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Business News/ Opinion / Banking lessons from Canada
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Banking lessons from Canada

Banking lessons from Canada

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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

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.

Also Read Manas Chakravarty’s earlier columns

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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Published: 02 Jun 2010, 09:29 PM IST
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