Canadian Bank Regulation

[Michael]

Canadian Bank Regulation

There is lots of talk going on about what kind of regulation is right for banks. President Obama has specifically mentioned Canada's financial regulatory system as a good one to emulate.

On the surface, this is easy to say - Canada's banking system was less affected by the insanity of the last half-dozen years and as such, Canadian banks are in much better shape financially than just about any other nations banks at this time. As it stands now, two of the only seven banks in the world with AAA credit ratings are Canadian and four of the top ten largest banks in North America are Canadian banks (mostly due to the meltdown in the assets of formerly larger US banks, since normally, none of Canada's banks make the North American top ten list).

And yes, there is certainly one particular policy in Canadian banking regulation that could certainly help to improve US banking regulation. That is the Canadian regulatory focus on "principles" not "rules". Canada regulates banks (and finance companies and hedge funds and insurance companies) based on the principle that they are engaged in banking. This means that ANY institution that engages in activity 'akin' to banking is covered by the same regulations - and there is only one regulatory body run by the Feds which has authority from coast to coast over all financial instutitions (of any type).

This is contrasted with US banking regulation which is divided between the Federal government, states and even counties. US banking regulation is also divided according to the legal structure of the companies being regulated (different regulatory bodies for commercial banks, investment banks, hedge funds, insurance companies, finance companies, corporations vs partnerships, etc). As a result, there are lots of loopholes and ways to play regulatory arbitrage games (and much greater opportunities to 'capture' the regulator). If you think this is bad enough, keep in mind that a massive corporation like Citibank, built by buying up a bunch of other banks, finance companies, investment banks, etc., has different parts of the same company subject to different regulatory rules regimes (and regulators).

In this respect, the regulation of US banking/financial industry could certainly be improved by the application of the Canadian approach. Though, few people bother to mention that the US has the regulatory system that they do because of the political system they have (which is based a hodge-podge of different competing jurisdictions - no surprise the US regulatory structure follows the same pattern). Similarly, Canada has the regulatory structure that it has because of the political system that it has - where the federal government is usually dominant and supreme in law. The point here is that the US can't adopt the Canadian approach to bank regulation without making massive changes to their political system (and that's not going to happen).

(btw, this mirrors the comparison between Canada and USA on election laws. Canada has one set of elections rules from coast to coast, overseen by one government body - USA has separate elections rules for every county in the USA - meaning there are well over a thousand jurisdictions and rules systems involved)

But looking at this issue this way 'hides' something else. That is to say, Canada's bank regulatory system is not unique. Quite a few countries in Europe (as well as UK and Australia) share a similar regulatory approach - yet these same countries have banking problems that compare quite closely to the US banking problem. Ergo, a 'principles-based' approach to bank regulation is no 'silver bullet' to fix US banking problems.

Obviously, there is something else about the Canadian banking/regulatory system that makes it more 'secure' than the banking sectors in other developed nations. The 'principles' based regulatory structure is insufficient to account for the difference.

One clear issue of distinction is the pattern of 'deregulation' that has characterized the banking/finance industry in the developed world over the last twenty years. This passion for deregulation was most noted in the USA and UK (under the rubric of "neoliberalism"), but the fact is, France, Germany, Netherlands, Switzerland, Ireland and Iceland all engaged in exactly the same game (if not more so since they had many more regulations to deregulate than the Americans did). Fact is, when it comes to over-leveraged balance sheets, European banks are in far worse shape than most American banks. The 'hot shot in red suspenders' playing fast and loose with high risk games on Wall Street' wasn't limited to just Wall Street.

It is to be noted that Canadian banks tried hard to join in that same game and lobbied the government furiously for the same deregulatory changes that would let them adopt similar financial strategies being followed by Citigroup and BofA. The Canadian Government (Minister of Finance Paul Martin to be specific) said "no". These same Canadian banks also lobbied hard for permission to merge together and to purchase insurance companies so they could create some monster-sized banks like the ones in the USA. Again, Finance Minister Paul Martin said "no".

As a general rule, Paul Martin's decisions had wide public support and approval. The banks were seen as exactly what they were - seeking opportunities to expand profit opportunities that had no beneficial effect for their customers or society in general (and thus were denied).

This is the one area that Canada proved to be unique - Canada is the ONLY country that resisted the 'neoliberal deregulation' phase (craze) of the last twenty years that swept across the USA and Europe. How does one adopt (or teach) this kind of political conservativism? Canada has a long history of engaging in this type of approach to political issues. Clearly, this is part of Canada's political culture, not just a set of rules that can be copied by other nations.

And it is to be noted that if Canada was unlucky enough to have had a Conservative government in power at that time, Canada would be in the same boat as everyone else right now as it was one of the first priorities of the present Conservative government upon entering office in 2006 was to begin making those same regulatory changes that the banks had long requested (and had been rejected). It was only the quickly blowing up financial markets that prevented this policy from being completed as the Conservatives retreated quickly in the face of the worldwide crashing financial/mortgage market.

For anyone who's interested, here's a link to a pretty good article on the Canadian banking industry and one that covers off in detail pretty much the same issues I'm raising here.

