Lorena del Castillo Campos

The Canadian banking system absorbed the key sources of systemic risk: the mortgage market
and investment banking and was tightly regulated by one overarching regulator

In 2008 the US crisis was characterized by bank failures and government bank bailouts but in
Canada nothing happened.

So many economist investigates and suppose that Canadian conservatism and superior
Canadian regulation has been the factors that help the financial system be established.

The United States had different crisis : in the antebellum era, under the National Banking
system (1863-1914), in the 1930s under the Federal Reserve System, as well as in 2008; but
the Canada‘s banking system remained stable throughout all of this time.

Canada the federal government have the power to regulate banks and in the US this doesn't
happen.

A more concentrated and regulated financial system may have been slower to innovate, may
have been slower to invest in emerging sectors, and may have provided services at monopoly
prices. (cita) This is what may happen in Canada.

United States

Alexander Hamilton : found the First Bank that is a federally chartered institution. This first
bank was permitted to branch nationwide along the lines of the celebrated Scottish banks.

The first proposed of the legislation has a problem: The Constitution said that the federal
government could coin money and regulate its value; it said nothing about setting up banks.
(cita). This problem would divide the power between the federal government and the states.

The disturbed state of the currency after the War of 1812 creates the need for a new federal
bank = The Second Bank of the United States. This idea of a federal bank evoked strong
passions again because some politicians want to preserve as much power in the states as
possible. As a consequence the charter of the Second Bank was not renewed, and the chartering
of banks became the sole prerogative of the states.

After the collapse of the Second Bank,some states experimented with a new system̳ → free
banking→ allowed individuals to establish banks wherever they wanted in a state → they need
deposits of government bonds as a requirement to protect note holders → this help the market
for state government bonds but dismiss the benefits to the states from chartering banks.

To protect this kind of banks they banned branch offices → banking system fragmented. Also
this protection causes that the states can exclude branches of banks chartered in other states →
system of small local banks.
Lorena del Castillo Campos

But this local banks were protected because Congressman and Senators would not support
legislation that can break local banks, even this legislation would have increased the stability
of the system as a whole.

During the Civil War the Republicans were able to establish a new system of federally
chartered banks: the National Banking system → elevated the successful free banking systems
of New York and Ohio to the national level.

The national banks were forced to follow state bank branching rules, so they could not branch
across state lines this caused that in the United States were a "dual" banking system → Banks
could be chartered by either state governments or the federal government → This fragmented
bank system was unable to supply capital for America's rapidly growing industrial sector.

All of this debilities of the bank system provoque the creation of financial markets because
they can provide longer-term financing and also the inefficiency of the fragmented banking
system in terms of transfer funds across regions incentive people to move funds through
financial assets traded in financial markets.

This financial markets and investment banks successfully provided capital for long term
development, but created a large unregulated sector that was subject to financial panics.(cita)
→ the shadow banking system.

Canada

In the early nineteenth century, the colonial governments in now Ontario and Quebec there
were chartered banks that looked very similar to the First Bank of the United States. This banks
had the right to issue bank notes, had the right to branch, had time-limited charters and had
close ties to the State. But the charters of the Canadian banks were renewed. (Bordo, Redish,
& Rockoff, 2011)

By the time of Confederation in 1867 there were 35 chartered banks in the four colonies that
englobe in the Canadian federation. In the British North American Act that created Canada, the
federal government was given exclusive jurisdiction over:
1. currency
2. coinage
3. banking
In contrary the U.S. constitution gave the federal government exclusive jurisdiction only in:
1. currency
This ocacionate that the role of the state in bank chartering were important.

In the legislation in 1867, the canadian government turned to establishing the framework for
banking in the new country. The bank regulation was little → They had the right to issue notes
Lorena del Castillo Campos

against general assets, also banks could lend against real bills but not against real mortgages or
household goods.
Over the late 19th century restrictions on entry increased because the government increase the
minimum capital stock and the required stock should be paid before the bank opened. The
Canadian banking industry backed by the federal government limiting entry and policed by the
Canadian Bankers Association.

The implications for financial stability

The twin weaknesses of the American financial system:

1. Commercial banking system divided along state lines
2. Volatile financial markets in which a "shadow banking system" of unregulated or
lightly regulated investment banks and other financial intermediaries participated
produced a series of financial panics.

The fragility of the undiversified banks was amplified by asymmetric information and in the
absence of a lender of last resort→ bank runs → financial crises.

The pyramiding of reserves → the right of rural national banks to hold some of their reserves
in the form of deposits in a reserve city national bank, which could in turn could hold some of
its reserves in the form of deposits in a central city national bank.

