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Banking and Financial Services: Prudence Equals Strength

Canada's banking and financial services industries have maintained careful policies that are reaping benefits during the global downturn.

Location Canada 2009
These days it's tempting to think that the term "sound banking system" is an oxymoron, along the lines of "deafening silence," "genuine imitation," or "pretty ugly." But while economic matters have certainly gotten pretty ugly in the United States and much of the world, in Canada there's still plenty of talk about a sound banking system.

Don't take the Canadians' word for it, though. The World Economic Forum says so, in its 2008-2009 Global Competitiveness Report. Right there in the section labeled "Soundness of Banks," at the top of the list, is Canada, ahead of Sweden, ahead of Luxembourg, and far ahead of the United States - whose battered banking system holds down 40th place, in the same neighborhood as Germany and the United Kingdom.

Canada fares well in other financial measures, too. In particular, the World Economic Forum sees strength of investor protection as a selling point in Canada, ranking it fifth among the world's nations. The nation places sixth in the world in overall financial market sophistication, according to the World Economic Forum, and ranks in the top 20 in venture capital availability and the legal rights index.

Keeping watch over the country's financial sector is Julie Dickson, superintendent of financial institutions. She has no illusion about the challenges that face her country's banks - it is, after all, a global recession, and Canada is well plugged into the global economy. But she believes Canada's banks are in a comparatively favorable spot.

"The economic downturn is the second wave to hit the system since August 2007," she told a banking conference in January. "Canadian banks handled the first wave, global financial market turmoil, relatively well compared to many of their global counterparts. The second wave, a serious economic downturn, is hitting while financial market turmoil remains ongoing."

That second wave affects banks' capital levels and profits. And while it's hard to predict the extent of the downturn, "the Canadian banking system is probably better positioned than most other systems to deal with this second wave," according to Dickson. "It is very well capitalized, and has avoided the need for government injections of capital, unlike most advanced systems in the world, and has been able to tap the capital markets for additional capital."

Canada's institutions are so well capitalized, in fact, that Time magazine last November called Canada "the new gold standard in banking." The nation's major banks needed no bailout, unlike many of their American, British, and German counterparts. The Canadian government did step in to back interbank lending, not because the banks really needed the help but because of concerns that similar moves made in other countries could end up placing Canada's banks at a competitive disadvantage.

How has Canada managed so well in the face of such an economic hurricane? There are probably about as many economic views as there are economists, but a common theme is prudence - Canada's financial institutions and their regulators have been careful all along, less likely to make some of the decisions that led Wall Street astray.

Prudence is not the same thing as excessive, head-in-the-sand caution. Canada's institutions know that a modern economy needs healthy investment to thrive, and investment always brings an element of risk. The nation would not rank in the top 20 for venture capital if it were unwilling to take carefully considered risks. But it has maintained safeguards that it now seems clear have been lacking in many of the world's other economies.

Building a Solid Brand
Canada's reputation for fiscal prudence is firmly established, and Dickson was talking about it well before the global economy skidded off the road. In an address in June of 2008, she recounted a conversation with an observer in the United Kingdom, who spoke of a "Brand Canada" reputation. "The person noted that, internationally, the Canadian `brand' is very strong," said Dickson. "This is based on the perceived strength of the underlying fiscal and economic fundamentals, and the lower risks associated with Canadian banks, the corporate sector and the household sector."

A key component of that branding: "Canadian banks are generally seen as strong counterparties, as they tend to be more conservative and better capitalized than many other banks." According to Dickson, the ability of Canadian banks to withstand financial market turmoil "was evidence not only of their own efforts, but also of prudent oversight and supervision, including features of the Canadian market such as strong capital positions."

The office that Dickson heads has long maintained stricter capital guidelines than can be found in many countries, and it has encouraged openness and transparency on the part of financial institutions. Simply put, her office "does not allow banks to take on risk without having the commensurate amount of capital to backstop that risk." In hindsight, that seems like a no-brainer, but that kind of simple Canadian wisdom has been in rather short supply in some other parts of the global financial system. Brand Canada, according to Dickson, "is strong capital, both in terms of level and quality. Brand Canada is also increasingly being linked to robust disclosure by banks."

