Remarks on the Canadian banking system

A commenter writes,

Before the depression, the US heavily regulated banks and restricted the founding of branches; there lots of small banks tethered to local markets. In contrast, Canadian banks didn’t face such stringent regulations and were larger and more diversified. For this reason, in the US we had an epidemic of bank failures, and Canada did not.

My thoughts:

1. The best part of Canadian banking is their mortgage design: a five-year rollover, with recourse. Recourse means that if your house goes down in value, you cannot just turn the keys in to the lender and walk away. They can come back to you to make up their loss. Our 30-year, fixed-rate, no-recourse mortgage has lots of credit risk and interest-rate risk that sits with the lender, until stuff happens, and then it goes to the taxpayer. We got stuck with losses from interest-rate risk during the S&L crisis, and we got stuck with losses from credit risk during the 2008 crisis.

2. The worst part of Canadian banking is the high concentration in large banks. As in Europe, this goes along with a very stunted equity market. Firms raise capital using debt, and they owe that debt to big banks. The U.S. system, with its much more prominent stock markets, is better.

3. The worst part of the U.S. financial system is the political power of trade associations and large banks. The trade associations have leverage over Congress, and the large banks have leverage over everybody in Washington. In Canada, the big banks have to respect the regulators. Here, the bank executives can go over the heads of the regulators any time they need to.

4. Over the last thirty years, we have seen a decline in the relative importance of the stock market in the U.S.:fewer public firms, many fewer IPOs, and firms raising less of their capital in the stock market. At the same time, we have gone from a fragmented banking system to one that is very highly concentrated. Household wealth also has become more highly concentrated.

I think that if you don’t do something to limit the growth of big banks, you end up with big-bank-dominated corporate finance, meaning less active equity markets and a less democratized financial system. Also, given our political culture, you end up with the political system subservient to the CEOs of the biggest banks. In short, you combine the worst of Canada and the worst of the U.S.

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12 Responses to Remarks on the Canadian banking system

  1. B.B. says:

    I think “recourse” is a red herring. In 2007, if US mortgages had been recourse, what difference would it have made? The people who were buying houses with zero-down ARMs and teaser rates didn’t have the wealth or income to pay a recourse mortgage.

    All that happens, is the bank comes after you after you default on your mortgage, and then you declare bankruptcy. It all comes down to the same thing in the end.

    As you say, make the system easier to fix rather than harder to break. Require a 20% down payment, and limit cash-out refis, and banks will have a much easier time. And we won’t have to quibble about recourse mortgages, which are political unacceptable anyway. We need more than capital requirements for banks; we need leverage ratios for households.

    We may find out soon just how robust the Canadian system is. There are signs that the housing bubble is cracking, and thrifts are distressed.

    • Andrew' says:

      At the time, I wished that exactly this would happen, but the government who runs the bankruptcy courts could restructure the mortgages en masse.

      The idea was to thread the needle to make the payments manageable and would shore up the value of the asset on the bank’s balance sheet.

    • Handle says:

      Some states had full recourse mortgages, and, IIRC, there were some studies that concluded it didn’t seem to matter that much.

      However, there were two complicating factors weaken the confidence of the conclusion. First, by a quirk of history, given the pace of Westward expansion and political trends in vogue at the time, many of the states with recourse didn’t have particularly hot or pricey real estate markets. Of course one could guess that “Well, that’s because of the recourse,” but that’s not the whole story.

      Second, it was ‘full recourse’ in name only, with many of those states introducing arbitrary delays and legal uncertainties that it was hard to study the impact of ‘true recourse’ in action.

      • Andrew' says:

        All the anecdotal evidence I heard (having nothing to do with real-estate, just paying attention to public info) suggested that there was no way to litigate these things at the rate that would have been required by the speed of the financial crisis.

        Streamlining and making recourse fair could be one of those things that makes the financial system both harder to break and easier to fix.

      • Andrew' says:

        In other words, we don’t know if recourse mattered if it was logistically impossible to use. It could be recourse in name only, but completely impractical for banks to do, especially with governmental foot-dragging during a deep recession.

        We would have to compare cases where it was actually implemented heavily AND did not help. Even that is tenuous in a national financial system. You’d have to separate out the parts of the bank that benefited from it versus the next state over that did not and figure out if one cross-subsidized the other.

  2. collin says:

    Whenever in doubt about any difference of Canada versus the US, I always come down to the basic joke “That Canada is God’s control subject in his global experiments.”

