Wednesday, 31 August 2011

Why didn’t Canada have a banking crisis in 2008 (or in 1930, or 1907, or…)?

Canada’s banking system has always been a case of owner’s pride and neighbor’s envy. It has had this history of having minimal impact of any global crisis on its financial system. And it is never really talked about much except during crisis. You hear about US banks, UK banks and even Europe U-Banks but not much about Canadian banks except when there is a crisis and they escape unscathed.

This paper tracks the reasons for Canada’s fin system. The answer is its history of financial regulation. US struggled to have a unified financial regulation and had multiple regulators and charters with powers divided between states and centre. Canada the federal had powers to regulate the financial sector and hence we have a much better and regulated financial system.

A key initial difference between Canada and the US was that in Canada the Federal government had the power to charter and regulate banks. In the US the Constitution did not unambiguously give the Congress the power over banking. This led to the subsequent fights over the constitutionality of the First and Second Banks. In the US after the demise of the Second Bank the states were responsible for chartering banks. Also there has always been a strong populist distrust of the concentration of financial power in New York and the northeast. This in addition to states rights explains the revocation of the charters of the two Banks of the United States and the difficulty in establishing a central bank.

By contrast the jurisdiction over Canadian banking was not established until the British North America act that created Canada in 1867. By then the branch banking system with a few large banks was well established in the colonies and the BNA Act gave power to regulate banking to the Federal government effectively locking-in the branch banking system. This probably did not reflect a fundamental preference for central control in Canada, but rather a path dependent process. Contrast federal regulation of banking with the regulation of securities markets, which remains – albeit controversially – an area of provincial regulation. The Toronto Stock exchange was incorporated in 1878, the Montreal stock exchange in 1872 – a few years after confederation.

Moreover Canada didn’t have the deep seated distrust of financial power that prevailed indeed many Canadians were Tories (or their descendents) who had fled the American revolution and who had no problems with emulating the institutions of the mother country. Also the founders of the earliest Canadian banks were Scots who adopted the Scottish banking system which had served Scotland well in the eighteenth century. Financial populism never had the traction that prevailed in the U.S.

The paper points how US always had a shadow banking system as banks were fragmented and limited in size. So US had a more active capital markets system and ways were sought to get more non-bank funds from the market:

Because of the fragmented US banking system, and because of various restrictions placed on the assets the banks could own, securities markets emerged to finance most economic growth, unlike Canada which developed a bank-based system. Mortgage markets and housing finance also developed differently in the two countries. Investment banks, which participated in the creation and marketing of securities, became an important part of the system. Thus the United States always had something like the ‘Shadow Banking system’ that has been the subject of so much recent discussion.

This is real interesting. Shadows have been there for a while…

The paper goes on to explain how Canada was never impacted either in Great depression, inflation crisis in 1970s and 2007 financial crisis.

US tried to implement Canadian system earlier but failed:

An attempt was made beginning in the 1980s to encourage the U.S. system to move in the direction of the Canadian system. But this did not happen. Partly the failure of a Canadian style banking system to emerge in the United States was the result of the initial state of the industry in the United States where the investment banks had long played a larger role than in Canada. Partly, however, it may have been because the United States had failed to understand the nature of the Canadian “Great Bargain” whereby oligopoly would be permitted, but it would be a tightly regulated oligopoly, or more likely because from the beginning of the nineteenth century there was great opposition to the United States establishing a British style oligopoly and once that option was rejected political economy considerations prevented it from ever being adopted.

Superbly written paper.

Explains how much economic history matters and how it interferes in even changing a few mistakes which are identified.

The structure and performance of financial systems is path dependent. The relative stability of the Canadian banks in the recent crisis, in our view, reflected the original institutional foundations laid in place in the early 19th century system. In the early national period in the United States, the states assumed the right to charter and regulate the banks in their states. Supporters of Hamilton’s vision of an active federal government were able to charter the First and Second Banks of the United States, but opposition to federal control from a variety of sources including opposition from advocates of a narrow construction of the constitution, especially in the South, and from the state chartered banks themselves, prevented the development of nationwide branching systems. The result was a fragile, crisis prone, banking system, but one that for all its weaknesses was deeply entrenched politically.

Even a crisis as deep as this one has not been able to produce the desired changes in US fin system. Banks remain too big to fail and are only getting bigger. Worse, there is no attempt to unify or simplify the financial regulation system. It still remains fractured with multiple regulators with no role clarity.

by: Amol Agrawal


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