Tuesday, August 18, 2009

Why Canadian Banks Did Better in the 2008 Financial Crisis

The IMF released a paper that analyzed why certain countries and banks fared much better than others during the financial crisis of 2007 and 2008, with particular attention paid to Canadian banks.

Then usual explanation is that better banks were more conservative (like the Canadian Banks) and better capitalized. However, this is not so according to the IMF. The banks that did better are those that had a diversified depositor base, those who were not concentrated on a few larger investors. A clear example of the latter was Bear Sterns.

The IMF study looked at big banks, those whose assets were 0ver $200B Euros at the end of 2006. The reason banks survided and did well is related to capital reserves and liquidity ratios, i.e., how much money the bank actually can count on when the money is needed (and that can be sold quickly).

Canadian banks in general take less risks (particulary with mortgages, only 3% is subprime), but were not well capitalized at all. They only scored in the third quartile of all banks considered, below average! Their differentiator was their depositor structure, how diversified was its base of depositors. Canadian banks take money from the general public, who did not cause any run on the banks (their deposits are insured), thus, nothing happened. Other banks however, concentrated on the wholesale market and took large investments from other big banks or investment institutions. When these big banks panicked, they caused the trouble. This turned out to be their recipe for disaster.

Relevant quotes from the paper:

"The Canadian banking sector is dominated by six large banks with an integrated nation-wide branch network. The national franchise is highly profitable and valuable, and banks are keen to preserve it, thereby avoiding excess risks that could compromise the franchise. Customers value the capabilities of a nation-wide bank branch network, and the demand for it serves as a barrier to the contestability of Canadian banking services especially in deposit and debt card products. Limited external competition reduces pressures to defend or expand market share, again reducing incentives to take risks. Retail funding supply and retail loan demand appear well-matched in Canada, reducing banks’ need to engage in wholesale borrowing or lending activities. Larger corporations typically borrow directly from capital markets, or from syndicates that include and are often led by foreign banks, possibly because a higher capital requirement increases local banks’ cost of capital and reduces their competitiveness in the syndicated loans market. Finally, the Canadian mortgage market is relatively conservative, with a number of factors contributing to the prudence of mortgage lending (see Kiff, 2009). Less than 3 percent of mortgages are subprime and less than 30 percent of mortgages are securitized (compared with about 15 percent and 60 percent respectively in the United States prior to the crisis). Mortgages with a loan-to-value ratio of more than 80 percent need to be insured for the whole amount (rather than the portion above 80 percent as in the United States). Mortgages with a loan-to-value ratio of more than 95 percent cannot be underwritten by federally-regulated depository institutions. To qualify for mortgage insurance, mortgage debt service-to-income ratio should usually not exceed 32 percent and total debt service 40 percent of gross household income. Few fixed-rate mortgages have a contract term longer than five years.


The paper analyzed pre-crisis balance sheet structural fundamentals of Canadian banksand compared them with banks in other OECD countries. We found that ample retail depository finding was the key factor behind the relative resilience of Canadian banks during the turmoil. Sufficient capital and liquidity were also important but played a less distinctive role. In addition, a number of regulatory and structural factors have reduced Canadian banks’ incentives to take risks. Results allow a conjecture that strong structural fundamentals of Canadian banks will remain a source of their resilience as the financial turmoil and economic recession persist."

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