Peter Boone, a Canadian, is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of 13 Bankers.
As a serious financial reform debate heats up in the Senate, defenders of the new banking status quo in the United States today — more highly concentrated than before 2008, with six megabanks implicitly deemed "too big to fail" — often lead with the argument, "Canada has only five big banks and there was no crisis."
The implication is clear: We should embrace concentrated megabanks and even go further down the route; if the Canadians can do it safely, so can we.
It is true that four of Canada's major banks managed to earn a profit during 2008, all five were profitable in 2009, and none required an explicit taxpayer bailout. In fact, there were no bank collapses in Canada even during the Great Depression, and in recent years there have been only two small bank failures in the entire country.
Advocates for a Canadian-type banking system argue this success is the outcome of industry structure and strong regulation. The chief executives of Canada's five banks work literally within a few hundred meters of each other in downtown Toronto. This makes it easy to monitor banks. They also have smart-sounding requirements: If you take out a loan worth over 80 percent of a home's value, then you must take out mortgage insurance. The banks were required to keep at least 7 percent Tier One capital, and they had a leverage restriction so that total assets relative to equity (and capital) was limited.
But is it really true that such constraints necessarily make banks safer, even in Canada?
Despite supposedly tougher regulation and similar leverage limits on paper, Canadian banks were actually significantly more leveraged — and therefore more risky — than well-run American commercial banks.
For example, JPMorgan Chase was 13 times leveraged at the end of 2008, and Wells Fargo was 11 times leveraged. Canada's five largest banks averaged 19 times leveraged, with the largest bank, Royal Bank of Canada, 23 times leveraged. It is a similar story for Tier One capital (with a higher number being safer): JPMorgan Chase had 10.9 percent at the end of 2008 while Royal Bank of Canada had 9 percent. JPMorgan Chase and other American banks also typically had more tangible common equity — another measure of the buffer against losses — than did Canadian banks.
If Canadian banks were more leveraged and less capitalized, did something else make their assets safer? The answer is yes: guarantees provided by the government of Canada.
Today over half of Canadian mortgages are effectively guaranteed by the government, with banks paying a low price to insure the mortgages. Virtually all mortgages where the loan-to-value ratio is greater than 80 percent are guaranteed indirectly or directly by the Canadian Mortgage and Housing Corporation.
The system works well for banks; they originate mortgages, then pass on the risk to government agencies. The United States, of course, had Fannie Mae and Freddie Mac, but lending standards slipped and those agencies could not resist a plunge into assets more risky than prime mortgages. Let's see how long Canada resists that temptation.
The other systemic strength of the Canadian system is camaraderie among the regulators, the Bank of Canada and the individual banks.
This oligopoly means banks can make profits in rough times — they can charge higher prices to customers and can raise funds more cheaply, in part because of the knowledge that no politician would dare bankrupt them.
During the height of the crisis in February 2009, the chief executive of Toronto Dominion Bank brazenly pitched to investors: "Maybe not explicitly, but what are the chances that TD Bank is not going to be bailed out if it did something stupid?" In other words: Don't bother looking at how dumb or smart we are. The Canadian government is there to make sure creditors never lose a cent. With such ready access to taxpayer bailouts, Canadian banks need little capital, they naturally make large profit margins, and they can raise money even if they act badly.
Proposing a Canadian-type model to create stability in the United States is, to be blunt, nonsense. We would need to merge banks into even fewer banking giants, and then reinflate Fannie Mae and Freddie Mac to guarantee some of the riskiest parts of the bank's portfolios.
With a handful of new "hyper-megabanks," we'd have to count on the political system to prevent banks from going wild; Canada may be able to do this (in our view, the jury is still out), but what are the odds this would work in Washington? This would require an enormous leap of faith in the regulatory system immediately after it managed to fail repeatedly and spectacularly over 30 years.
Who can be confident that powerful corporate lobbies, hired politicians and captured regulators can become so Canadian so soon?
The stakes would be even greater with these megabanks. When such large banks collapse they can take down the finances of entire nations. We don't need to look far to see how "Canadian-type systems" eventually fail. Britain's largest bank, the Royal Bank of Scotland, grew to control assets equal to around 1.7 times British gross domestic product before it spectacularly fell apart and required nearly complete nationalization in 2008-9. In Ireland the three largest banks' assets combined reached roughly 2.5 times Ireland's gross domestic product before they collapsed. Today all the major Canadian banks have ambitious international expansion plans — let's see how long their historically safe system survives the new hubris of its managers.
There's no doubt that during the coming months many people will advocate some form of a Canadian banking system in America. The largest banks and their lobbyists on Capitol Hill will love the idea. For some desperate politicians it may become a miracle drug: a new "safer" system that will lend to homeowners and provide financing to Washington, while permitting politicians and regulators to avoid tough steps.
Let's hope this elixir doesn't gain traction. Smaller banks with a lot more capital — and with an ability to fail when they act stupidly — are what American citizens and taxpayers really need.
Canada’s concentrated megabanking system is often held up as a model for why Americans shouldn’t worry about their own large banks. Two economists explain why this thinking is wrong.
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Catherine Rampell is the economics editor at nytimes.com.
David Leonhardt writes the Economic Scene column, which appears in The Times on Wednesdays.
Sewell Chan writes about economic issues from Washington D.C.
Marc Lacey is The Times's bureau chief for Mexico, Central America and the Caribbean.
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Economics doesn’t have to be complicated. It is the study of our lives "” our jobs, our homes, our families and the little decisions we face every day. Here at Economix, David Leonhardt, Catherine Rampell and other contributors will analyze the news and use economics as a framework for thinking about the world. We welcome feedback, at economix@nytimes.com.
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Special Features The Debt TrapA series about the surge in consumer debt and the lenders who made it possible.
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An accounting of the government’s rescue package.
Three economists explain what worked and what didn't.
A map of unemployment rates across the United States, now through January.
Faces, numbers and stories from behind the downturn.
A series about the surge in consumer debt and the lenders who made it possible.
A series exploring the origins of the financial crisis, from Washington to Wall Street.
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