The chill that fell over global credit markets in 2007 and hardened into a near-total lending freeze in 2008 and early 2009 was like no other crisis since the Great Depression. Major disruptions in markets for complex assets and for wholesale funding left countries with sophisticated financial systems particularly exposed.

These failures of the credit market extended beyond the financial sector and into the real economy. Businesses were unable to get the short-term funding necessary to meet payrolls, for example, and individuals couldn’t continue ingrained consumption habits. Governments at all levels are now left to deal with serious fiscal shortfalls because of reduced tax bases.

The relationship between the financial system–Wall Street, if you will–and the real economy–Main Street–formed the basis of a vicious feedback loop: Troubled banks were unable to lend; Businesses and consumers had no funding; Businesses cut costs; Consumers lost income; Neither was able to service debt; Banks became more troubled.

The primary consideration in this discussion about the health of the financial system is–or should be–the system, not the “financials” that comprise it. Bottom line: Are businesses and individuals able to borrow money to expand and consume and therefore grow the economy?

Critics of the US federal government’s moves to rescue the system find the effort wanting and suggest that the inability to properly diagnose and treat the problem–insolvent banks–sets the stage for years of lackluster economic growth.

Japan in the 1990s illustrates the perils of concentrating rescue efforts on banks “too big to fail” and simultaneously too big to succeed. Barry Ritholtz, CEO and Director of Equity Research at Fusion IQ, proprietor of The Big Picture, and author of Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy, summarized the Japan comparison in a recent interview with the New Jersey Star-Ledger:

They [Japan] had zombie banks around for 10, 15 years. They didn’t put any of their banks out of their misery, and they had a decade-long recession.

The idea of saying Citigroup is insolvent was unthinkable to them [the US Treasury Dept and the Fed]. They were a sacred cow. If the sacred cow gets mad cow disease, you’ve got to put it down. The problem with bailouts in general is when an industry or company goes bankrupt it typically means that there is a structural flaw in the setup of that company.

Instead of fixing the problem we’re essentially covering up the cracks with a lot of cash. We (still) have banks that are engaged in any manner of highly leveraged, highly reckless speculation. We have yet to fix that.

That “too big to fail” financials were met with “bailouts,” plural, specific to individual institutions rather than a solution designed to rescue the system is a policy choice with the potential to foster a Japan-like scenario in the US: out-on-their-feet banks unable to grease the rails of commerce and a multi-decade economic slump.

While Canada wasn’t immune to the turmoil, the impact north of the border was much less severe. Funding conditions for Canadian banks deteriorated, and their profitability declined, but not as severely as in other Western countries.

Canadian banks didn’t require massive public bailouts of the kind rendered unto Citigroup (NYSE: C); this is an important distinction that should convey some comparative advantage to Canada vis-à-vis the US and the rest of the developed world’s banks for the foreseeable future.

And its US brethren, and government guarantees on bank funding–put in place for precautionary reasons and to “level the playing field” Canadian banks competing with other global banks backed by the implicit guarantees of their respective governments–weren’t drawn upon. This resilience is a pleasant surprise given Canada’s dependence on the US economy. It certainly highlights the fundamental strengths of Canadian banks.

These fundamental strengths have thus far insulated Canada from the worst of the meltdown’s consequences. But the viability of the US financial system is still the issue that hangs over any discussion of global economic recovery.

This lingering weakness could, however, prove an opportunity for Canadian banks interested in expanding existing US operations. The stress-test process in the US has helped the global industry by providing visibility to credit risk. Lack of transparency has been a problem for healthy banks interested in purchasing weaker institutions because they couldn’t see what’s inside particular loan portfolios.

But given Canadian banks’ third quarter numbers, particularly the trend-changes in loan loss provisions (down) and capital ratios (up), it’s reasonable to expect them to get more involved in acquisitions. Bank of Montreal CEO Bill Downe suggested as much in a conference call to discuss results, hinting that his bank may get involved in Federal Deposit Insurance Corporation-assisted deals in the US.

By the Numbers

During their fiscal third quarter (ended July 31) the Big Five once again demonstrated the value of conservative banking. The numbers announced in late August boosted Canadian banks’ reputation for prudent management during this severe economic downturn.

The Standard & Poor’s/TSX Composite Index gained 16 percent during the fiscal quarter ended July 31, bolstering trading fees and mutual fund sales for Canada’s banks. Provisions for loan losses were also significantly lighter than analysts’ forecasts. The bottom line: Bank of Montreal (TSX: BMO, NYSE: BMO), Bank of Nova Scotia (TSX: BNS, NYSE: BNS), Royal Bank of Canada (TSX: RY, NYSE: RY) and Toronto-Dominion Bank (TSX: TD, NYSE: TD) all exceeded expectations. Only Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM) failed to meet forecasts.

