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WorldMarch 1 2013

Canada's winning formula

As Mark Carney prepares to step down as governor of the Bank of Canada and transfer his talents to the UK, a snapshot of Canada’s banking system shows it as the soundest in the world. So, what challenges does Mr Carney's successor face?
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Canada's winning formula

Position vacant – governor of the Bank of Canada. Candidates must have technical competence in finance, skill in macroeconomics and an excellent knowledge of the financial sector. They also must be skilled in moral suasion, and have the ability to deal with being blindsided by unforeseen events and expertise in working in a shared authority environment. An ability to deal with the long shadow cast by Mark Carney, the current governor, a bonus.

Or so the job advertisement might read, as the Bank of Canada searches for a replacement for Mr Carney, who departs on June 1, 2013, to become the next governor of the Bank of England, succeeding Sir Mervyn King.

Rock star governor

Bankers rarely attract epithets such as ‘rock star’ and ‘hero’ but Mr Carney arguably earned them. His career path took in the chairmanship of the Financial Stability Board in 2011, a rumoured flirtation with national politics and the appointment to the Bank of England. During and after the 2008 financial meltdown, no Canadian bank required a bailout and the financial community, while shaken, did not self-immolate, as happened on Wall Street and elsewhere.

That stability played a large part in the World Economic Forum’s ranking of Canadian banks as the world’s soundest for the fifth consecutive year in its Global Competitiveness Report 2012–2013, published in September 2012. During and after the crisis, journalists, bankers and regulators looked to Canada, trying to deduce its winning formula. A decision as historic as Mr Carney’s appointment renewed the focus of the international banking community on the Canadian system and its stability.

Three major players have responsibility for the banking system at the national level. The Bank of Canada has responsibility for monetary policy. The Office of the Superintendent of Financial Institutions (OSFI) ensures the soundness of federally regulated institutions, including banks, insurers and other players. The Department of Finance has responsibility for the smooth running of the country’s finances and sometimes the finances of individuals, for example, when it orders changes to mortgage regulations.

Moral suasion

Many bureaucracies have hard and fast lines of authority, as well as less official but still important relationships. While the governor of the Bank of Canada has less statutory authority than some believe, the officeholder has a tradition of moral suasion for ensuring that the country’s banks stay in line; a tradition made workable by the small number of banks.

“When the governor of the Bank of Canada was worried about something such as overly aggressive loan-making, he would just call the [banks’] presidents in and have a chat,” says Bill Scarth, professor of economics at McMaster University in Hamilton, Ontario, and research economist at the Toronto-based think tank CD Howe Institute.

The bankers would usually comply rather than face changes to monetary policy, something Mr Scarth describes as a blunt instrument. “It’s just a lot easier to regulate somebody if you only have to have to play golf with (a small number),” he says. While the practice continues, the Bank of Canada now has a policy of forward guidance in which the governor commits to keeping interest rates within a particular range for a stated period.

Political decision-making dating back 15 years, stringent regulation and conservative bank management all contributed to Canada’s relatively smooth sailing.

While Canadian banks do have US businesses, a decision in December 1998 may have worked to limit their cross-border expansion, according to Dan Hallett, director of asset management at Ontario-based HighView Financial Group. Then-finance minister Paul Martin refused to let four major Canadian banks merge. The Royal Bank of Canada and the Bank of Montreal had planned one union, while the Toronto Dominion Bank and Canadian Imperial Bank of Commerce (CIBC) planned another union. They argued that they needed to merge to compete more effectively as global players, but Mr Martin quashed the mergers.

That, says Mr Hallett, reduced the banks’ global aspirations and limited their involvement in the US market, which may have prevented their exposure to the subprime market.

The decision was a political one and had nothing to do with crisis prevention, Mr Hallett recalls. The mergers might have proceeded if Mr Martin and the banks had approached the issue differently but the refusal meant that Canadian banks had less exposure to US mortgage problems a decade later.

Conservative values

OSFI regulations and bank management practices make for a cause-and-effect relationship. Canadian banks had higher capital-to-loan requirements than US banks and their own investments are more tightly regulated than those in the US and that explains the link between regulation and management. Because Canadian bank regulations are conservative, bank administrations are also conservative, Mr Scarth suggests.

Moreover, Canada does not have a well-developed shadow banking system. The US scene also had a far larger shadow system in which consumers used instruments such as uninsured money market funds as proxies for insured bank accounts. “In the US [they were] happily thinking they had deposit insurance,” says Mr Scarth. “More and more people were doing their banking through institutions that didn’t have deposit insurance.”

That often happened when individuals wanted to park money outside the market and left it in cash accounts or money market funds at these institutions. While the concept of ‘parking’ funds outside of insured deposits certainly occurred in Canada, it was not to the same extent. That meant that more funds were held in insured deposits.

Some Canadians currently question the possibility of a housing bubble but no one suggests an implosion on the scale that happened in the US. The seeds were sown for the US mortgage mess during the administration of former president Bill Clinton as it eased mortgage restrictions as part of an effort to find an engine for the economy that might replace the flailing auto industry.

