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Effect of the Financial Crisis on Canada

Effect of the Financial Crisis on Canada

Stability of Canadian Banking Sector in the Face of the Global Financial CrisisIn September 2008 what started out as a housingbubble transformed into the worst recession that the United States had seen indecades. Although the crisis started in the developed countries, primarily theUS and European countries, all countries around the world suffered from its adverseeffects featuring bankfailures and government bailouts. Canada, although close tradingpartners with the US, and Europe was the only G7 country (Refer to Fig. 1) withno bank failures or bailouts and faced asignificantly milder recession (Haltom, 2013). Naturally,economists became interested in the cause for this stability, notable factors beingCanada’s undeniable conservative approach and exceptionally strict regulation. Why were Canada’s banks stable in the face of the 2008 global financial crisis? This paper argues that the initial banking framework constructed in the early 19th century caused Canada’s banks to be stable. First, the resulting oligopoly allowed for easier regulation and implementation of restrictions by one overarching regulator. Second, Canadian banks, known to be less risky because of diversification allowed them to be less vulnerable to shocks. Lastly, with only 6 main competitors, there was low competition not leaving room for the shadow banking industry to thrive. This paper is organized as follows: by comparing Canada’s banking system with that of the USA we begin by highlighting the direction that the Canadian banking system took in the 19th and early 20th centuries. We then consider reasons why Canada demonstrated such resilience in the 2007-2008 financial crisis. Discussing this question will allow for other countries to learn and possibly implement the successful aspects of the Canadian financial system to better handle crises of this sort in the future. Figure Source: World Bank, 2012Figure 1 GDP growth (%) and soundness of banking systems according to GCR (scale 1-7, 1=need bailouts, 7=sound) in G7 countries, 2008-09Note that although, there exist trade-offsbetween stability and competition, defined as the “regulator’s dilemma,” thecosts of stability won’t be identified nor will they be weighed against thebenefits. This paper will focus primarily on the reasons that Canada remainedstable in the face of the economic crisis in 2008. The stability of the Canadian banking system in the 2008 globalfinancial crisis is not a singular event. Throughout history, the bankingsystem in the US faced at least eight major banking crises in the antebellumera, under the National Banking system and until the Federal Reserve System wasestablished in 1913, unlike the Canadian banking system that experienced twominor incidences in the 1830s associated with problems in the US (Bordo et al.,2011). This difference originated because of the establishment appointed thejurisdiction over chartering and regulating banks. In Canada, the federalgovernment and in the US, the state government. A dual banking system emergedduring the civil war when the national banking system was established inaddition to the state banking system already in place. The American banking systemrestricted nation-wide branch banking whereas the federal jurisdiction in Canada allowed branching acrossprovincial and territorial borders. In the British North American Act that combinedfour colonies to create Canada in 1867, the federal government was given absoluteauthority to build the banking framework. The Canadian banking system evolvedinto an oligopoly that Bordo, Redish and Rockoff described as “a cartel backedby the federal government and policed by the Canadian Bankers Association” asthe need for a charter limited entry into the industry. Due to theseinitial institutional foundations, although Canada currently has 80 banks, 93percent of the market share is dominated by only six with one financialregulator[1], Office of the Superintendent of Financial Institutions(OSFI) unlike the US that havemanaged to charter 7000 banks and multiple financial regulators (the Fed, FederalDeposit Insurance Corporation, Office of the Comptroller of the Currency andstate regulators) (Haltom, 2013).OSFI supervises every aspect of the financial institutions: mortgages,insurance, investments, etc. Althoughbranching is no longer prohibited in the US, this one restriction created afragile and fragmented “unit banking[2]”in America as opposed to the highly concentrated and stable banking system inCanada in the face of the 2008 global financial crisis[3].It is well known that Canada enforces strictregulations and restrictions on their financial system. Capital requirementssuch as capital adequacy regulatory standards, permissible capital deductionsand regulatory capital are amongst the most restrictive in the world (WorldBank 2012). Canada has greater debt regulation such as restrictions onleveraging and reduced incognito leverage or off-balance sheet (OBS) items. Inaddition to strict regulations, every five years, Canada reviews charters andregulations to incorporate and adapt to innovation and unfamiliar risks thatmay be developing. What allows these regulations and changes in restrictions tobe feasibly enforced and easily