    1) I still have not heard a satisfactory answer on why smaller banks are better than fewer and larger ones. In the developed world with smaller and local banks, it is the US that is the historical oddball here and bank decentralization may be more prone to bank failures. (Notice the worst Mortgage companies were not the biggest banks.)
    2) I am still dubious on the importance of recourse loans and if it is wise to put on risk on banks versus families. Lots of failure in Europe and it is hard costly for recourse anyway. If libertarians are whining about the Complacent Class, maybe we should find ways to make failing less brutal for families. Corporate bankruptcy is lot forgiving than individual bankruptcy.
    3) In terms of larger companies the last thirty years, I still have not heard how this companies are better at managing the Economies of Scale than anything the government has done. Look at airlines in which the government broke up in 1978 but now we are settling for fewer airlines. Or even internet companies, how in the heck did the market settle on Facebook or Amazon? In terms of Facebook, there is really no government interference here. Look at Hollywood movies and they weakening all foreign makers today and dominate the market. If managed properly, economies of scale is a very powerful force.

    • Andrew' says:

      1) Do you want to hear an answer that you won’t buy?
      When you say things like this:
      “If managed properly, economies of scale is a very powerful force.”
      I am inclined to think you will never understand what libertarians are trying to say. It’s like what Warren Buffett said about Value Investing. He can talk for hours to some people never absorb it, but others it clicks immediately and they start doing it before he finishes the first sentence.

      And Warren Buffett doesn’t even manage or create economies of scale, and he is THE GUY that knows their power. He looks for the evidence that someone else built it and maintained it for decades before he buys in.

      • collin says:

        I probably should have noted that companies (not economies) are better at managing economies of scale. Large companies are dominating the economy because they are better at managing economies of scale, quicker to adjust and there are advantages of incumbents. Obviously this is not all true (ie Sears) but say Google has been effective. (And they have had failures as well.) I still don’t see the large corporations or inequality in the developed world than effective large companies and economies of scale. (And just think how much it cost Facebook for an additional user?)

        • Andrew' says:

          I can’t speak for all libertarians, but I would say as a libertarian, we would have more of tendency to assert that economies of scale are discovered rather than managed or created. Arnold generalizes even further with his Patterns of Sustainable Specialization and Trade. There isn’t a ton of economy of scale with something like personalized medicine (that happens to be on my mind right now) but it could still be a sustainable business practice. As long as one is not forcefully cross-subsidized at the expense of another, libertarians are not going to tend think it is much of a problem. I just think, lucky for that guy. Facebook is largely lucky. Lot’s of people are trying to win the winner take all markets, but few do.

          Now to banks. I split the problem in two. Small banks have less of a capital cushion. But they are also less likely to succumb to trends. In my mental model, the housing bubble and bust was in part because too much capital funneled into housing and trees don’t grow to the sky. Smaller banks with more independent management are less likely to get into trouble. Homeowners who are not so incentivized to over-buy housing are more likely to diversify, thus having a greater probability of avoiding the bubble and bust in the first place. But I think we would agree that once bust is cascading, it is not time to pile on and amplify the damage.

        • Andrew' says:

          For a simple model illustration of my “theory,” imagine 3 banks, A, B, and C. A and B are exactly half the size of C. Within C there are 2 branches that are equal in size, C1 and C2. So, the “size” of A=B=C1=C2.

          Assume a financial crisis. A goes to B and says “I need a loan. Brother can you spare a dime?” How much more likely is C2 to loan to C1 than B is to loan to A? How punitive will the rates demanded be? What if A lies about the soundness of their balance sheet, or at least B suspects A could be lying?

  3. Handle says:

    Progressives often complain about a system that, “cruelly allocates all risk to the weakest individuals.”

    However, our recent experience with banks tell us that the optimal holder of risk in private transactions is indeed always the party with the least political power.

    So things should indeed be arranged such that Wall Street allocates all risk to Main Street. Because if Wall Street is left holding the bag, it will just easily arrange a government bailout for itself. Whereas Main Street seems to know that if it’s in line to get screwed, it really will get screwed and won’t be able to do much about it. That’s a good precaution against moral hazard.

  4. RohanV says:

    Regarding #1, this is what the Canada Morgage and Housing Corporation sees as the difference between Canada and the US housing markets. Mostly, the government doesn’t prioritize home ownership (we don’t have a mortgage deduction for income tax, for example), and tends to support the housing market through the mortage insurance framework.

    My personal belief is that the stability of the Canadian financial system is more of a “personnel is policy” effect. Our young, ambitious financial whiz kids jump to the United States, as the opportunities and potential income there is far greater. The culture, language, and even time zones are pretty much the same. The ones who stay behind and join the Canadian financial system are the people who seek less risk, who prefer to stay closer to home. A financial system made up of people like that is perhaps more “small-c” conservative and less likely to indulge in higher risk–but potentially lucrative–schemes.

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