Last banks standing

Canada's Big Five have been held up as international models. How did they get here -— and where might they be headed?

It wasn’t long ago that Royal Bank of Scotland was held forth as an example of everything its Canadian counterparts should aspire to. Once a stodgy Edinburgh-based outfit with seemingly dim prospects, RBS became a big fish by swallowing large British competitors. The world was its oyster: Over the past decade, RBS executed daring mergers in foreign markets, too, including the U.S. and China. By last year, it had become the world’s largest bank by assets. Britain smiled: Queen Elizabeth II knighted CEO Fred Goodwin in 2004 for “services to banking.”

Recent events cast Sir Fred’s services in a different light. RBS reported a £24.1-billion ($42.8 billion) loss last year — the largest ever by a British corporation. Saving it necessitated a £20-billion ($35.5 billion) bailout, under which the British government assumed majority ownership. Britain frowned: Goodwin found his reputation in tatters, his home targeted by vandals, his past acts investigated by regulators. Taxpayers (who now own 70% of the bank) were not amused to learn his pension will pay approximately £700,000 ($1.2 million) annually while the treasury dwindles under the strain of RBS’s excesses.

RBS’s blue blood pools with that of others recently sacrificed at the altar of greed and incompetence. The U.S. witnessed several bank failures that rank among the largest in its history, such as Washington Mutual and IndyMac. Governments find themselves the stewards of formerly admired private banks such as Germany’s Hypo Real Estate and Belgium’s Fortis Bank. Banking’s old imperative — unfettered growth — has been replaced by something more basic: survival. The new mentality has spurred shotgun weddings, such as that between Germany’s second- and third-largest banks, Dresdner Bank and Commerzbank.

Yet amid this gory hecatomb, you will find not a single Canadian financial institution. Indeed, Canada’s long derided — or, more often, ignored — banking sector has arrived at a moment of international celebrity. No less prominent a figure than U.S. President Barack Obama said earlier this year: “I think Canada has shown itself to be a pretty good manager of the financial system and the economy in ways that we haven’t always been.” The International Monetary Fund says Canada’s financial system “appears to be in a position to weather financial turbulence.” The World Economic Forum calls it “one of the soundest in the world.”

Such adulation boosted the self-esteem of its recipients. “We have a lot to brag about,” Federal Finance Minister Jim Flaherty told one audience. “We have not seen any bank failures or anything close to that.” Mark Carney, governor of the Bank of Canada, recently delivered a smug lecture on banking reform. “Many of my comments today apply more acutely internationally than domestically,” he said. “Our system is better. Regulation has been more consistent. Our banks have been more conservative. Credit conditions in Canada remain superior to those in virtually every other industrialized country.”

Amid such lyrical waxing, it’s easy to forget the long period during which Canadian banks were unfashionable. A few short years ago, many thought the Canadian Imperial Bank of Commerce (TSX: CM) — one of the nation’s so-called Big Five — offered a resounding demonstration of everything a solidly managed bank shouldn’t do. CIBC bungled its way to the epicentre of major U.S. corporate scandals like Global Crossing and Enron; more recently, it suffered losses on U.S. sub-prime-related securities. That CIBC somehow survived it all was taken as evidence not of inspired management, but rather that Canadian banks were indeed bulletproof. As for the rest — well, they were often written off as timid lackeys, largely unsuccessful outside their tepid home market and forever condemned to lurk in the shadows of bolder institutions like RBS.

But that world has been turned on its head. RBS is the world’s largest bank no longer, and its government overlords may bust up what’s left of it. By virtue of their continuing existence, Canadian banks have jumped in the rankings. They’ve even been able to raise more capital — albeit at relatively steep cost — on their own. How is it that they’ve suddenly become an example others wish to emulate? And could it be that Canada’s banks were saved by the chains they’re most desperate to cast off?

Canada, as seen by some outsiders, may seem unfamiliar. “A number of regulatory experts here,” wrote an admiring Irish newspaper columnist, “pointed to Canadians’ strong sense of citizenship and taking responsibility for one’s own actions as a key reason for the stability of its financial system.” Lest these qualities be deemed a universal Canadian quality, someone should tell him that Conrad Black grew up here. (He also sat on CIBC’s board for years.)

But even if such explanations seem unsatisfying, Canadian banks clearly are different. And they’ve been different for a long time. Thousands of American banks collapsed during the Great Depression of the 1930s. As for Canada, “its 10 banks with 3,000-odd branches throughout the country did not even experience any runs,” observed Milton Friedman and Anna Schwartz in their seminal 1963 classic, A Monetary History of the United States. In fact, just two Canadian banks have failed since 1923, the Canadian Commerce Bank and the Northland Bank of Canada.