Bank of Montreal led off by reporting a 6.9 percent increase in net earnings to CAD557 million (CAD0.97 per share), up from CAD521 million (CAD0.98 per share) a year earlier. Trading revenue surged on the equity market rally, interest income rose, and BMO set aside less money to cover bad loans. Two areas where BMO beat forecasts–net interest income and provisions for credit losses–bode well for future earnings.

Capital markets income grew 30 percent while net interest income rose 14 percent. As this month’s A Thousand Words feature details, Canadian banks’ foundation is traditional deposits, and BMO’s Canadian personal and commercial banking was solid again, with income up 13 percent. Net income from US operations fell 10.7 percent.

BMO set aside CAD417 million to cover bad loans, down from CAD484 million a year earlier, defying analysts’ expectations for an increase. Provisions for credit losses a year earlier included CAD247 million to cover two corporate accounts related to the US housing market. Management maintained the quarterly dividend at CAD0.70 a share.

Bank of Nova Scotia set a revenue record for the second consecutive quarter, as higher net interest income and strong trading boosted numbers. Domestic banking reported a record quarter–led by an increase in consumer deposits and asset-management fees–while net interest income was boosted by higher loan volumes and improved lending spreads. Increases in provisions for bad loans held back the results, though, and net income fell 7.8 percent to CAD931 million (CAD0.87 per share) from CAD1.01 billion (CAD0.98 a share) a year earlier.

Provisions for credit losses rose to CAD554 million from CAD159 million; though this figure more than tripled, it still came in below expectations.

Scotiabank said trading revenue more than doubled in the quarter to CAD514 million, a level management acknowledged was unsustainable.

Net income from Scotiabank’s international operation fell 6.9 percent to CAD312 million as the rise in the Canadian dollar ate away at the value of profits from abroad. The greatest deterioration in Scotiabank’s loan portfolio came from its international commercial lending, though results there still came in better-than-expected.

Bank of Nova Scotia left its dividend unchanged for the sixth straight quarter at CAD0.49 cents a share.

Royal Bank of Canada reported earnings surged 24 percent in the third quarter as a big jump in trading revenue offset higher loan-loss provisions. Net income was CAD1.56 billion (CAD1.05 a share), up from CAD1.26 billion (CAD0.92 a share) a year earlier.

Loan-loss provisions more than doubled to CAD770 million from CAD334 million a year ago but were down by CAD204 million quarter-over-quarter.

Royal Bank reported CAD1.6 billion in trading revenue in the quarter, more than 20 percent of total revenue of CAD7.8 billion. Earnings from its capital markets division were CAD562 million, more than doubling from year-earlier levels on stronger trading revenue.

Canadian banking division earnings fell 5.6 percent to CAD669 million, partly due to higher loan-loss provisions. Royal Bank’s international consumer banking, which includes Raleigh, North Carolina-based RBC Bank, lost CAD95 million, its fifth straight quarterly loss, on rising loan-loss provisions.

Wealth-management earnings came in at CAD168 million, down 10 percent from a year earlier due to the market decline. Insurance earnings improved by 21 percent to CAD167 million as revenue from the segment soared 84 percent and premiums and deposits increased.

The dividend was unchanged at CAD0.50 a share.

Toronto-Dominion Bank reported fiscal third quarter net income of CAD912 million (CAD1.01 a share), down from CAD997 million (CAD1.21 a share) a year earlier but still well above analysts’ expectations.

Provisions for credit losses nearly doubled to CAD557 million, up from CAD288 million in the same quarter a year ago but down from the CAD656 million it set aside in the second quarter. Total quarterly revenue rose to CAD4.67 billion from CAD4.04 billion.

Canadian operations posted record profits of CAD677 million, up 5 percent from the year-earlier period. The boost came from strong volume growth in personal and commercial lending as well as cost-cutting. TD’s US operations earned CAD242 million, down 11 percent from a year earlier on higher loan losses. TD’s quarterly dividend will remain at CAD0.61 a share.

Canadian Imperial Bank of Commerce was alone among the Big Five in failing to meet expectations. The bank reported much higher loan losses and a fistful of writeoffs in the third quarter.

CIBC reported net income of CAD434 million (CAD1.02 a share), up from CAD71 million (CAD0.11 a share). Excluding all items, the bank earned CAD1.36 a share, but that was below consensus expectations of CAD1.39 a share.

CIBC said the largest one-time item this quarter was mark-to-market losses of CAD106 million (CAD0.27 a share) on credit derivatives in its corporate loan-loss hedging program. The bank said this had previously been a source of gains due to deteriorating credit conditions, but narrowing credit spreads have reduced those previous gains.

Loan-loss provisions rose to CAD547 million from CAD203 million a year earlier.

CIBC’s retail business posted revenue of CAD2.3 billion and net income of CAD416 million, while wholesale banking revenue and earnings came in at CAD572 million and CAD86 million, respectively.