A Tale of Four Countries- Part 4: Canada and Banking Reform

There is nothing new in the fact that Canada has been held up as a model for banking reform. During the height of the crisis and in its aftermath when reform was debated, many economists were looking to where there was limited financial disruptions and Canada and, to a lesser extent, Australia were cited. In fact, among international watchdogs of the financial sector and banking, Canada has been rated number one for four consecutive years. This writer is no fan of Obamaphile Paul Krugman, but he has been one of the most vocal proponents of the Canadian model for reform.

Before we can discuss what we can learn from Canada and apply it to the United States, we need to look at what went wrong, why, and the differences between Canada and the United States. There is no doubt that the burst of the housing bubble in 2006 precipitated the financial crisis that ensued. This, in turn, was fueled by historically low interest rates and kept that way in response to the dot com bubble bursting and in reaction to the 9/11 terrorist attacks. Alan Greenspan, who was Chairman of the Federal Reserve, has admitted that keeping these rates low for so long helped fuel the housing frenzy.

Although there is debate, there is no doubt in my mind that the Community Reinvestment Act, passed during the Carter Administration, was an underlying cause of the housing frenzy. This law fundamentally changed how banks did business, especially with respect to minority and low-income wage earners. In late 1999, the New York Times had reported that the Clinton Administration was placing pressure on Fannie Mae and Freddie Mac to expand loans to low and moderate income people. George W. Bush called for reforms at least 17 times and they went unheeded. But,Bush also played a role in that there was no active discouragement of these lending practices in his zeal towards an “ownership society.” Recently, the Federal Reserve has absolved the CRA of any responsibility here, but from 1993-1998, some $467 billion in mortgages were provided by CRA-regulated lenders to low and moderate-income borrowers which represented about 10% of the market share. By 1998, that market share dropped to 3%, but in the run-up to the crisis, as much as 50% of all loans were to CRA-regulated or tangentially regulated lenders. As a result, there was intense competition for revenue and market share in the mortgage market coupled with a limited supply of creditworthy borrowers. The easiest solution was to expand the market to those on the fringes of creditworthiness and the uncreditworthy themselves.

Thus the subprime lending market exploded. There were also innovative mortgage options offerings like adjustable rate mortgages, Alt-A mortgages, no document loans and the like. Because of the activity, many lenders sprung up and they, like traditional banks, used independent loan originator agents that received a fee for their services. Although they were supposed to adhere to loan underwriting guidelines, one independent audit found that close to 80% of these loans failed to meet those guidelines in some way. In effect, we had people purchasing homes who had no business purchasing homes nor having the financial means to pay those mortgages. To make matters worse, there were some examples of predatory lending practices where borrowers were misled. But, not all the blame lies at the feet of bankers. With a President (Clinton) pressuring banks to make loans and community organizers seizing on the opportunity to make homeowners of people who had no right being homeowners (ACORN), it only made the problem worse.

Because there was not enough safe investments, risk had to spread around thus the derivatives market took off. These are the notorious mortgage-backed securities and collateralized debt obligations. They were first proposed in the early 1970s at various times by no less than four Nobel winning economists and were designed to spread risk among lenders. They derive their value from mortgage payments and home prices. As long as there are payments coming in and appreciation in home prices, they are a viable instrument. However, instead of being a risk-spreading vehicle, they soon evolved into a short term profit-making vehicle for banks. When investment banks and hedge funds became involved (the so-called shadow banking industry), they largely operated without the regulations that governed depository banks and publicly-held interests. This is where greed enters into the equation. Granted, executive compensation had grown to obscene levels and golden parachute resignation packages essentially rewarded what amounted to nothing more than failure. Banking executives became the whipping boys and face of the financial crisis, but executive compensation was not the primary cause of the problem; it was and is a public relations nightmare.

The result was that as home prices began to fall due to a glut of housing and too much bad money chasing that housing, mortgages began to become delinquent or in default. Since many homeowners used their homes as ATMs with home equity loans, they over-leveraged and became more indebted. In effect, a confluence of events created a perfect financial storm that brought that sector to its knees in 2008-2009. Icons of Wall Street like Bear-Stearns and Merrill Lynch fell by the wayside shaking confidence in the entire system. It also did not help that rating agencies were over-valuing the derivatives. Furthermore, the regulators were largely asleep at the helm.

So what did Canada do right? First, it needs to be noted that Canada was not totally immune to the global effects of the financial crisis, only that the effects were less dramatic. Second, there is huge difference in the underlying philosophy of the American and the Canadian banking systems that is further reflected in the regulatory framework of both countries. To put it simply, Canadian banking practices are considerably more conservative than those in the United States and that is the primary difference. The greater risk-taking ability in the US does have its good effects, namely funding new enterprises and encouraging entrepreneurial innovation.

Canadian banks start on a more solid base in that upwards of 30% of their assets are deposits. They rely less on securitization. Because they have a conservative appetite for risk, they start out fortified against huge losses when crisis erupts. While many here rail against the concept of “too big to fail,” that alone is not the cause of the financial crisis since Canada likewise has banks “too big to fail;” the financial sector is dominated by six banks in Canada. Because any leverage is well-managed internally by banks and by regulators, it restrains the aggressive growth of assets which is the opposite of the United States. Hence, there is less need for entering the derivatives market to make profit AND the major banks shied away from and then abandoned altogether subprime lending in 2008.