Article (http://www2.macleans.ca/2009/04/06/our-so-called-genius-banks/3/)

In other words, Canada's banking system may be in pretty good shape - but this is no thanks to the Canadian bank executives or shareholders - if it was up to them, they would be lined up with Citibank and BofA right now begging to be bailed out from bankruptcy.

[Greendruid]

Excellent post Michael! Even an economics idiot like me understood that one.

I was wondering where you think the CMHC (Canada Mortgage and Housing Corporation for those uninitiated) rules about mortgages figured into all of this. My understanding is, and please clarify if I'm wrong, that the CMHC will deny you a mortgage if it is foreseeable to be out of your financial reach. The number I remember from our home purchase was 40% of your income/assets on a monthly basis. Again, the CMHC is a crown corporation so is effectively the government regulating how deep into debt Canadians can get where their mortgages are concerned. I was under the impression that the banks have similar (but less effective) bodies or rules or principles for credit management. Am I mistaken about that? Both of these things seem worlds apart from the US situation.

[Michael]

Excellent post Michael! Even an economics idiot like me understood that one.
:thanks:

I do pride myself on my ability to explain complex socio-political-economic concepts in a way that other people can understand them. :)

I was wondering where you think the CMHC (Canada Mortgage and Housing Corporation for those uninitiated) rules about mortgages figured into all of this. My understanding is, and please clarify if I'm wrong, that the CMHC will deny you a mortgage if it is foreseeable to be out of your financial reach. The number I remember from our home purchase was 40% of your income/assets on a monthly basis. Again, the CMHC is a crown corporation so is effectively the government regulating how deep into debt Canadians can get where their mortgages are concerned. I was under the impression that the banks have similar (but less effective) bodies or rules or principles for credit management. Am I mistaken about that? Both of these things seem worlds apart from the US situation.
Yes and no.

The CMHC serves the role that Fannie Mae (US version of the same thing) was originally set up to provide. The difference is that the CMHC has not deviated from its original mandate, while Fannie Mae has grown into a monster (mandated by orders from Congress).

That is to say, CMHC does provide a similar service of buying up mortgages from banks as a way to provide needed liquidity for the mortgage market. However, CMHC is only allowed to do this with a relatively smallish portion of the mortgage-financing market. The effect of this is that the 'rules' that CMHC establishes have become highly influential for all of the private companies selling mortgages. If CMHC won't buy or insure a mortgage (because it doesn't meet their criteria) then most mortgage lenders in Canada won't touch that mortgage - even if CMHC financing isn't involved.

That is to say, following the CMHC rules is technically voluntary. If you don't need their money, you can ignore their rules. But most industry players in Canada consider the CMHC rules to be benchmarks. Most importantly, the mortgage (and re-mortgage) insurance industry uses the CMHC benchmarks to determine availability of coverage (financial companies can buy insurance against the failure of mortgage holdings - but no insurance company will cover any mortgage that doesn't meet CMHC standards).

So yes, the CMHC rules were definitely part of the same 'regulatory' defense that helped Canada avoid the meltdown in mortgage banking over the last decade. The explanation is exactly identical to the one I gave in the OP. The Federal government gave no support to 'deregulation' in the banking-finance sector and thus, CMHC never relaxed their rules.

In contrast, Fannie Mae in the USA was created to serve exactly the same purpose as CMHC. However, over time, political meddling from Congress has pushed Fannie Mae into a much larger role - effectively financing the vast majority of mortgages in the USA. At the same time, the regulatory rules that Fannie Mae was supposed to follow were all routinely written down in favor of the banking industry who are supposed to be 'commerical clients' of Fannie Mae, but Fannie Mae was essentially prevented from 'saying no' to anyone.

In this respect, Fannie Mae became just another conduit for US tax money to be transfered to the wealthy elites (who own all those thousands of US banks), without any rules being applied. Essentially, Fannie Mae grew into being an 'entitlement' program for rich financiers. Basically, the mortgage finance industry figured out that they could issue a mortgage to anyone regardless of any ability to repay the mortgage, and then re-sell that mortgage to Fannie Mae (US taxpayer) without any questions asked. When the mortgage failed, the taxpayer is on the hook, not the company that sold the mortgage.

Thus US mortgage issuers were able to earn fat profits on the fees for issuing mortgages but entailed ZERO risk from doing so. Needless to say, they went on an binge/orgy of selling mortgages to anyone they could.

In Canada, the CMHA rules prevented this from happening since no one would re-finance any mortgage that didn't meet CMHA specifications - this meant that the initial seller of that mortgage was on the hook for 100% of the risk of the mortgage.

CMHC, like Fannie Mae, was set up to do risk-pooling of private mortgage financing - in order to prevent a financial meltdown like the one that occured in the 1930's. CMHC has remained exactly this. Fannie Mae got turned into something else entirely - a sweetheart deal for private capital (classic case of privatizing profits and socializing loses). This was all done on orders from Congress.

Bottom line is that the difference is entirely a matter of politics. Canada retains that old and quaint British notion that the goverment ought to serve the interests of the people in a fair and neutral manner. That's entirely different than the US political environment where 'to the victor goes the spoils' seems to be the reigning dogma.