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Some reasons why Canadian banking is special
Via Scott Sumner, here is a list from Nick Rowe:
1. We never had restrictions on interstate banking, so Canadian banks spread their assets and liabilities across Canada. (So it doesn’t matter if a local housing market goes bust).
2. We don’t have Glass-Steagal. The investment banks joined the retail banks some years ago.
3. We don’t have mortgage interest deductibility from taxes. So paying down your mortgage is a tax-free investment. So most people want to pay down their mortgages.
4. (Except in Alberta), mortgages are fully recourse. You can’t just walk away from a negative equity home and hand the keys to the bank; the bank will come after you for the difference.
I wouldn’t describe those differences as “Canada is more regulated”.
But we do have higher capital requirements. And mortgages over 80% must be insured (mostly by the government-owned CMHC).
I would add one more feature of the Canadian banking system, which it shares with a number of other systems. If a Canadian investor wishes to take some risk, the New York-based banks may be the most efficient means of doing that.
Addendum: Megan McArdle offers a theory of Canada.
Posted by Tyler Cowen on May 8, 2009 at 07:35 AM in Economics | Permalink
Comments
The article starts off with "I don’t really know why Canada’s banks seem to have done well (touch wood). Maybe we just got lucky".
That's true. Here's what happened.
Canada's major banks were looking to merge several years ago so that they would be big enough to take part in all that exciting action happening south of the border. Competition regulations prevented them from doing so. Investment banking. Big banking. Aggressive global-scale banking. None of this boring backwater business.
At the same time Jean Chretien resigned and was replaced by long-time Finance Minister Paul Martin as Prime Minister. Martin came into the job with a significant problem - he was seen by much of the country as being too much in the pockets of big business (from whence he came). So when the banks came to Martin to demand the right to merge he demonstrated his independence - and surprised everyone - by saying no. So the banks didn't get to take part in the fun.
Everyone thought that they would come back a year later and ask again, and that this time Martin would say yes. But in the meantime he made a mess of his prime ministership and got the boot by the electorate. So the banks had to wait. And while they waited that big playground turned into the mess we know and love today.
Any idea that Canadian banks were saved the major losses of American banks by their own good sense and prudence is so much tosh. It was a fluke of history.
Posted by: tom s. at May 8, 2009 8:03:35 AM
Disclaimer: the linked-to article points to Worthwhile Canadian Initiative (http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/04/canadian-vs-us-bank-regulation.html). There's a blog by people who really do know what they are talking about, unlike me.
Posted by: tom s. at May 8, 2009 8:05:30 AM
Any idea that Canadian banks were saved the major losses of American banks by their own good sense and prudence is so much tosh. It was a fluke of history.
And the explanation for why they were saved the major losses and bank failures during the Great Depression, etc.? Canadian banks have had one enormously long lucky streak with, in many ways, less regulation-- or at least the sort of legislation (Glass-Steagall, etc.) claimed as significant by people looking for scapegoats here.
Posted by: John Thacker at May 8, 2009 9:21:49 AM
One difference is that Canadian banks have not been regulated in way which favors lenders/greater risk, they have been regulated to ensure less risk and more stability. On the other hand the US regulations disallowed prepayment penalties, didn't not allow recourse for mortgages etc. Basically the US government has systematically favored lenders over banks. This is part of what caused the present crisis.
Posted by: assman at May 8, 2009 9:32:36 AM
It is true that non-conventional mortgages here (i.e., those financed with less than 20% down) have to be insured using the Canada Mortgage and Housing Corporation (the CMHC), but it's "through" the CMHC, not "by" the CMHC. In other words, if I buy a house with 5% down, I also have to pay extra cash to the CMHC to protect the bank. *I* pay, not the bank and not the CMHC. And I don't receive the benefit of the insurance if I default, the bank does. This might make the banks less reluctant to lend, but a better way is simply to apply for a conventional mortgage (no CMHC involvement required).
When my wife and I bought our latest house, we put 75% of the purchase price down in cash. The bank practically fell all over itself to lend us the remaining 25%.
Posted by: Garth Wood at May 8, 2009 9:40:45 AM
I have made this point before, but Canadian mortgages always had fairly stiff pre payment penalties. This indirectly cuts down on speculation based on interest rate moves. You cannot simply refinance your mortgage based on the lower prevailing interest rates, without paying to get out of your old mortgage. This provision also reduces the price movements of the mortgage backed securities.
