with a US bank as the SVB crisis unfolded.
The history of Canadian and US banking sectors is a puzzle that rewards the study and continues to provide a reference point for contemporary practice in dealing with troubled banks. Calomiris and Haber (2014) theorize in their concept of “The Game of Bank Bargains,” which they describe as a game that is played between bankers, governments, and interest groups with political power, that countries do not “choose” their banking systems, but rather they “get” a banking system consistent with the institutions that govern the distribution of political power within their societies (for a review of this book with specific comment on Canada, see Ciuriak 2016). The present Commentary builds a case that, at least in terms of stability, countries do get to choose: they can choose to address the negative externalities of bank failures, or choose not to. For Canada, these lessons appear to be fully internalized in Canada's approach to financial sector regulation and supervision. For the United States, there are lessons there for the taking.
