Joe Martin and Chris Kobrak, the authors of the book: “From Wall Street to Bay Street: A comparison of the US and Canadian Financial Systems" in the interview by Agnieszka Krawczyk.
Agnieszka Krawczyk: Why have you decided to write this book? Are there such big differences between the two systems?
Joe Martin: There are huge differences between the two systems. Most people are ignorant of the commonalities, differences, and interactions between the two financial systems. Clearly, since their independence from Britain, Canada learned more than the United States from its neighbour’s financial innovation, principally about what NOT to do.
Chris Kobrak: While American legislators succumbed to populism and regional financial regulation through much of U.S. history, Canada for the most part instituted a financial system based on Hamilton’s ideas of sound money and federal control of banking. They were more akin to British institutions and organizations that strongly influenced Canadian finance well into the 20th century. Since the 2008 Financial Panic, however, many Americans, seem more willing to question the sustainability of the U.S. financial model. Interest in alternative financial systems has increased. Few Americans realize that a different financial system developed next door, one with greater stability yet one able to fund a vibrant housing market and general economic growth, offering a vision of how to satisfy a broad range of interests shared by the two countries. Nevertheless, organizations and institutions from one country to another cannot be successful imposed or interchanged, even between two closely connected by geography, without consideration of and adaptation to national particularities. History creates different cultures, which in turn created different patterns of business and other forms of social interaction. Like European countries driven by globalization and regional dependencies to greater integration, Canada and America need to understand better the origins of their institutions to those elements that are essential and that should be kept, and those that might be better jettisoned. Our book will explore those national particularities and suggest ways in which both countries might learn from the other. At this time, this kind of learning might be even more important for American readers.
AK: There is a conviction that the Canadian financial system is very regulated whereas the United States have stuck to the laissez faire philosophy or they did so before the crisis, at least. Do you confirm such distinction?
JM: A hundred years ago a researcher for the National (USA) Monetary Commission noted “No one can pretend, after scrutiny of the earliest Canadian charters, that the laws governing banking were strict or their conditions severe.”
If anything the converse is true. Canada did not have a Superintendent of Banking until 1923, more than a half century after the country came into existence and it took a major bank failure [the Home Bank] to move government to create a regulator. The Superintendent provided light regulation counting on the banks’ external auditors and internal staff to be prudent. Canadian banks were not prudent during the LDC crisis of the 1980s. This lack of prudence was compounded by a difficult economic crisis in 1982 – GDP per capita declined by 4.2%, the worst decline since the Great Depression, as well as sell off in the price of oil which hit the oil producing part of the country. The price of oil declined 60% between 1980 and 1986/7.
CK: Canadian regulation was less formal and more centralized than American, which reflected to varying degrees during US history a strongly based federal system with very divided responsibilities for banking and money among states and the national government.
JM: In 1985 two western based banks, Canadian Commercial Bank (CCB) and Northland Bank, went under. These were the first Canadian bank failures since that of the Home Bank in 1923. That same year the Mercantile Bank nearly collapsed and was forced to merge with the National Bank. At the time the Mercantile was the seventh largest bank in Canada. This was quickly followed by the disappearance of the ninth and tenth largest banks in Canada: the Bank of British Columbia and the Continental Bank, respectively.
All of which led the Government of Canada to create the Office of the Superintendent of Financial Institutions (OSFI) in 1987. Since 1987 it is fair to say that the Canadian banking system has been well, not necessarily heavily regulated in contrast to the light regulation of the first 120 years of Canada’s existence.
Bank of Montreal, Montreal, photo from c. 1880/ Fot. BMO Financial Group
AK: And how did US react to the LDC crisis?
CK: American regulatory policy and reaction to the LDC and other financial crises had two distinctive components. The first was a breakdown of regulatory constraints to universal banking. These included steps to allow more interstate banking, easier entry of foreign banks into the United States, and progressive weakening in the separation of investment and commercial banking. The second was an increasing reliance on international standards of capital and liquidity adequacy, often referred to as the Basel Accords, coordinated by the Bank of International Settlements (BIS).
AK: On the Forbes list of greatest world companies 2012, Global 2000, there are 3 companies from Canada and all these are banks. The main branch of Canadian economy is the banking and financial sector. The deposits of 5 largest Canadian banks, the so called “big five” exceed the GDP of Canada. What are the historical roots of such dominance of this sector?
JM: Canada came into existence on July 1, 1867 amidst major bank failures – the Bank of Upper Canada and the Commercial Bank of the Midland District as well as some smaller banks. At the time there were more banks in operation than there are today. In the first 40 years of Canada’s existence – to 1910 – there were more bank failures. However the thrust of legislation and perhaps the Canadian character were marked by a desire for stability.
Historically the key factors were the following. Firstly, adequate capitalization was required by law. Secondly, in contrast to the post Jacksonian American system, Canada had branch banking. In such a situation if one section of the country is in bad shape the banks can benefit by the fact that other parts of the country are in good shape, i.e. they have diversity in both assets and liabilities. An important factor is that until the 1960s the banks were not allowed to make mortgage loans which certainly stood them in good stead in the Great Depression. Now mortgages are an important part (40%) of the asset mix but, unlike in the US, Canada does not allow mortgage interest deductibility nor real property tax deductibility. In most of Canada we do not have non-recourse mortgages and the banks own the mortgages which makes real estate much safer in Canada than in the US. Another thing is greater flexibility in reference to cash reserves. Historically, especially in New York state the law required fixed cash reserves of 15 to 25 percent – in banking terminology – “dead money”. In Canada all banks had capital requirements and kept a reserve in gold or legal tenders but the amount was not fixed by law, this being left to the prudence of the bankers. Thus they had better conditions for developing. In 1992 Canada abolished reserve requirements.