implemented is the highly concentratedstructure of the banking system. This facilitated coordination is alsobeneficial during a time of financial crisis. When discussing the 2008 global financialcrisis, it’s important to note the role in lack of regulation and restrictionsin causing it. The problems started with sub-prime[4]housing loans, which by 2006 were approximately 15 percent of pending mortgagesin the US (Edey, 2009). There was a lack of regulation in identifying riskassociated with administrating credit to borrowers with unreliable credithistory and legitimate proof of income and lack of restrictions regardingloan-to-valuation ratio. The crisis continued to develop as the securitizationof these sub-prime loans through mortgage-backed securities (MBSs)[5]and collateralised debt obligations (CDOs)[6]which are asset backed securities. These securities generated high returns andincorrectly received good credit[7]ratings by rating agencies attracting investors (Edey, 2009). The inevitablerise in mortgage delinquencies, reaching 11 percent at its peak, on thesesub-prime mortgages that followed eliminated the confidence in theseinvestments as the housing bubble burst. The first impact on the globalfinancial markets was apparent when French banks suspended funds they wereinvesting in US MBSs. Other European banks and OBS agents linked to them hadalso invested to a great degree in these securities making them prone to heavylosses (Edey, 2009). In contrast, Canada’s mortgage financingregulations aren’t structured to allow for such careless lending. In Canada,banks keep mortgages rather than selling them to investors. Before thefinancial crisis, approximately 30 percent of Canada’s mortgages weresecuritized, much less than the US which stood at almost 70 percent (Halton,2013). In addition, less than three percent were sub-prime mortgages,significantly reducing the risk that Canada was exposed to as tight regulationencouraged safe mortgages (Halton, 2013). Financial institutions are prohibitedfrom giving loans without at least a five percent down payment. If the downpayment is less than 20 percent, mortgages are required to have insurance.Strict restrictions for insurance are also in place as it is only approved iftotal household debt-to-income ratio is less than 40 percent. Theserestrictions kept mortgage default rates below the historical average of lessthan one percent in Canada (BLACK**). This highly concentrated banking systemalso provided incentive to banks to engage in less risky activities as a singlefailure would severely injure the financial system. Due to the small number ofinstitutions in effect their engagement in less risky activities, OSFIsuccessfully prevented the failures that sub-prime mortgages brought to theglobal market from entering Canada’s banks.Figure Source: World Bank, 2012Figure 2 Bank nonperforming loans (as % of total loans) in Canada, Japan, UK, and the US, 2008-09The unit banking system of the US resulted in small,fragile and undiversified banks. There was a chartered bank per city or regionwith no branches. Historically, these small banks held similar assets whichwere primarily local loans and mortgages. Leading up to the 2008 crisis, mostbanks were engaging in MBSs and CDOs investments attracted by the promise ofhigh returns. According to the BondMarket Association of the $25.9 trillion bondmarket, mortgage debt contributed to $6.1 trillion (Lambert, 2006).Alreadyless diversified than banks in Canada sub-prime lending added to this risk.Rating agencies gave CDOs high credit ratings on the basis that they werebacked by mortgages that were regionally diversified. The CDOs were incorrectlyrated as they consisted of primarily sub-prime mortgages, the regions in whichthese mortgages were issued made little or no difference to their risk. The banks in Canada with nation-wide branchingoriginally started off with geographically diversified assets, customers andrisk constructed to be less risky which allows them to absorb shocks. With asmall number of chartered banks, individual banks grew to be very large and in1987 after the Bank Act was revised to increase competition, Canadian banksabsorbed securities brokerages making them bigger than ever. This resulted indiverse sectors, investments as well as loans credited to customers. Canadianbanks were now engaged in wealth management, insurance, mortgages lending, and securitiesbrokerage (Pruss, 2015). Although attractive to smaller banks, thetrade-off between higher return and high risk wasn’t one that Canadian banksneeded to weigh. Only three percent of Canadian mortgages were sub-prime whichfurther supports my argument that Canadian banks maintained diverse assetsdespite the pull of high return that CDOs and MBSs offered. The effects of thisdiversification were demonstrated historically with the small number ofrecessions and bank failures that Canada has faced in comparison with the USand in their ability to absorb shock in the 2008 financial crisis.  