Friday, April 2, 2010

Is Canada Better Regulated?

As the United States struggles with achieving any substantive financial system regulatory reform against the well financed opposition of bank lobbyists intent on preserving the profitability of systemic risk, there has been a weak and poorly focused debate on whether Canada, which was relatively unaffected by the current financial crisis, has a better regulated financial system or not and, if so, why.

In May 2009, The Wall Street Journal argued that the Canadian financial system is not exportable to the United States, because Canada does not promote affordable home ownership through government subsidized programs with down payments as low as 3%.  In Canada you need a down payment of at least 20% or you are required to purchase mortgage insurance.  Mortgage interest is not deductible in Canada.  While a homeowner in the United States can walk away from a loan if the balance on the mortgage exceeds the value of the home, in Canada mortgage holders are strictly responsible for the their home loans and the lender can file claims against other assets.  While the purchase and sale of asset backed securities is permissible in Canada, only 27% (as compared to 67% in the United States) of mortgages have been securitized with the rest remaining on the books of the banks.  Canadian banks were profitable in Q4 2008 and the Canadian government bought 55 billion Canadian dollars of insured loans from the banks in the first half of 2009 as the global financial crisis intensified to assure liquidity.  While much has been made of Canadian banks having a lower average leverage ratio (18:1) than the US commercial banks (26:1) and US investment banks (40:1), the balance sheets are not comparable, because the US banks are allowed to carry toxic debts at inflated values not consistent with fair market value.  What good are higher leverage ratios if the balance sheets are essentially fraudulent?  When Canada's Office of the Superintendent of Financial Institutions (OSFI) was formed more than twenty years ago, to regulate banks, insurance companies, and pension funds, it has concentrated on risk management.  Rather than housing, bank regulation, less securitization, or monetary policy, did Canadian banks just practice more prudent risk management?

In January 2010, the Financial Times concentrated on the "cultural" differences between Canada and the United States.  Mark Carney, a governor of the Bank of Canada, said "Canadian bankers are still bankers.  They ... are proficient at managing credit risk and market risk ... they have retained a banking culture through(out) the organization."  The head of OSFI, Julie Dickson, stresses the principle based approached as opposed to legalistic rules in assuring three specific restrictions are followed:  capital requirement of a Tier 1 of at least 7%, quality of capital in which 75% of Tier 1 must be in common shares, and a leverage ratio no higher than 20:1.  The OSFI wants to be told everything that is going on. "Having lawyers looking at this line or that clause and debating with you about whether something is do-able or not is not the right conversation to have.  The right conversation is the principle.  You have to know the risks you are undertaking."

Canada has an uncomplicated and well coordinated regulatory framework involving the central bank responsible for stability of the overall system, the superintendent responsible for the stability of the financial system, a consumer protection agency responsible for protecting individuals, and a finance ministry responsible for setting the broad rules on ownership of financial institutions and the design of financial products.  In the early 1990's, after a period of failed trust companies, the government set out to create a risk aware financial system.  While the Financial Times article also caters to a "robust" mortgage market with only a 1% default rate while having approximately the same home ownership rate as the United States, David Dodge, a former governor of the Bank of Canada, maintains the structure of the banking business allows the banks to make healthy profits without taking extreme risks.  "You had a set of banks that had essentially very profitable domestic commercial banking franchises.  They had to be pretty bad in their other business to lose money overall."

Some commentators have been attempting to posit a growing Canadian housing bubble by looking at housing prices in Vancouver, which has caused Worthwhile Canadian Initiative to ask for a data documented proof of how falling prices in Vancouver can be expanded into a made-in-Canada recession?  In actuality, Canada has not had an over investment in housing.  It has been recovering from under investment in the 1990's, following the housing bubble of the 1980's, and what one is seeing now is typical price reaction to supply and demand as lower prices have reduced extra supply and prices are no going back up to prior levels.