Beyond insisting on more prudent levels of capital, Canada has managed to keep investment bankers under a more watchful eye than their American counterparts faced in the past. One strategy dates back to the 1980s, when Ottawa agreed to let commercial banks acquire investment dealers, which meant those acquired investment operations had to abide by stricter rules. Many Americans are now wishing that Wall Street had been getting the same kind of scrutiny.

The other part of prudence is planning ahead, and Canada has been taking steps designed to ensure that its financial system remains strong even as the world's economy falters. For example, Minister of Finance Jim Flaherty has backed legislation establishing an economic action plan, with a host of changes and concepts designed to keep the economy moving in a positive direction. In introducing the legislation, Flaherty said, "Our plan will see Canada emerge from this recession on a sustainable fiscal footing, with better infrastructure, a more skilled labor force, lower taxes and a more competitive economy."

This kind of planning began well before the times got so tough, Flaherty told a Toronto audience last fall. "Long before this global credit crunch and gut-wrenching market volatility ever appeared on the radar screen, our government began preparing for the possibility that the stability of our financial institutions, and the will of Canadian consumers and businesses, would be severely tested," he said. That included instituting permanent tax relief in advance of the downturn to help solidify the country's footing: "In the eyes of the international community, and in the eyes of scores of economic experts, we have put Canadian families and businesses in the best possible position to deal with today's global uncertainty." Pointing to such measures as a minimum down payment and a maximum amortization period for new government-backed mortgages, Flaherty said, "Our forward-looking approach included efforts to prevent mortgage bubbles like the one in the U.S. from happening here."

In an address last November, Flaherty acknowledged "our financial system has been characterized as unexciting," due in part to the Canadian preference for prudence and the regulatory regime that has carefully balanced stability and efficiency. But he made no apologies to those who have found the Canadian financial sector dull, because those attributes have provided protections that are now the envy of the world: "If Canada's financial system is boring, perhaps the world needs to be more like Canada."

Financial Services Snapshot
Canada's financial services industry (including insurance) has a long history of steady, solid growth, by many measures. The sector's gross domestic product hit $78 billion by 2007, according to Industry Canada statistics, recording a compound annual growth rate of 3.4 percent over the previous decade.

More than 127,000 establishments make up the sector, about two-fifths of them in Ontario and another fifth in Québec, roughly 15 percent in British Columbia, and 12 percent in Alberta.

As it happens, regulatory moves that some might not have liked in the past have turned out to look wise, an irony not lost on the writers of a PricewaterhouseCoopers 2008 report on the Canadian banking industry: "Historically, Canadian banks have been restricted from bulking up to rival the size of global banks. Ironically, their constrained size may have protected them from some of the excessive levels of exposure experienced by some global banks."

That's not to say there aren't some giants on the Canadian banking landscape. The industry is dominated by what some refer to as the Big Five: Royal Bank of Canada, Toronto-Dominion (TD Bank), Scotiabank, Canadian Imperial Bank of Commerce (CIBC), and Bank of Montreal. All are major players, with deposits in the hundreds of billions of dollars, and, like American banks, they provide services well beyond simple banking operations. These are big banks, and they're strong - for example, one recent ranking from the Oliver Wyman Group consultancy placed Bank of Nova Scotia among the 10 most stable banks in the world.

The strength of these institutions can be felt not only across Canada but across the border as well. In fact, while institutions elsewhere are reeling, Canadian banks are building upon their strong positions by continuing to make acquisitions, both in Canada and around the world.

BMO Financial Group, for example, is buying the Canadian operations of the huge American International Group, the target of urgent rescue efforts by American regulators. Scotiabank emerged as a buyer of Sun Life Financial's stake in the CI Financial Income Fund, and also a Peruvian private pension fund, one of a number of financial acquisitions it has made in that country. Scotiabank in the past year has moved into Moscow and Istanbul, while BMO has established a full branch in Shanghai.

Canadian banks aren't immune to the problems facing the global financial services sector, and indeed, the headlines have included some layoffs. But those who keep watch over the industry believe their prudent strategies have been proven correct, and have left their country's financial sector in a comparatively strong place during a horrific economic time.

As Dickson has noted, "While regulation has costs, some Canadian banks may now be better placed to take advantage of global opportunities due to their financial positions. We have seen that having a prudent regulatory regime pays, and can be a competitive advantage."

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