The shadow banking activities, approximately 95percent of the American economy played a large role in the global financialcrisis (Haltom, 2013). Due to the highly concentrated nature of the Canadianbanking system that fostered low competition and enforced tight regulation, therisky shadow banking industry didn’t have the same demand or freedom to growthe way it did in the US. The financial sector in the US consisted of twoparallel banking systems, one that was regulated by multiple parties andanother that transformed from investment banks and other financialintermediaries into the shadow banking industry, a market for activitiesrestricted in the first (Bordo et al., 2011). Naturally, high risk activitiesgravitated towards the shadow banking industry which had vague restrictions andwere mostly outside the regulatory umbrella (Haltom, 2013). This lack of regulation wasfollowed by a lack of understanding in the risks associated with the industryas confidence levels were almost equal to that of the regulated sector. Krugmen(2009) claims that the problems associated with the crisis are less fromderegulated institutions instead involve risks associated with “institutionsthat were never regulated in the first place.” Asthe shadow banking industry grew, the US moved towards the same financiallyvulnerable position that they experienced before the Great Depression. Inaddition, the Bush administration used their power and relation to the Officeof the Comptroller of the Currency to eliminate any attempt to regulatesub-prime housing loans (Krugman, 2009).  In the decades leading up to the globalfinancial crisis, the Canadian banking system diverged further from that of theUS. Following the 1987 Bank Act revision, Canadian banks began engaging insecurities brokerages, mortgages and other activities that in the US, unregulatedinstitutions partake in. OSFIovertook the affairs of the Inspector General of Banks as well as theSuperintendent of Insurance becoming the sole regulator of all federalfinancial institutions in Canada overseeing in addition to the bank, pensionfunds, insurance and trust companies. With increasing risk, Canada increasedtheir regulation. Only approximately 40 percent of the Canadian economyincludes shadow banking activities, a considerable fraction of which Canada’sbanks have committed to. In addition, 60 percent of these are insured and haveaccess to lender of last resort thus protected by the federal government. Thecompetitive and unregulated environment that allowed the shadow bankingindustry to grow in the US didn’t exist in Canada. Countries around the world were left crippled inthe face of the 2008 global financial crisis, the most notable being the US wherethe crisis originated and developed. Canada was one exception as its bankingsystem remained stable with no bank failures or government bailouts. Throughouthistory, in comparison to the US, Canada has suffered through less recessions,less panics and less bank failures. In the 2008 global financial crisis, Canada’sresilience is to be noted as it was a result of the nature the original bankingframework created in the 19th century. Canada’s highly concentrated bankingsystem allowed for tight regulation, diversification and low competition in theindustry resulting in a less risky sector equipped to absorb the disastrous crisisof 2008. Although, Canada’s history has played a large part in constructingthis stable system and any one solution or explanation for financial stabilitywon’t miraculously save a nation, there is a great deal that other countriescan learn from Canada to better equip themselves to handle crises in thefuture. ReferencesBordo, Michael D., Angela Redish, and Hugh Rockoff. “Why Didn’t CanadaHave a Banking Crisis in 2008 (Or In 1930, Or 1907,Or…)?” National Bureau of Economic Research Working Paper No. 17312, August2011.Haltom, Renee.“Why was Canada Exempt from the Financial Crisis?” Econ Focus, Fourth Quarter, 2013, pp. 22-25. Refer to:         https://www.richmondfed.org/~/media/richmondfedorg/publications/research/econ_focus/2013/q4/pdf/feature2.pdfWorld Bank. Crisis-proofingfinancial integration: Canada, June 2012, pp. 30-33. Refer to: http://siteresources.worldbank.org/ECAEXT/Resources/258598-1284061150155/7383639-1323888814015/8319788-1324485944855/03_canada.pdfEdey, M. (2009), The Global Financial Crisis and Its Effects. Economic Papers: A journal of applied economics and policy, 28: pp. 186-195. Refer to: http://onlinelibrary.wiley.com/doi/10.1111/j.1759-3441.2009.00032.x/fullKrugman, Paul. TheReturn of Depression Economics and the Crisis of 2008. New York:W.W. Norton & Company, 2009. Lambert, G.D., 2006. Profit From Mortgage Debt WithMBS. Investopedia. Refer to: http://www.investopedia.com/articles/06/mortgagebackedsecurities.aspPruss, L., 2015. USA vs. Canadian Banking Systems. HQ Mortgages Inc. Refer to: http://hqmortgages.ca/2015/10/06/usa-vs-canadian-banking-systems/[1] Although securitiesmarkets are provincially and territorially regulated, they work cooperatively[2] many individual institutions but no branches[3] theadvantage to the highly concentrated system in Canada was also apparent duringprevious financial crises that both countries faced[4] loans that do notmeet standard criteria for good credit quality[5] asset backed securitybacked by a mortgage or collection of mortgages[6] pool of assets – mortgages– that are debt obligations that act as collateral[7] Received high ratingsbased on geographically diversified mortgagesGet Help With Your EssayIf you need assistance with writing your essay, our professional essay writing service is here to help!Find out more

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