What’s behind this resilience? Though hard to pinpoint, the differences between American and Canadian banks predate the Depression. Laurence Booth, a professor of finance at the University of Toronto’s Rotman School of Management, says they existed as far back as the 1820s, when Canada’s first bank — the Bank of Montreal — was still a fledgling. He chalks up many of the contrasts to that most intangible of forces: culture.

Americans, Booth explains, distrusted their bankers from the start. “They were afraid of having a central bank,” he says. “They were afraid of having a concentration of financial power in New York.” In support of this contention, he points to something Thomas Jefferson wrote in 1816: “I sincerely believe … that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.”

Among other things, this distrust generated a series of populist laws aimed at containing banks. Throughout their history, for example, U.S. banks faced rigid restrictions on where they could open branches. Some states prohibited the opening of any branches, period. (The U.S. allowed nationwide branching only in 1997.) In contrast, Canadian banks can open branches nationwide, resulting in fewer, but more geographically diversified, financial institutions.

Canadian banks have also been allowed to offer a broad array of products and services, from wealth management to insurance to investment banking. During the Depression, though, U.S. Congress took a hard look at how commercial and investment banking activities had commingled during the previous decade, and found evidence of fraud and rampant conflicts of interest. The remedy: the Glass-Steagall Act of 1933, which blocked bank holding companies from owning other types of financial institutions. (It wasn’t repealed until 1999.) Meanwhile, Canadian banks were allowed to buy up nearly all of the large investment banks in the 1980s, providing for a more diversified business.

There’s another cultural force at work: the difference between the commercial banker’s mentality and that of his cousin, the investment banker. Traditionally, Canada’s banks have been dominated by commercial bankers, whereas in America investment banking prevailed. “If you’re a commercial banker, you have a relationship with your client,” says Booth. “You make a loan, you get interest over five years, you look at their financial statements, you’re constantly talking to them.” Investment bankers, he says, take more risks and are largely preoccupied with cutting deals and collecting their fees. Booth says it’s no coincidence that CIBC’s most prominent gaffes took place when its management was dominated by investment bankers.

Canada’s bankers do seem more conservative: they avoided some of the riskier activities now plaguing elsewhere. For example, America’s banks fell in love with securitization — that is, the process of converting mortgages and other loans into investment products and selling them off. Critics claim this encouraged financial institutions to write bad loans. But in Canada, securitization was less common. “Our banks, when they sign mortgages, largely hold those mortgages rather than trading them,” Prime Minister Stephen Harper explained to an admiring CNBC anchor in February. “So they have a lot more interest in the underlying quality of those mortgages.” And since increasing defaults on sub-prime mortgages sparked the financial crisis, the comparative health of Canada’s housing sector proved a boon to Canada’s banks.

History suggests that left to their own devices, many bankers will be reckless. So it’s worth taking a look at the institutions charged with keeping them in check. In Canada, that’s the Office of the Superintendent of Financial Institutions Canada. OSFI has broad authority over banks, trusts and insurance companies. It keeps an eye on loan quality, risk management models and capital standards through periodic exams. “We have one prudential regulator in OSFI,” says Nancy Hughes Anthony, president and CEO of the Canadian Bankers Association. “Clear as a bell who that regulator is.”

Not so in the U.S. The Federal Reserve is responsible for bank holding companies and certain banks. The Office of the Comptroller of the Currency is responsible for national banks. The Office of Thrift Supervision oversees “thrifts” (otherwise known as savings and loan associations), which specialize in accepting savings deposits and offering mortgages. States regulate credit unions, but not national credit unions — those fall under the auspices of the National Credit Union Administration Board. “Gosh, I was in Washington just a couple of weeks ago,” says Hughes Anthony. “It is extremely difficult to figure out who regulates what.”

By contrast, the IMF recently praised OSFI for its “strong regulation and supervision” of banks. You can see that by looking at capital requirements. The “Tier 1 capital ratio” is industry bafflegab that refers to the equity and reserves a bank has on hand relative to its assets, its cushion to absorb unexpected losses. Generally, a bank that has a Tier 1 capital ratio above 6% is considered well capitalized, whereas a ratio below 4% is considered bad news. A decade ago, OSFI began insisting that banks maintain a ratio of 7%; Canadian banks tended to exceed that, so they entered the financial crisis well-capitalized. Meanwhile, Citigroup, one of America’s top banks, entered the financial crisis at less than 5%. (Strong capital ratios alone will not save banks — some stricken U.S. financial institutions were also well-capitalized before the crisis.)

One should not assume that Canadian bankers always welcome the restrictions they face. Both former finance minister and prime minister Paul Martin and former Bank of Canada governor David Dodge have said they felt pressure to deregulate.

