How has Canada managed to always exempt itself from financial crises?

Renee Haltom of Richmond Fed has a nice short note on the topic. Though much was covered by Bordo et al in this paper and the Halton summarises their idea broadly.

The main thing is that Canada’s banking system evolved very differently. The banks were large and relatively well divsrsfied which meant that if one sector went down, the banks would remain fine. In Us banks were much smaller and large in number as there was restriction on branching in other states.  Even Fed did not address this issue of unit banking and it went all the way till 1990s when this restriction was removed.

Other things in Canada were:

Canadian banks solved the bank run problem with no central bank. Scholars have chalked this up to a few things. First, its banks were inherently less risky because diversification helped them absorb shocks. Second, its banks could respond to depositors’ demand for cash by printing their own currency backed by general assets. Third, the system’s high concentration facilitated coordination in emergencies. The Canadian Bankers Association, a private consortium of banks, established a fund to honor notes issued by failed banks and arranged takeovers of failing banks when our country was enduring the panics of 1893 and 1907. As a result, note holders and depositors rarely experienced losses.

Competing banks had an incentive to prevent such losses because, in a highly concentrated banking system, a single failure would be bad for everybody. In exchange for support, they policed each other to prevent excessive risk-taking. “People were fairly confident that something would be worked out, so Canada didn’t get the panicky bank runs that we did in the United States,” Rockoff says. American banks tried the same with private clearinghouses and coinsurance schemes, but these efforts often failed; the banks’ interests sometimes proved too diffuse to provide confidence that panics would be averted. (The Canadian government did backstop the banking system on some occasions, mostly through regulatory forbearance, Redish says.

At the request of farmers, it loosened collateralization requirements on note issuance in 1907 and itself issued additional notes in 1914. Some scholars have also argued that banks were insolvent during the Depression but avoided runs because of an expected backstop by the government.) From its beginning, Canada’s banking system was structured to be less vulnerable to shocks and thus did not give rise to the need for a central bank to achieve stability. By contrast, the Fed was created to offset vulnerabilities in the American banking system.

Branching was opposed in US at every possible step:

As the financial system evolved, branching was defeated at every turn. The first attempts at creating a central bank — in 1791 and 1816 — temporarily established a dual system of both state- and nationally chartered banks. But fears about the concentration of power, including opposition to branching, led to the charters of both central banks not being renewed. After 1830, several states experimented with “free banking,” which allowed individuals to establish banks anywhere, but free banks were still prohibited from branching.

National banks were created to fund the Civil War by issuing notes backed by government bonds but were forced to
honor state branching limitations. The political infeasibilityof branching meant the Fed’s founders, despite Sprague’s
conclusions, barely even discussed it as a realistic option.

Because of restrictions, shadow banking developed in US big time whereas it was limited in Canada.

Can one simply borrow from Canada?

It can be tempting to look at the outward characteristics of another country’s stable financial system and conclude that its regulations or structure will produce the same stability here. But doing so may not address the fundamental sources of instability and could create new problems. “It’s very hard to imitate success once you realize that success is based on political institutions with deep historical roots,” Calomiris says.

Moreover, there may be ways in which our financial system outperforms Canada’s. Critics claim that Canada’s tightly regulated system is slower to innovate and fund entrepreneurs. And because there are only a few large banks, the failure of one could be difficult for the financial system to weather.

As for the way policy is made here, there are important cultural reasons for it. “If you went to Americans right now and said, ‘We can fix our problem; let’s just change the 17th Amendment so we no longer have a popularly elected government,’ I don’t think you’d find many takers,” Calomiris says. He is quick to point out that a less representative government does not produce greater stability; he and Haber overwhelmingly found that democracies outperform autocracies in financial stability. Instead, they emphasize that stability tends to prevail in democracies in which policy s made with an eye toward overall stability rather than popular interests.

Thankfully the idea is rejected. History and deep cultural roots make any such simple imposing of one system on another difficult.

So, knowledge of history is deeply important. This does not mean one should just remain in financial crisis. It is just that there are certain historical deep-rooted factors which one has to be aware while designing  reforms. Even if US tries to fix these crisis, history will always intervene. So next time things go crazy, the policymakers should be cautious:

There have been many proposed explanations for why our financial system proved much less resilient than Canada’s in 2007 and 2008, from insufficient regulation, to lax mortgage lending, to our history of government rescues. The longer lens of history shows, however, that any one explanation for financial instability — and therefore any one regulatory attempt to fix it — may be too simple. Even if unit banking is a relic of the past, it is still with us through its effects on the evolution of the U.S. financial system — just as reforms today will determine the shape and stability of the financial system of the future.

 

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One Response to “How has Canada managed to always exempt itself from financial crises?”

  1. How has Canada managed to steer clear of the worst effects of financial crisis? | MERCIAR BUSINESS CONSULTING Says:

    […] https://mostlyeconomics.wordpress.com/2014/05/06/how-has-canada-managed-to-always-exempt-itself-from… […]

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