May 14th 2009
From The Economist print edition
A country that got things right
“IT IS the only time I feel like royalty,” says the boss of a big Canadian bank, describing the reception he now gets in America. He is not the only one basking in acclaim. All of Canada’s main banks were profitable in the quarter ending January 31st, when market conditions were at their worst. None has needed government investment. The country’s financial system has been praised by Barack Obama.
Trouble is, some differences between the two countries are culturally ingrained. “The United States has an inherently higher risk appetite,” says a banker familiar with both sides of the fence. It is hard to find pre-crisis equivalents in America of the decision by Toronto-Dominion (TD) to exit its structured products business in 2005, or the 20-30% band that RBC imposes on the share of earnings that its capital-markets business can contribute.
Structural differences matter too. The Canadian system is an oligopoly of five dominant banks. That dampens price competition: independent brokers originate less than one-third of the mortgages in Canada, compared with up to 70% in America during the bubble. It also makes it easier for Canadian banks to pull back when things are getting too risky.
Having a few banks that are clearly too big to fail has led to more stringent supervision, including imposing a maximum leverage ratio and a single regulatory regime for commercial and investment bankers. Laxer and more fragmented capital regimes allowed the balance-sheets of banks elsewhere to balloon (see chart 4).
Perhaps the most striking divergence between Canada and America is in their regulation of mortgages. Interest paid on home loans is tax-deductible in America, encouraging people to borrow more; not so in Canada. American mortgages are non-recourse in many states, making it harder for lenders to pursue defaulting borrowers; not in most of Canada. (Then again, Britain is like Canada in these respects but still has soaring defaults).
Canadians taking out mortgages with a loan-to-value ratio over 80% must also take out insurance on them from a federal agency called the Canada Mortgage and Housing Corporation (CMHC). The banks insure the rest of their portfolios with the CMHC, which keeps them honest by applying strict standards to the mortgages they guarantee. Taking out insurance also brings the risk weighting that regulators apply to these mortgages down to zero, which means that the banks derive no capital advantage from funding them through securitisation. Some argue that Freddie Mac and Fannie Mae, America’s housing-finance giants, should likewise guarantee mortgages but not buy them.