At a mortgage backed securities conference I was at in the 80's, there was a lot of discussion about how to model the pre payment problem.
The Americans were amazed that Canadian banks didn't have to deal with the problem because of the stiff penalties on pre paying the mortgage.
One American could not understand how we allowed this infringement on our liberty.
A Canadian, clearly a Scot, rose and thundered: "It is for the protection of the banks; you Americans have an insolvent savings industry."
You could almost hear him adding "Bloody twit".
Posted by: Michael Webster at May 8, 2009 9:46:48 AM
I am not sure that NY's ability to offer more risky investments matters much. The problem with the banks this time around was the NY was offereing risky investments but falsely marketing them as safe (not that they necessarilly intended to falsely advertise, the investments may have been so complicated that no-one understood them).
For one reason or another, Canadian Banks had a better risk-management assessment. So they survived.
Posted by: Allan at May 8, 2009 9:47:24 AM
I suspect that Tyler's last point is fairly salient, perhaps more so with regards to the social organization and self-policing of bankers in Canada than with regards to the preferences of investors.
Posted by: sleepy_commentator at May 8, 2009 10:30:14 AM
Not just Canadian banks, but some of their largest quasi-bank financial services firms, too. For instance, Investors Group was offered the opportunity to get involved in a lot of the wheeling and dealing elsewhere, and politely declined. Investors is in relatively good shape right now.
Posted by: Garth Wood at May 8, 2009 10:37:04 AM
Thanks Tyler!
Just to add to Michael Webster's comment:
"One American could not understand how we allowed this infringement on our liberty."
In Canada there are two types of mortgage: "open" mortgages, which you can re-finance at any time; and "closed" mortgages, which you cannot re-finance or payoff without penalty (you have to pay the difference between the old and new interest rates).
In the US, if I understand it correctly, all mortgages are "open", by law.
If I understand the US correctly, then it is the US, not Canada, that restricts free markets, by banning (or refusing to enforce) the market in closed mortgages.
It's the same with recourse vs non-recourse mortgages. These are two markets in two different products. The US restricts (or fails to enforce) recourse mortgages, and so eliminates one market. Canada (as far as I know) allows both markets to operate, but nearly everyone chooses to operate in the recourse mortgage market.
So of the 4 possible mortgage markets (open vs closed, recourse vs non-recourse) the US only allows 1 market to operate.
Posted by: Nick Rowe at May 8, 2009 10:51:36 AM
The first point is badly explained. The geographic diversification is a Big part of the story not only because it made the canadian banks more robust in the face of local market conditions but because it slowed the adoption of securization.
In the U.S., some banks in the high growth areas with a lot of new family faced a high demand for mortgages but got a low volume of deposit. Other banks in older city with an aging population got big deposits but low demand for mortgage. So the securization was born: the first bank sells packaged mortgage to the second one. The "coast to coast" canadian banks did not need that. So they were mush slower to jump in all those "innovations".
The point "five" (CMHC mortgage insurrance) is crucial. In Canada, bank employees who meet mortgage customers in bank retail location do not do risk assessement. They fill the appropriate form (paper or electronic) and the CMHC tell them if the applicant meet the objective criterias to get the insurance. And whatever bank branch of various competitors in town you chose to do your mortgage application, your data will be sent to the same faceless civil servant (or computer) who will applies the rules. No bank branch manager can increase is short term volume of business by accepting bigger risk.
In my opinion, there is no difference in "values" or "culture" involved. Just different contraints and incitatives.
Canada have a DIFFERENT banking structure and regulation than the US. Whether it is "more" or "less" regulation is a question that should be left to improductive ideologue. ;-)
sorry for the mistakes, my first language is french
Posted by: Mercure at May 8, 2009 11:40:03 AM
The US restricts (or fails to enforce) recourse mortgages
You're completely off base here. Some states force banks into making all mortgages non-recourse, the US doesn't do it as a whole. In California only purchase loans are non-recourse, but banks aren't even going after the recourse loans anyways. Mainly because if those people had money, they would have likely avoided a foreclosure. Secondly, banks can tack on the pre-payment penalties they want. Many of the loans have pre-payment penalties, closing costs etc. that make it expensive to re-finance loan. Despite this, people still speculate and banks are free to offer no pre-payment penalty and no closing cost loans to attract business.