Because the country banks were relatively undiversified they held higher levels of reserves
than the Canadian banks, and the pyramiding of reserves enabled some return on reserve
balances. Additionally, as it was difficult to transfer good funds across the country the
correspondent relationships could act as a substitute for an interbank transfer system. This only
function in normal times but not in a crisis because rural banks would try to protect themselves
by withdrawing funds from their correspondents.

As the demand of notes was tied to the holding of government bonds, the amount of notes could
not easily expand to satisfy seasonal fluctuations in the demand for currency, as it happen in
the rural banks because in time when they need more notes, as they don't have the facility they
prefer to ask for they correspondents for cash → pressure on the New York money market,
increased short-term interest rates, and increased the vulnerability of the security markets in
the fall of the year.

the distrust of the commercial banks and the retreat of funds by country banks from New York
reinforced the crisis. In the crisis of 1893 began with several moments:
1. the failure of several stock market→ panic.
2. The banks began a wave of bank failures concentrated in the Middle West and the
South.
Lorena del Castillo Campos

3. Banks in these regions want to take out the money from their correspondents in New
York to give them more strength but this ocasionales weakening in the system as a
whole.
in 1907 there was another crisis :
1. The Trust Companies had activities including the traditional deposit taking of
commercial banks and investment banking but the panic began with the failure of
Knickerbocker Trust this engulfed the entire banking system, producing a suspension
of specie payments.
2. the National Banks, as the National Banks in New York, were unwilling to help the
Trust Companies.
3. But this wasn't all that generates the crisis, there were distrust as a whole in the banks.
4. The fragmented banking system contributed to a weakened regulatory regime and lack
of cooperation among large banks, even during financial crises → creation of the
Federal Reserve System in 1913 → promised to end crises through discount window
lending on the basis of eligible commercial paper to member banks
the defects of the dual commercial banking system and the unregulated investment banking,
were left intact.
Canadian banks did not experience the seasonal pressure that amplified the fragility of the US
system → The Canadian banks were permitted to issue banknotes against general assets this
help when note demand increases during the fall crop-moving season was readily met and did
not lead to an increase in interest rates and decrease in reserve ratios as occurred in the U.S.

Canada also had bank failures, but no banking panics. Also the Canadian branch banking
system was oligopolistic → imply higher cost banking and limited supply of banking services
but in Canada there were no information that their costs where higher and the competition of
banks were similar to the U.S.

2. The Great Depression and its aftermath

The Crisis of 1929-1933:

1. the stock market crash

2. distrust hit the small banks in the Midwest and South, and a contagion of fear spread
among depositors producing bank runs
the failure of the Bank of United States in December 1930 → increase in the distrust of the
banking system → currency in the hands of the public began to rise → The federal reserve
does´t help this bank maybe because of the fragmented banking system or maybe just because
national bank didn't wanted to help.

This crisis generate reforms → included the establishment of the Securities and Exchange
Commission (to regulate securities markets), the establishment of Federal Deposit Insurance,
the freeing of the Federal Reserve from the constraints of the gold standard (so that it could act
Lorena del Castillo Campos

aggressively as a lender of last resort) and the adoption of a stricter regulatory regime, among
other reforms. (Bordo, Redish, & Rockoff, 2011)

All of this regulation included clauses in the Glass-Steagall act that limited interest rates banks
and savings banks could pay on deposits.

the high competition for deposits had led to excessive risk taking by banks that why a stricter
regulatory regime was created.

they know that the U.S. dual banking system ocacionates weakness, but even so there were no
attempt to eliminate the state and local banks that had been the source of so much of the
problem → Instead, deposit insurance was introduced as a way of protecting small local banks
against runs.

The legislation only occasionate the division of the banking system with the creation of Glass-
Steagall Act and the newly created Securities and Exchange Commission Commercial banking
was separated from investment banking.

the Canadian Deposit Insurance Corporation was established in 1967.

the Bank of Canada Act was passed in 1934

The 1950s and 1960s was a period of financial stability in both Canada and the United States.
For Canada this was normal but for the U.S there were some activities that explain this unusual
behavior:
1. Deposit insurance reduced the incentive for bank runs
2. Banks and other financial intermediaries had invested heavily during the war years in
obligations of the federal government leaving them with low-risk portfolios.
3. The Federal Reserve was ready to intervene in financial markets if distrust of the system
threatened to become widespread.
4. Inflation was low protecting the solvency of banks and similar financial intermediaries
which are net monetary creditors.

this stability ends in 1970 were the inflation rise high levels and affect savings banks or any
financial institution that has loans in long term with low interest.