Macro and Other Market Musings has shown, in an analysis of a commentary on Canadian housing published by the Cleveland Federal Reserve written by James MacGee, David Beckworth shows the monetary policy of the Fed and the Bank of Canada were not the same and that the Canadian authorities got it right while the Fed was too accommodating with monetary policy being an important component in the US housing boom-bust cycle in which there was weak underwriting with collateral-based lending and the "... interest rates charged to non-conventional mortgages were closely tied to the federal funds rate ...".

In March 2010, Beckworth asked how Simon Johnson and James Kwak would reconcile the success of the Canadian banking system, which benefited from nation-wide branch banking allowing better geographical diversification of assets and quicker access to reserves, in this financial crisis since the nation-wide branch banking led to a very high concentration of Canadian banking in the 5 largest banks.  Later in March in a piece in Economix and an expanded version in The Baseline Scenario, Peter Boone and Simon Johnson responded that the Canadian banking system is a fallacy and not the answer, because over half of Canadian mortgages are "effectively" guaranteed by the Canadian government.  Despite home owners with less than 20% down payment being required to purchase mortgage insurance, Boone and Johnson insist that the Canadian Mortgage and Housing Corporation directly or indirectly guarantee these riskiest mortgages.  Boone ande Johnson also maintain the well coordinated Canadian regulatory system is actually an oligarchic camaraderie between regulators and banks, which is dependent on easy access to taxpayer bailouts.  Boone and Johnson assert this would mean the United States would have to shrink its banks into even larger mega banks and re-inflate Fannie Mae and Freddie Mac.  It is not just capital ratios, it is not regulation, it is size that matters for Boone and Johnson: "... smaller banks with a lot more capital --- and able to fail when they act stupid ...".

The Perry article, published by the conservative American Enterprise Institute, cited by Beckworth listed features of the Canadian banking system  which helped explain the resilience of Canadian banks compared to American banks:
       1.  Full recourse Mortgages in Canada in which the borrower remains fully responsible for the mortgage;
       2.  Shorter-Term Fixed Rates in Canada where mortgages carry a fixed interest rate for a maximum of
            five years at which time the rates are re-negotiated for another five years, allowing banks to achieve a
            better maturity match between assets and interest income and bank liabilities and interest expense;
       3.  Mortgage insurance is more common in Canada than the United States with approximately half of   
            Canadian mortgages carrying insurance compared to about 30% in the United States.  Private
            insurance companies in Canada have the authority to approve or reject a property appraisal giving
            them a strong financial incentive to approve realistic appraisals;
       4.  No tax deductibility of mortgage interest in Canada which means there is no tax advantage to home
            ownership and no tax benefit to converting home equity into household debt;
       5.  Higher prepayment penalties in Canada (three months of mortgage interest) which discourages the
            type of refinancing that took place in the United States;
        6.  Public policy differences with respect to low income housing, because Canada provides public
             funding of low income rental housing rather than encourage low income home ownership (I find this
             problematic since a mortgage payment should be less than a rental payment for a comparable piece
             of property and wonder if the US problem not a combination of easy securitization of high risk
             mortgages and lobbyists getting credit standards lowered, i.e., improper risk management);
        7.  Canada's larger bank concentration allowed more geographical diversification for deposits and loan
              portfolios (I have to ask if this was not the result of nation-wide branch banking in a country whose
              GDP is 1/10th that of the United States and the "geographical diversification" would be meaningless
              without proper risk management?);
         8.  Other differences contributing to bank safety in which only 35% of Canadian mortgages are
               originated by mortgage brokers and there is a much smaller sub-prime mortgage market resulting in
               approximately 63-68% of mortgages staying on the books of originating lenders which encourage
               prudent lending with banks putting more of their own capital at risk; additionally, all mortgage
               payments in Canada are made electronically limiting late payments.