Perhaps the most controversial restraints involve size. In 1998, the federal government blocked attempted mergers of Royal Bank of Canada (TSX: RY) with the Bank of Montreal (TSX: BMO), and of CIBC (TSX: CM) with Toronto-Dominion (TSX: TD), partly to avoid concentrated ownership in the financial services sector. Though theoretically possible, mergers between the Big Five are still widely regarded as politically untenable.

Meanwhile, in other countries, blockbuster mergers long ago became viewed as the only way to survive. A 2004 brochure from the Boston Consulting Group captured the mood well. “If you sense your own vulnerability and see a potentially excellent merger fit, don’t be afraid to initiate a bold acquisition move,” it counselled. “In the age of the banking titans, many players will soon be leaving the dance together. Can you afford to be left behind?” That same year, an op-ed in the Financial Post lamented that the Royal Bank of Canada couldn’t match RBS’s accomplishments: “How did a low-rank Scottish bank with no obvious global prospects rise to the top of the world market and become a growth powerhouse in little more than a decade? By doing the things Canadian banks are prohibited from doing.”

RBS’s fall proves that the biggest aren’t always the fittest. Did merger restrictions actually save Canada’s banks? Some doubt it. Hughes Anthony thinks size is a red herring. “If you look in the U.S., you see big banks in trouble and small banks in trouble,” she says. “I don’t think a merger per se is either good or bad. It’s just a vehicle by which you do business.” Booth, though, argues that banks acquiring other banks of similar size are taking huge risks. “The best way to do an acquisition,” he says, “is big buys small, integrates the culture and information system without taking all the systemic risk of big buying big.”

Falling employment. Plunging exports. Industries in turmoil. The challenges for Canada’s economy are legion. But thus far, Canadians haven’t had to divert many resources to shoring up their banks. That’s no small advantage: recent events loudly demonstrate that when bankers take leave of their senses, the resulting mess can be more expensive to clean up than misbehaviour in virtually any other sector.

Not only are Canadian banks still solvent, but they’re actually doing a decent job fulfilling their traditional roles in our economy. They haven’t, for instance, stopped lending. “Canadian banks remain solid and have filled the gap resulting from the retreat of other non-traditional lenders,” wrote TD economist Grant Bishop in a recent report. Moreover, the benefits will almost certainly extend beyond the current economic crisis. Dominique Strauss-Kahn, managing director of IMF, recently told the Financial Times that economies cannot recover until their banking sectors are on firm footings.

During and after crises, the rules often get rewritten. That’s happening now, and the changes proposed promise to be radical — one policy analyst called it “the end of financial regulation as we know it.” Hurried revisions could result in poorly crafted rules, yet the new order may seem a lot more familiar to Canadians. Irish Prime Minister Brian Cowen, for one, has vowed to follow Canada’s example while reforming his country’s financial regulatory system. “It’s a global race, I’d say, to get boring like the Canadian banking system,” Flaherty told an audience recently.

But the resilience of our banks should not be overstated. True, even before the tumult of last fall, the World Economic Forum called our banking system the best in the world. Virtually every recent piece of journalism about Canada’s banks mentions this. The WEF’s ranking system included a score for the soundness of banks between 1 (indicating insolvency and the possibility of a bailout being necessary) and 7 (meaning banks are generally healthy). Canada topped the list with 6.8, beating Sweden, Luxembourg, Australia, Denmark and the Netherlands, all of which scored 6.7. Yet Germany, the United States and United Kingdom all scored 6 or better, and each of those countries is now bailing out large banks. Leaning too heavily on the WEF’s numbers might be a mistake.

Our banks are not impervious. Some have already suffered significant losses. And more are likely coming, as mortgage delinquencies and consumer bankruptcies rise. The Canadian consumer is highly leveraged — not a good thing when asset prices are plunging and unemployment is surging. Some argue that the banks have not made sufficient provisions for future loan losses. How much worse would things need to get before our banks started running into serious problems? “It’s really tough to say,” says Hughes Anthony.

No less an authority than a Canadian banker has warned that his industry’s comparative health is of limited benefit. “Just because our banks didn’t collapse, Canadians are running around saying, ‘Wow, aren’t we terrific?’” TD CEO Ed Clark said recently. “But the reality is, this economy is going to get whacked just as hard as economies around the world.”

It’s also worth reflecting on what Canada’s conservative banking culture costs. Michael Burt, associate director of industrial outlook, trade and investment at the Conference Board of Canada, argues that it means Canada’s banks grow more slowly during booms.

“The U.S. is a more vigorous, flexible, productive and innovative culture than Canada,” says Booth. “It’s also a riskier culture. It has more volatility. We’re more stable, we’re more risk-averse, we’re not as aggressive. It’s the tortoise and the hare. At the moment, the tortoise is looking pretty good.”