In light of the fact that over the past two years the Canadian financial system has proved very resilient compared to its international peers, there has been a lot of talk as to why this has been the case. See here and here for example.
Yesterday VoxEU had a post on the subject based on new research done at the IMF. The authors’ full study can be found here.
As far as I know, this is the first rigorous study on the subject. And their conclusion is very interesting:
Our paper analyses the pre-crisis balance sheet structures of the largest commercial banks in OECD countries and relates them to bank performance during the turmoil. Our regression analysis shows that incidents of bank distress can be explained rather well based on just three pre-crisis accounting-based financial ratios: a critically low (below 4%) equity-to-asset ratio, insufficient balance sheet liquidity, and a funding structure that relied less on a stable deposit base and more on wholesale funding.
Empirically, the funding structure, as measured by the depository funding to total asset ratio, is the most robust predictor of bank performance during the turmoil.
The authors evaluated both the asset side and liability side of the equation and concluded that the most important factor in shielding the Canadian banks was their greater reliance on deposits instead of wholesale funding. It was not some special cultural attribute of Canadian risk managers, or some all-seeing power of OFSI. That being said, on the asset side, they do point out that the regulatory environment did play a role. From the paper:
Canadian banks were indeed distinguished by limited exposure to troubled U.S. assets. There are a number of possible explanations for this beneficial outcome: sound risk management, regulation that discourages non-core foreign activities (see next section), and potentially low gains from diversification into a closely correlated economy. There is no doubt that limited exposure to troubled U.S. assets has contributed to the stability of Canadian banks during the turmoil.
In addition, the fairly sheltered competitive environment also resulted in a more robust financial structure. Again from the study:
The Canadian banking sector is dominated by six large banks with an integrated nationwide 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.
This last point is very interesting. We can probably infer that, all else equal, having a less competitive environment results in rent-like profits for the banks at the expense of their consumer base. However, because of this, banks did not need to be bailed out by the government, a cost that would have been ultimately borne by taxpayers. In other words, and if I am reading this right, the lack of competition in Canada acts as a sort of tax on savers, where the revenue raised served to protect the financial system. And since this is a tax on savings, it would be progressive, as richer citizens would tend to have more money saved in the banks.
Whether that’s correct or not, this is a very interesting paper well worth a read. I’m sure we’ll see more on the subject in the coming years as regulators try to develop a better regulatory environment
Via Free Exchange
-update. Felix Salmon adds some thoughts about banking structure.