The American way

Canada, its government and its banks did not go very far down that road. “We were way less willing to go down the road of allowing ever more lax regulations on mortgages,” says Mr Scarth. Stories of unbelievably easy mortgage procedures dominated the scene and made for a strange counterpoint to Canadian practices, according to Terry Campbell, president of the Canadian Bankers Association.

“A defining principle of Canadian banks was that we lend money to people who will pay it back,” he says, paraphrasing a conversation with a bank chief executive. “It seems to have been forgotten in many other jurisdictions. That’s a key part of it.” 

During the earliest days of the crisis the government also tightened mortgage regulations, including reversing earlier changes in areas such as amortisation. That provided another measure of stability in the Canadian mortgage market.

Mr Carney and the Bank of Canada lowered the key policy rate six times during 2008 and three times during 2009, and worked to put more money and more liquidity into the system. Arguably though, the Bank of Canada’s actual freedom to manoeuvre is somewhat limited. When the US Federal Reserve lowered the benchmark rate to near zero, Mr Carney and the Bank of Canada had little choice but to follow suit. Leaving Canadian rates too far above those of the US would have led to speculative runs on the Canadian dollar, sending it higher than previously and probably costing untold numbers of Canadian export dollars and jobs.

Mr Carney also has the very attentive ear of James Flaherty, Canada’s minister of finance. Mr Flaherty allowed the Canada Mortgage and Housing Corporation to take over some of the banks’ mortgage portfolios, thus expanding their lending capacity at a crucial time.

Keeping rates low

Notwithstanding this track record, the next governor of the Bank of Canada will have to deal with the overhang from Mr Carney’s rock star status, as well as continue at least two of his crusades. He has repeatedly encouraged the business community to help drive recovery more aggressively, especially given current low interest rates. At the same time he has warned that overly indebted consumers face a rude awakening if interest rates increase, perhaps in 2015.

“Mr Carney’s real challenge and the challenge for his replacement will be keeping rates low for as long as needed for the economy, encouraging the people in companies that you want to borrow, to borrow more and to encourage those highly indebted consumers to pay down their debt,” says Mr Hallett. “It’s kind of like opening the barn door but only wanting one group of animals to run out and others to stay in.”

To be sure Canadian banking is not without its challenges. Fitch Ratings says that the “major Canadian banks are expected to face a more difficult operating climate in 2013” and cites several factors, including the same highly leveraged consumers and mortgage debt, although it adds that Canadian banks have sufficient cash cushions to absorb some deterioration in the housing market.

In June 2012, the Department of Finance took several measures designed to calm the housing boom. These in turn will lower demand for mortgages. It revised maximum amortisation to 25 years from 30 years, reduced to 80% of the home’s value the amount that could be borrowed and the gross debt service ratio to 39% of income. Fitch says these measures would reduce consumer vulnerability to adverse shocks and benefit Canadian banks’ loan quality. Bank earnings are expected to remain sound throughout 2013 but earnings growth will decelerate with the potential housing slowdown and other factors. The report also cites margin pressure and volatile capital markets earnings at the banks.

Varying vulnerabilities

The actual degree of vulnerability depends on a specific bank’s exposure to the sector, explains Peter Routledge, research analyst at the National Bank of Canada. “CIBC has a pretty significant revenue headwind because so much of its business is focused on the household,” he says. By comparison, the Bank of Nova Scotia earns about one-third of its earnings from Canadian personal and commercial lending and about 30% from international operations.

One possible solution available would be for banks to grow their wealth management platforms. However, because that sector is consolidated in Canada, banks looking for this solution will have to acquire outside the country, a potentially expensive strategy with other risks, says Mr Routledge.

Cross-border challenges include what Mr Campbell calls “extra territoriality”, referring to the impact of US legislation on Canada. “We worry about the extra territoriality of US laws,” he says, referring to the US Foreign Account Tax Compliance Act (Fatca). The US government sees the regulations as a tool for catching tax evaders in foreign countries.

Under Fatca regulations, non-US financial institutions must obtain specific information from every client to determine whether the account-holder could be a US citizen. Where the account-holder may be a US citizen living in a foreign country, the bank has to further question the individual for clarification. Where the individual is a US citizen, the bank must report the client’s information to the US Internal Revenue Service or close the account if the individual blocks transfer of information.

The regulations are extra-territorial in the extreme, according to analysis from the Canadian Bankers Association. “If the financial institution is unwilling or unable to co-operate, then that institution and every one of its clients worldwide, US or otherwise, are subject to a punitive withholding tax on any income derived from US investments or any gross proceeds from the sale of US assets,” it says in a statement. So clients could lose money and still face taxation. Barring a change, Fatca regulations will come into effect on January 1, 2014.

There are global challenges, although at a lower threat level than in 2008. Another slowdown in Europe would affect the global economy and exert pressure on banks and the economy via a pass-through effect from the US economy. Deleveraging in other countries means challenges for Canada’s financial stability as the resulting reduced spending from the US would reduce Canadian exports.

Canadian banks also face a philosophical challenge. An athlete who wins numerous consecutive championships faces pressure to continue the winning streak. So too Canadian banks face an implied challenge to continue winning those citations.

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Read more about:  Americas , Canada