In the wake of the financial crisis in 2008, many banks in the US collapsed and/or had to be bailed out, but Canadian banks sailed through the crisis relatively unscathed. Since then, financial commentators and policy analysts have probed at the sources of the resilience of the Canadian financial system.
Our study, entitled ‘Does regulatory regime matter for bank risk-taking? A comparative analysis of US and Canada’, attempts to provide answers to these questions. We attribute the reasons primarily to differences in regulatory regimes in Canada and the US and the resilience of the banking sector in Canada, which the Financial Times calls ‘the envy of the world’ and Paul Volcker—the former Federal Reserve Chairman—has touted as the model for what a reformed American system should look like.
In the study we contrast the regulatory regimes in the US and Canada in terms of the structure of the banking sector, supervisory responsibilities, and the mortgage market, among other features.
The banking system in Canada consists of a small set of (six) large banks that account for approximately 92.7% of the total assets and contribute almost 92% of the credit to loan markets, with a concentration ratio of 92.7%. Given the highly-concentrated structure of the banking system the banks are tightly regulated and supervised to ensure the stability and efficiency of the financial system. Banks have higher capital requirements, greater leverage restrictions, and fewer off-balance sheet activities than the US. In contrast, the US banking system is comprised of a very large number of small financial institutions and hence is much more fragmented. The six largest bank holding companies in the US accounted for almost 58.5% of total industry assets as of 30 June 2014. The concentration ratio of the largest six bank holding companies in US was almost 58%.
To ensure consistency and minimize competing regulatory objectives, the administration of prudential regulation of Canadian banks and insurance companies is under the jurisdiction of only one prudential regulator—The Office of the Superintendent of Financial Institutions (OSFI). In the US however, banking is regulated at both the federal and state levels, with each subsidiary of a banking conglomerate might be subject to a different regulatory authority according to whether it was classed as an insurance company, investment bank, or commercial bank. This multiple regulatory structure can create competing regulatory objectives.
Also, in Canada, mortgage interest is not tax deductible. As a result, Canada has not seen a tax-driven distortion in the level of housing debt and did not experience a housing boom and bust on the same scale as that which occurred in the US during the 2009 financial crisis. In contrast, mortgage interest is tax deductible in the US, and this benefit encourages people to take on higher mortgages, sometimes to fund purchases of consumer products. In addition, the implicit policy of granting financial access to the poor compelled banks in the US to relax their lending rules, and to engage in ‘low document’ mortgage lending without direct verification. This deviation from traditional prudential financial management practices, in part, contributed to the financial crisis whose epicentre was the housing sector.
In summary, as compared to the US, the Canadian financial system is characterized by a high degree of concentration, a strong regulatory regime, stringent capital requirements for banks, federal supervision, and strict mortgage market regulations.
Using a sample consisting of the major banks in Canada and the US, we study the extent to which the regulatory regimes affected the risk-taking behaviour of the banks over the pre-financial crisis period of 1995 to 2008, using the z-score as the main measure of risk and ROA volatility and solvency ratio for robustness checks. The z-score measures the distance from insolvency; a higher z-score indicates that the bank is more stable. In addition, we use survey-based measures of financial regulation and supervision compiled by the World Bank to provide further insight into the differences between the Canadian and US banking regulatory regimes.
We find that Canadian banks exhibit higher z-scores and therefore lower risks than their US counterparts. Entry restrictions which create concentrated banking structure and strong supervisory power are positively related to Canadian banks’ z-scores, suggesting that these factors constrain excessive risk taking by the banks. This effect is, however, attenuated by restrictions on banking activities.
The study also decomposes the risk measure, the z–score, into its components, namely profitability (ROA), profit variability (standard deviation of ROA) and Capital Adequacy ratio, and re-estimate their baseline regression with the view to identifying the source of the risk reduction. We find that entry restrictions and highly concentrated market structure enable Canadian banks to generate higher profits and lower variability of asset returns, while restrictions on bank activities reduce profitability and increase variability in asset returns. However, the benefits the banks derive from entry restrictions and concentrated banking structure seem to outweigh the effect of asset usage restrictions, which lead to the lower risk that we observe for the Canadian banks. These results show that the lower risk and the stability experienced by the Canadian banks emanate from high profitability and lower profit variability, both products of the concentrated nature of the banking industry in Canada which seems to emphasize scale rather than competition.
Bank regulation has different aspects(eg capital requirements and capital restrictions, activity restrictions, entry restrictions, and supervisory power) and each of them affects risk taking incentives of banks differently. For example, while lax regulatory regimes in the form of low activity restrictions can enhance charter value and consequently lead to lower risk taking, ease of bank entry can increase competition, which in turn can induce higher risk taking. Recognizing this differential effect, we investigate the impact of each component of regulation on bank risk taking in the two countries. Interestingly, we find that in Canada (compared to the US) tighter entry restrictions lead to lower risk taking. This result is consistent with the hypothesis that tighter entry restrictions create concentrated banking structure and high profits for banks and this takes away the incentive to take on higher risk. Similarly, having strong supervisory power, emanating from a single regulator (with no conflicting regulatory goals) leads to lower risk taking by Canadian banks.
The study is valuable because it contributes to the discourse on regulatory regimes and risk taking at a time when governments are looking for ways to design optimal regulatory regimes that can help prevent another banking crisis. From a policy standpoint, the study identifies the different aspects of regulation that have contributed to the resilience of the Canadian banking system. If Canada’s banks and its regulatory regime are to be a model for the world, then our study has implications for the types of regulatory reform needed to promote bank stability.
Sana Mohsni is an Associate Professor of Finance at the Sprott School of Business, Carleton University.
Isaac Otchere is a Professor of Finance at the Sprott School of Business, Carleton University.