Furthermore, their capital ratios are well above those prescribed in international protocols (Basel II). For example, those guidelines call for Tier I capital ratios of 4-8% while Canada requires ratios of 7-10%. But in practice, Canadian banks maintain capital ratios of 10-13%, not only above the Basel II requirements, but those required by Canadian law. That helps create that cushion against financial meltdowns and allows Canadian banks to better weather the storm. But, the banks were still able to raise high quality capital in the private market. At the height of the financial crisis in 2009, Canadian banks raised over $14 billion in private capital, mainly through the sale of stock.

The Canadian banking regulatory framework is integrated and streamlined. The emphasis is on sound lending and banking practices, not on growth and profit per se. Growth and profit exist, but it is conservative and gradual. Unlike what the Federal Reserve has become, their counterpart- the Bank of Canada- is a lender of LAST resort. One need only look at their mortgage lending practices. First, here certain states require private mortgage insurance for mortgages where the “down payment” is less than 20% of the loan. In Canada, it is mandatory nationally. They have a counterpart to our Fannie Mae and Freddie Mac for a secondary mortgage market, but there is decidedly more oversight. Non-prime mortgages are limited and banks ceased them altogether in 2008. Borrowers are held to a higher degree of personal responsibility. Banks themselves, not independent brokers, originate loans which avoids finger-pointing and forces banks to practice sound underwriting practices. That breakdown in the underwriting process was a leading cause of the problem in the US. Loans can be securititized and there is a derivative market, but it is used for liquidity, not to transfer risk since they make less risky loans in the first place. Finally, mortgage interest is not tax deductible as it is in the United States so there is not that governmental incentive towards home ownership or investment primarily in real estate dictated by the tax code.

Most importantly, regulation is principle-based. In the US, it is rule-based. Although considered more regulated than the US banking industry, it oddly acts unregulated to a certain extent. Banks are counted on to use their own best judgment in all transactions and then prove compliance. In effect, they are continually “stress testing.” Thus, good risk management is the Canadian way of doing business, not an exercise in compliance with regulatory rules.

Also, depending on the multitude of financial transactions a bank performs, American banks are subject to a hodgepodge of regulatory agencies each defending their own turf and bureaucracy (and budgets). To name a few, a single bank may have to comply with regulations from the Federal Reserve, the SEC, the FDIC. the Comptroller of the Treasury, and the National Credit Union Administration. In Canada, there is a single entity with governmental oversight which regulates the whole banking entity, subsidiaries and all. Some may rail against a centralized regulatory agency as having too much power (much like the consumer protection board created within the Federal Reserve by Frank-Dodd), but having one allows the regulators to be more proactive and to react quickly when crisis occurs; the right hand is not working against the left hand.

Banks in Canada generally do not extend unsecured credit without upfront charges due to the heightened risk of default on these loans. Perhaps one of the worse aspects of the Canadian system are the highly unpopular monthly fees automatically debited from the accounts of depositors. However, this discourages the use of derivatives to bolster a bank’s bottom line. US banks are moving in that direction due to the still-hodgepodge regulations being promulgated under Frank-Dodd. For example, limits on transaction fees charged by banks to businesses for credit/debit card transactions has led to the demise of free checking at many banks.

The main characteristic of the Canadian model is that they encourage very conservative lending practices which mitigates risk. Make no mistake, Canadian banks do make “risky” investments, just not to the extent as US banks. As one Canadian banking executive stated in 2010, to copy the Canadian system in the United States, one would have to transplant ingrained Canadian banking prudence. That simply is not in the character of Americans. In effect, the result would be a sound, but “boring” banking system.

So, what can the United States do? As a Canadian official observed, Americans have a tendency to “over-solve” a problem. Thus, we get reactionary, knee-jerk legislation like Sarbanes-Oxley and Frank-Dodd. As one can see from this series of articles, it is the government that creates the problem by interference in the free market be it energy policy, health care, agriculture, retirement security, or banking. Entities like the FDIC, FHA, and SEC are products of the New Deal. The Federal Reserve is the product of the early 20th century progressive movement. Unsound social engineering policies, best exemplified by the Community Reinvestment Act and tax deductibility for mortgage interest, only make the free market interference worse. A case can be made that the tax code is a less a system of revenue generation and more a vehicle for social engineering. Fannie Mae and Freddie Mac need to be broken up with their assets sold on the open, free market and the whole secondary mortgage market privatized without the implicit backing of taxpayers. My taxes and your taxes should not be used to put unqualified buyers in homes they cannot afford and who have no right getting loans in the first place.

In essence, we need a return to more conservative lending practices with strong, fundamental underwriting of loans. Special interests like ACORN at one end of the spectrum and Bush’s “ownership society” on the other end have no place in American banking. If that means that a certain segment of the society statistically receives a fewer number of loans, then that is the price that must be paid for a sound banking system. Perhaps the best lesson we can take from the Canadian system is to enforce vigorously the laws and regulations currently on the books and doing so consistently and quickly, rather than promulgating more regulations, creating new agencies, and “over-solving” the problem the government created in the first place.