Posted by: Byrk at May 8, 2009 11:42:03 AM
Byrk,
I fail to see how he is "completely off base." Does not his parenthetical comment of "or fails to enforce" cover the exception that you're making. You seem to be arguing that the US does not restrict recourse mortgages, merely that the banks fail to enforce them because of the effort.
Posted by: John Thacker at May 8, 2009 12:08:56 PM
#4 is very stabilizing. With so much of the economy tied to housing and mortgages you don't to exacerbate booms and busts. If you do you are relying on quality administration to "fix" the excess bubbles-busts. This added failure point doesn't exist in Canada and this in itself frees up another productivity gain: administrators here don't have to generally be preoccupied with housing prices.
Posted by: Phillip Huggan at May 8, 2009 1:16:42 PM
This discussing leads me to think about who has more knowledge the borrower or the lender. The lender may be smarter but the borrower knows more about his ability and to what extent he will go to to pay so putting more responsibility on the lender may be a bad idea.
Posted by: Floccina at May 8, 2009 1:34:59 PM
The 'historical fluke' theory needs to explain how an extremely similar historical fluke came to pass in Australia. Those 4 points are all true of Australia as well, save that we have a couple of banks which chose to be pure investment-banking plays (and a couple of these have indeed perished).
Posted by: Patrick at May 8, 2009 2:58:53 PM
We have a lot of points about the current situation.
But the Canadians also went through the 1930s without bank failures.
does anyone have ideas about what differences were important in both the 1930s and currently.
National banking rather than regional banking obviously played a big role in both cases, but what else?
Posted by: spencer at May 8, 2009 5:00:23 PM
Patrick: The point of my "historical fluke" comment was that Canadian banks were impatient to get into the US market, and could have done had they merged. But they were prevented from merging, hence avoided getting into a dodgy market at the top. But obviously that's Canada-specific. Were the Australian banks able to buy up American banks and so get a foothold in the US market? My uninformed guess is no - so the Australian banks were not faced with the temptation that the Canadian banks were.
Posted by: tom s. at May 8, 2009 5:18:42 PM
The WSJ has more on this. One point: if you put less than 20% down, you had to buy insurance. How much grief would that have saved?
Posted by: Larry at May 8, 2009 9:14:38 PM
France has a biggest housing price bubble than the USA yet banking problems on housing will be very limited because the regulator did its job (at least a part of it) and continued to enforce some significant money down on the vast majority loans. (And consumer protection laws shot down some banks who tried to selled non capped variable interest rate loans and if there were capped.)
A no-down loan is just the bank buying junk equity, it's not a loan.
Posted by: Laurent GUERBY at May 9, 2009 3:48:39 AM
Least surprising Megan McArdle sentence of the day: 'I don't find "they were more tightly regulated" a plausible explanation.'
Posted by: tom s. at May 9, 2009 4:17:17 PM
> One point: if you put less than 20% down, you had to buy insurance.
not much grief. what would you have done when the insurance companies blew up (which they would have)?
eg insurance is not helpful against systemic risk unless the insurer can print money.
Posted by: babar at May 9, 2009 8:46:49 PM
I don't know if anyone's mentioned this but Australia, that tiny little forgotten country, is one of the world's largest economies (12th from memory) and one of its major banks just posted a 1% dip in half-year profit. Just 1%. Yet these banks had sharemarket falls to rival some of the American giants, for no reason other than fear.
So, another system that's holding up very strongly. Having just read that article about Canada on the other blog and comment #1 here, the similarities are remarkable. Competition policy has prevented banks from merging. The banking market was more tightly regulated after the Asian crisis of 99.
Posted by: Jonk at May 10, 2009 5:18:49 PM
You'll notice that most of the losses on mortgage defaults were concentrated in four states, none of which are near Canada: California, Arizona, Nevada, and Florida.
Daniel Patrick Moynihan used to note that the rate of social problems such as crime, illegitimacy, and dropping out of high school were lower in states closer to the Canadian border. He advocated to policymakers that they should attempt to move their states up near Canada.
Perhaps we can add defaulting on mortgages to Moynihan's list?
Posted by: Steve Sailer at May 10, 2009 6:33:26 PM
A VOXEU column and an IMF working paper argues that Canadian banks have been more resilient because they rely on more stable retail deposits from households instead of short-term wholesale funding from interbank markets. They also propose a Pigovian tax on short-term wholesale funding to get other banks to do the same.
http://www.voxeu.com/index.php?q=node/3901
Posted by: commonwealth at Aug 27, 2009 12:32:12 AM