AK: Has anything changed since then? Has Canada introduced fixed reserves after the crisis of 2008?
JM: In terms of fixed reserves – the US still requires 10% but the British Commonwealth countries do not require a fixed reserve. The regulatory authorities think the level of capital requirements is a more important control than a fixed reserve. Also, ever since the original Bank Act of 1871 there had been a provision for decennial review of the Bank Act (now every five years), which means Canada has a gradual, evolutionary system unlike the US where Dodd Franck (Wall Street Reform Act of July 21, 2010) was the 1st major revision since the 1930s.
AK: This policy and the trust in your bankers’ prudence gave effects. According to the Global Competitiveness Report of the World Economic Forum of 2010 the Canadian Banking System is the safest banking system in the world. The world experienced it when between 2008 and 2010 200 banks collapsed in the United States and no bank in Canada. What are the main success factors of Canadian banking system?
JM: Personally I think Canadian banking and Canadian government learned a lot from the mistakes of the 1980s – LDC Crisis, the severe economic downturn in 1982, the dramatic decline in the price of oil – Alberta’s economy contracted 16% in one year, the bank failures which are rarely talked about. The Government moved from lackadaisical Bank regulation [the Superintendent of Banking was on a two month cruise when the banks were going down in the 1980s] with the Office of the Superintendent of Financial Institutions which took its job very seriously. Government action plus the memory of the 1980s in the banking system plus the more sensible legislation around mortgage lending all contributed to Canada’s success.
AK: Does this mean that you had no problems during the financial crisis?
JM: No – the most obvious problem was the Asset Backed Commercial Paper – $30 billion problem that had to be worked out. The market for the paper froze in 2007. The money wasn’t gone but it was locked up. A way was worked out to unfreeze the value. Not everyone was happy but the general sentiment was that it was a reasonable solution for investors getting their money back albeit much more slowly than they thought would be the case when they made their original investment.
Bank of Montreal, contemporary building in Toronto, day view/ Fot. BMO Financial Group
AK: Currently, the property prices in Canada are the highest in history and last year the household debt of the Canadians hit its record and it was greater than at the beginning of the crisis. Do you share the opinion of the Canadian Minister of Finance, Jim Flaherty, that the system is safe and that the chilling down of the Canadian economy is not necessary? Do you think that we are facing the pre-crash situation or maybe the prices will be slowly going down and the situation will calm down in a natural way…?
I have concerns… Personally I sold our Toronto house five years ago and am now a renter for the first time since 1966. So I expect a slowing down and some adjustments around household debt. But the fact is it is still a seller’s market not just because interest rates are low but also because there is limited inventory relative to demand. There are a lot of immigrants coming to Canada every year which adds to the demand as well as off shore money seeing Canadian housing, including the condo market, as a good, safe investment.
AK: Who should learn from whom in this situation? Did U.S. learn something from the crisis and did Canada learn something from the U.S. experience?
JM: The history of Canadian banking since the Jackson era nearly 200 years ago has been to look to the US for what NOT to do. For example when the Fathers of Confederation met in 1864 and framed the resolutions which were forwarded to the Imperial Government [which resulted in the 1867 British North American Act] they were conscious not only of the death and destruction in the US Civil War but the weakness of the American constitution – no reference to banking or currency, to the weakness of the US $, to bank failures. From the US experience they learned what NOT to do. This continued through history… The US introduced an income tax in 1913. Canada did the same four years later. Initially both countries provided mortgage interest deductibility but Canada quickly [early 1920s eliminated that provision. The US never did – and this was one of the reasons for the problems of 2008. So for most of the past two centuries Canada saw the US, at least in terms of the banking system, as a model of what not to do. If you want proof of this I can send you a 1906 speech by a Canadian banker showing how the Canadian system was better.
Bank of Montreal, contemporary building in Toronto, night view/ Fot. BMO Financial Group
AK: So, what is the direction the banking and financial systems of the world should go to?
CK: For me the solution is very simple. Banks must stop trading in complex derivatives, which are not traded on public markets and standardized, beyond a certain limit of their capital. I think the Basel Accords are virtually useless. They don’t sufficiently address mismatching of assets and liabilities, contain too many national compromises, and little in the way of enforcement teeth. Banks must reduce their leverage well beyond what they call for. Similarly, attempts to segregate trading for a bank’s own account and for clients are unenforceable and too complex. Lastly, we need basic G20 agreements to these standards and their enforcement.
AK: When will the book appear on the market?
JM: The book will be on the market in the spring of 2015. It will be published under the UTP/Rotman imprint – UTP stands for University of Toronto Press. All is going well.
AK: I wish you fruitful work and thank you for the conversation
The photos of the buildings of Bank of Montreal published thanks to the courtesy of BMO Financial Group
The Polish version of the interview is available in the May edition of the BANK Financial Monthly.
Joe Martin is Executive in Residence and Director of Canadian Business History at The Rotman School of Management, University of Toronto. Prior to joining the University he was Chairman of the Global Consulting Practice of Deloitte.
Chris Kobrak is a professor of finance at ESCP Europe, Paris and of business and financial history at The Rotman School of Management, University of Toronto. Professor Kobrak is a CPA with ten-years of business experience and holds MBA and PhD degrees from Columbia University in NYC.