3. The Great Inflation and the Growth of Shadow Banking

Lorena del Castillo Campos

In the 70´s both Canada and U.S were affected because of the high levels of inflation ,
globalization, lower cost of information and a political movement toward deregulation

This high levels of inflation had a consequence of a maximum in the nominal interest rate and
fixed nominal debt contracts.The interest rate was established by the Q in the Glass- Steagall
Act at 0% on demand deposits and 2.5% on time and savings deposits to incentive commercial
banks to lend the money rather than putting the money on deposit in reserve city banks.

As the interest rate increase → led to an outflow of funds from commercial banks and savings
banks and a rapid growth of money market mutual funds → this founds were not regulated but
they act like banks making deposits of long term.

the 1987 Bank Act revision which allowed the Canadian banks to own securities dealers.

There were many changes in regulation: The Office of the Superintendent of Financial
Institutions (OSFI) took over the functions of the Inspector General of Banks and the
Superintendent of Insurance and became the regulator and monitor of all federally incorporated
financial institutions→ incorporate trust companies and pension funds as well as insurance
companies and banks.

Canada Deposit Insurance Corporation and the Bank of Canada does not have a regulatory
function but the Bank is responsible for regulation of systemically clearing and settlement
systems and as lender of last resort for systemic financial stability.

In the 80´s also the U.S had changes :

1. Deregulation as a way of salvaging the savings (savings and loan) banks from the
ravages of inflation→ speculation that produced failures.

Deregulation move the U.S. closer to the Canadian model → banks such as Bank of America,
developed a coast-to-coast presence along the lines of the Canadian banks.

In 1999 the Glass-Steagall Act(separates investment banking from commercial) was replaced
by the Financial Services Modernization Act (Gramm–Leach–Bliley Act) → hope that
commercial bank will buy investment banks to form universal banks like in Canada, but this
never happen because of the fragmented commercial system and the lifting of restrictions the
investment banks were more important in the U.S more than in Canada → an expansion in the
investment banking sector rather than their absorption by universal banks in which the
commercial banking arm was dominant, as was the case in Canada.

The investment banks were regulated by the Securities and Exchange Commission but this was
more a regulation for the information that this banks gave to the buyers more than to regulate
the functionality.
Lorena del Castillo Campos

Canadian regulation under OSFI was more stiff than in the United States, mandating higher
capital requirements, lower leverage, less securitization, the curtailment of off balance sheet
vehicles, and restricting the assets that banks could purchase.

Implications of these changes

In Canada, the result of deregulation was that the chartered banks absorbed more of the
financial system and regulation became more unitary. In the US, financial innovation and
deregulation led to an expansion of shadow-banking and greater reliance on financial markets.
(Bordo, Redish, & Rockoff, 2011)

Use of Money market mutual funds

In the U.S this funds reflected the inability of the commercial banks to offer customers high
interest rates on deposits. But Canada does´t reflected this consequences.

In 1990 this funds were famous in both countries but more in the U.S and un Canada this funds
were absorbed by the banks.

In 2008 this funds were 6 times more bigger than the private domestic demand deposits so the
Treasury guaranteed a net asset value of $1 for MMMFs to prevent a run on the fund.

Reliance on markets

A fragmented banking system, with a lot of regulators, incentive the use of financial markets
to transfer funds across regions and economic sectors and to finance industrialization. The U.S
create capital markets while the Canadian financial system remained more bank based. This
causes that the U.S became more vulnerable.

Mortgage finance

In the US a homeowner in the late 20th century would probably have had a fixed rate mortgage
with a term of 30 years, and the right to prepay the mortgage if interest rates fell. But the banks
present 2 problems (how to access a national capital market and how to avoid a maturity
mismatch between demand (or short-term) deposits and long-term loans. This was solved by
making package of mortgage and selling them as a security.

In Canada a homeowner in the late 20th century have a mortgage that amortized over 25 years
but a term of only 5 years. To resolved the maturity discord they put the charge of refinancing
on the consumer.

Leverage
Lorena del Castillo Campos

In Canada the largest brokers are all owned by a large bank, and the consolidated entity is
regulated. In the US the investment brokers remained distinct from the commercial banks.
(Bordo, Redish, & Rockoff, 2011)

In 2000 in the U.S the investment banks increment their leverage but had low regulation →
higher fragility of the system.

When you compare all the banks, Canada banks were more leveraged.

The statistics that would allow one to plot the overall leverage of the banking system
(conventional and shadow) are not readily available because the ones that are in charge of
propose this information are the financial regulators and in the case of U.S they are fragmented.

Bibliography
Bordo, M. D., Redish, A., & Rockoff, H. (2011). WHY DIDN’T CANADA HAVE A BANKING
CRISIS IN 2008 (OR IN 1930, OR 1907, OR ...)? NATIONAL BUREAU OF
ECONOMIC RESEARCH.