It’s now conventional wisdom that Canadian banks fared better during the economic/financial crisis than its Western peers. But why are Canadian banks more resilient? A recent IMF Working Paper by Rocco Huang, economist at the Federal Reserve Bank of Philadelphia, and Lev Ratnovski, economist at the North American division of the International Monetary Fund, concludes that “the funding structure of Canadian banks was the key determinant of their resilience during the turmoil.”

Huang and Ratnoviski conclude that ordinary people account for Canadian banks’ strength. “Reviewing the data, we note that the pre-crisis capital and liquidity ratios of Canadian banks were not exceptionally strong relative to their peers in other OECD countries. However, Canadian banks clearly stood out in terms of funding structure: they relied much less on wholesale funding, and much more on depository funding, much of which came from retail sources such as households.”

Retail deposits are the most “sticky” source of bank funding because they’re covered by deposit insurance. Interbank depositors are relatively informed and less likely to withdraw from fundamentally sound banks. By contrast, money market wholesale funding is often uninformed and may “run” based on mild negative news or rumors.

As the table “On Deposits” suggests, Canadian banks are clearly the “positive outliers” among OECD banks in the ratio of depository funding to total assets. On this ratio, almost all large Canadian banks are in the top quartile. Anecdotal evidence also suggests that a higher fraction than in the US of Canadian bank deposits are “core deposits,” i.e., transaction accounts and small deposits, which are “stickier” than large deposits.

One likely reason for Canadian banks’ firm grip of deposit supply is their ability to provide one-stop service in mutual funds and asset management. Unlike in the US, Canadian banks have been historically universal banks, and there’s relatively less competition for household savings from other alternative investment vehicles.

From Why are Canadian Banks More Resilient?:

[I]ncidents of bank distress can be explained rather well based on just three pre-crisis accounting-based financial ratios: a critically low (below 4%) equity-to-asset ratio, insufficient balance sheet liquidity, and a funding structure that relied less on a stable deposit base and more on wholesale funding.

Empirically, the funding structure, as measured by the depository funding to total asset ratio, is the most robust predictor of bank performance during the turmoil.

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Canadian banks’ pre-crisis balance sheet structures were broadly similar to those of banks in other OECD countries with one notable exception – funding structure. Canadian banks were in the top quartile of the OECD sample in terms of their use of depository funding. The advantage of stable deposit funding may have insulated them from the freeze of wholesale funding. Commercial banks increasingly use short-term wholesale funds to supplement traditional retail deposits. Existing literature mainly points to the “bright side” of wholesale funding: sophisticated financiers can monitor banks, disciplining bad ones but refinancing solvent ones. This paper models a “dark side” of wholesale funding. In an environment with a costless but imperfect signal on bank project quality (e.g. credit ratings, performance of peers), short-term wholesale financiers have lower incentives to conduct costly information acquisition, and instead may withdraw based on negative but noisy public signals, triggering inefficient liquidations) markets, contributing to their resilience.

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On the supply side, large Canadian banks, benefiting from their nationwide footprints and a universal banking model, are able to offer one-stop service to households, which helps attract and retain household savings. On the demand side, in recent years, Canadian banks experienced slower asset growth than their neighbours in the US, leading to a narrower funding gap and hence a lower need for wholesale funding in addition to household savings.

Under Canada’s Bank Act, Schedule 1 and Schedule II banks are both investment banks and deposit-taking institutions. They have steady, secure streams of cheap capital. Under the Glass-Steagall Act, American institutions were prohibited from engaging in investment banking as well as commercial banking.

Arguably, the US investment banks that failed were holdovers from Glass-Steagall (despite the fact that the US legal regime changed in 1999). They didn’t have this retail base of cheap capital. Indeed, there are no more stand-alone investment banks in the US, as even Goldman Sachs and Morgan Stanley were forced to become bank holding companies in order to survive the turmoil in the capital markets in the wake of Lehman Brothers’ bankruptcy.

Thus, there is in the structure of the banking regime a partial explanation for the relative stability of the Big Five Canadian banks.

Canada’s banking system has also been well-regulated by the Office of the Superintendent of Financial Institutions (OSFI). Unlike the US, where regulatory jurisdiction is fragmented, OSFI has jurisdiction over a broad list of financial institutions including banks, trust and loan companies, insurance companies and other financial institutions.

While OSFI’s mandate is “to ensure that financial institutions are regulated … so as to contribute to public confidence in the Canadian financial system,” it leaves the management of the financial institution to individual boards of directors and management of the institution itself. In understanding why Canadian banks have been relatively successful, it is also important to examine approaches to systemic risk at the bank level.

CE Editor Roger Conrad has often surmised that the US financial system would look more like the utility industry once the crisis settles; that’s not exactly how it’s likely to turn out based on the current state of things. Perhaps, however, policymakers and voters should give this a little more thought.

A simple comparison of mortgage practices bears this out. Canada’s system is marked by much more conservative residential lending. Less than 3 percent of Canadian mortgages are subprime and less than 30 percent are securitized. In the US, approximately 15 percent of pre-crisis mortgages were subprime, and about 60 percent of all mortgages were securitized.

Canadian financial institutions have been well-regulated. However, in addition to strong regulation, Canadian banks have survived because a more conservative culture pervades all aspects of banking business, from lending to trading.