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Banking lessons from Canada

Banking lessons from Canada
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First Published: Wed, Jun 02 2010. 09 29 PM IST

Updated: Wed, Jun 02 2010. 09 29 PM IST
Finance ministers from the Group of 20 (G-20) countries will meet in the city of Busan in South Korea on Friday and Saturday to set the agenda for the summit to be held in Toronto, Canada, later this month. High on the discussion list will be a levy on banks proposed by the International Monetary Fund (IMF) and rules to tighten banking regulation and supervision. South Korean finance minister Yoon Jeung-hyun has said that ways to control destabilizing cross-border capital flows will also be discussed.
We, in India, can congratulate ourselves and former Reserve Bank of India (RBI) governor Y.V. Reddy, in particular, for our banks being largely immune to the crisis. Good policy certainly had a role to play, but the freedom from contagion for our banks was also because of our insularity, the lack of full convertibility on the capital account and the “underdeveloped” nature of our financial system. In spite of all that, some of our banks faced some tense moments immediately after Lehman Brothers Holdings Inc. went bust in September 2008.
Illustration: Shyamal Banerjee/Mint
So what should be India’s stance on banking reform? As far as the bank levy is concerned, the proposal is that banks should be taxed so that they can pay for future bailouts. Such a proposal makes sense for the US or for Europe, where it’s the ordinary taxpayer who has had to face the burden of rescuing his bank. But the US wants the bank tax to be global, because it doesn’t want its own banks to lose competitive advantage by being taxed, while others are not. There’s little reason for India agreeing to such a tax—our banks sailed through both the Asian and the current crisis. While the state has had to bolster bank capital in the past—through innovative methods such as recapitalization bonds—it has no need for a special bank tax. Our priorities should be very different, such as ensuring access to bank funding for small companies, expanding the corporate debt market, developing the use of hedging instruments and guarding against their mis-selling, consolidating the banking system and improving human resource practices in state-owned banks.
In short, India’s banks face challenges rather different from those faced by their counterparts in the developed economies. Much more interesting from the point of view of the developed countries is the case of the Canadian banking system, which has proved remarkably resilient in spite of the very close integration of the Canadian economy with that of the US. The question that bank regulators need to ask is: what is so special about the Canadian banking system that allowed it to withstand the crisis? The Canadians themselves have said that one, unlike the US, banking is far more concentrated in Canada, with the top five universal banks holding more than 80% of assets; two, this makes regulation easy and they have one regulator for financial services; three, their mortgages were safer because of more stringent down payment rules; four, Canada’s tax system does not allow deductibility for mortgage payments; and five, securitization was less common among Canadian banks.
An IMF working paper of July 2009, authored by Lev Ratnovski and Rocco Huang, titled, “Why are Canadian Banks more resilient?” offers more insight. Did a high capital ratio help? The authors took a sample of 72 major banks from the Organisation for Economic Co-operation and Development area and found that the capital ratios of Canadian banks, although high enough to avoid insolvency problems from minor losses, were below average and not particularly strong. Was it high liquidity ratios, then, that did the trick? The answer is that while Canadian banks were liquid, quite a few of the most liquid banks in the developed economies, such as Citigroup Inc., Barclays Plc and UBS AG, had to have capital injections. The paper points out that balance sheet liquidity can provide only a temporary relief from funding pressure. The authors then consider funding structure, i.e. deposit-taking versus reliance on wholesale funding and find that most Canadian banks had a high level of deposits, which was a source of resilience during the crisis. But then Washington Mutual Inc., a US bank which had to be taken over, had a very high level of funding from deposits.
Much depends, therefore, on effective regulation and on exposure to risky assets. The IMF paper points out that only around 30% of mortgages were securitized and there was no housing bubble in Canada. Also, Canadian banks were less exposed to US assets. The authors say this was because “banks subject to more rigorous capital requirements than elsewhere are less competitive internationally; they have lower incentives for foreign expansion except in cases where they can have a distinct competitive advantage”. But, perhaps, the most important requirement, which the IMF paper does not discuss, is sound macroeconomic policy that does not rely on debt-driven growth that leads to asset bubbles and the under-pricing of risk.
It’s unlikely that a consensus on the new bank regulations will be put in place at the Toronto meeting or even at the Seoul G-20 meet later in November. The real work is being done by the Basel committee, which has proposed a slew of reforms on capital ratios, higher tier I capital, additional capital for the trading book, leverage and liquidity ratios and pro-cyclical capital buffers. They would do well to consider the lessons from the Canadian banking system.
Manas Chakravarty looks at trends and issues in the financial markets.
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First Published: Wed, Jun 02 2010. 09 29 PM IST