While size is a consideration when commercial and investment banking are mixed together, the real measure is not size but whether the financial entity (bank, pension fund, hedge fund, insurance company) is systemically dangerous in its operation.  A simple, uncomplicated and well coordinated regulatory system which includes independent consumer protection is highly desirable.  Such a regulatory system without a strong emphasis on proper risk management would be ineffective.  It is all about the principle of proper risk management and the active enforcement of the principles of risk management.  That is the difference between the Canadian regulatory system and the Untied States, which actively promotes risk taking.  We should be looking for financial regulatory reform which stresses the principles of risk management.

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6 comments:

  1. Simon Johnson's report on Canadian banks was somewhat misleading. You may want to look at the BofC Financial System Review which I had then consulted, since at the time I was only able to access Canadian data from the OSFI. See below on page 24 (Box 3).
    http://www.bankofcanada.ca/en/fsr/2008/fsr_1208.pdf

    What they stated was very clear. Capital adequacy ratios were significantly higher in Canada than the US, the UK and Euro zone during most of the 2000s. On the other hand, the leverage ratios in Canada were higher than the US commercial banking ratios, as Johnson argues, BUT as the review said, this latter indicator is a bit misleading, since the standard measure of the leverage ratio does not include the total of off-balance-sheet assets which were very much higher in the US commercial banking sector. It is the latter which is more useful to recognize and not the narrow leverage ratio, especially since the whole problem of securitization was much more serious in the US than in Canada revealing all the high stakes risk problem faced by US banks.

    This is why what Boone and Johnson say is a bit misleading. However, I do agree that our oligopolistic banking sector has not served us well as consumers of their services! But the fact Canada banks were making oligopolistic profits was probably also a factor (as I said) which did not pressure them to engage in securitization à outrance! Hence, the tradeoff was one of high monopoly profits or high-risk securitization! It's not clear to me that our system is better and certainly at no time would I say that US banking regulators should follow Canada by making the system more concentrated! That would be folly! But, still it did save us from the worst effects of securitization.

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  2. Minor point: I think that in Alberta residential firt mortgages are non-recourse [the lender can only repocess the property, but not take action against the mortgagee, unless there is fraud]. So [at least in Alberta] a morgator is even more stongly motivated to make sure that the underlying assets have adequate value, and the morgatee has the character and capacity to service the debt.

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  3. Interesting post. At the risk of over simplifying, I think Canada (along with Australia) evaded the US's problems for one reason: it never developed a 'shadow banking system'; so, the banks were never driven to take on greater credit risk in the face of falling margins.

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  4. What about CMHC and it's build up of debt to fuel the housing bubble?

    Risk of loss severe there if real estate slumps, and taxpayers will have to cover the losses.

    I don't see a lot of difference to the US from a high altitude - both had Government and systemic Banking support blowing up the bubble and taxpayers get the bill. Different roads came to the same end.

    It's all relative of course, compared to other nations, like currencies. Too many other nations ahead of Canada at the credit slaughterhouse at the moment, and little room to advance. Go Canada.

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  5. In Canada federal election campaigns are largely financed by the state. Although private campaign donations are allowed they can only be made by a voter and not by unions or corporations. There is a low limit on private donations and on overall spending. As a result our politicians are not quite as ready to sell the public interest down the river in return for campaign contributions from lobbyists.

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  6. As a Canadian, I feel it necessary to say a few things: 1) There is a definite housing bubble in the major Canadian cities, look at the demographica housing report, it is now more expensive to live in Vancouver than London (using income) and most people cannot afford a decent home in the major cities (Calgary, Toronto, Van, Ottawa), where virtually all our population lives; 2) Also, Canadians may be forced to buy insurance if they don't have a 20% downpayment, but look at the CMHC(our fannie/freddie) website, they do securitize and sell of bundles of mortgages, and even more worrying, virtually all the Canadian banks demanded that people take out mortgage insurance and that the gov't implicity back the debt, otherwise they wouldn't lend to them; and 3) A lot of the difference is cultural, while no doubt Bay Street bankers are a greedy bunch, just look at what Gord Nixon (CEO of RBC bank) made the last couple of years, its not even the pocket change from a mid level nobody at Goldman or Hedge Fund.

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