This article analyzes the role that deregulation has played in increasing the over-leveraged position of the big five Canadian banks.
To start off with, we present a brief snapshot of the Canadian reserve requirements in the early 1800s before an official ‘Bank Act’ had been drafted.
Before Bank Act
Canada has historically had very close ties with the United Kingdom as being part of the Commonwealth.
In the 1830s, the U.K. had a strong influence over the banking policies in Canada.
The British government had demanded several provisions to be incorporated into all of the bank charters of Canada because they were seen as undesirable.
Several of the following provisions were;
- Suspension of cash payments for 60 days to result in the forfeiture of the charter;
- Notes were to be issued at any branch to be redeemable at the head office but not at other branches;
- One-half the capital must be paid in immediately;
- Loans to directors or officers (or on paper bearing their names) must be limited to one-third of the total advances;
- No bank must hold its own stock or to lend on it;
- A weekly statement of the bank’s affairs must be made and a semi-annual statement to be sent out to the legislature;
- Shareholders to be liable for the amount of their shares – the double liability
- Compliance must be met with certain conditions in making loans, to see that the bank should remain a creditor and did not become a partner.
From 1841 onward, this along with other provisions, were incorporated into all of the bank charters. This effectively established a 50% reserve ratio on demand deposits. Further information regarding these provisions can be found in the following article: History of Banking System in Canada.
More than two decades later, this reserve ratio was drastically altered, allowing banks to loan out far more money than they had in the past and thus allowed them to become more leveraged than they had been in the past.
This next section provides the historical context for the bank act which was the legislative framework used to govern all of the banks in Canada. This act is still enforced upon the Canadian banks to this day.
Bank Act of 1867
The Bank Act was formally introduced by the finance minister of the day, Francis Hincks in 1867.
The act provided the codification of the existing bank charters and determined the legal capacity of the banks. In other words it laid out what Banks could or could not do and held them accountable for their actions.
Since its inception in 1867, the original bank act was subject to many revisions particularly throughout the 20th century.
Global events such as WW1, the Great Depression of the 1930s, and WW2 had significantly influenced the banking policies and this had a profound impact on the changes that were made to the bank act.
Many of these changes weakened the position of the Canadian banks and allowed them to hold riskier, over-leveraged positions. This is exemplified below.
Significant Revisions to Bank Act
1913 – Loans were made to farmers upon the security of grains and loans to ranchers on the security of cattle. This was essentially an earlier form of collateralized loans that would be introduced later.
For a farmer the collateral would be the grains harvested and used as security in exchange for a bank loan. This would be beneficial for farmers because they would be able to enjoy access to bank loans in the event of a natural disaster or poor yield that would affect their crop.
1954 – Banks were given the power to make mortgage loans and extend personalized loans.
The significance of this had been that the banks were allowed to enter the business of household lending.
1967 – The 6% ceiling on the interest rate of bank loans were eliminated.
The significance of this event was that prior to the amendment, banks had not been allowed to engage in mortgage lending to households. Market interest rates were generally above 6% during the mid-1960s therefore the 6% ceiling limit had limited banks from capitalizing on mortgage lending.
This amendment also eliminated restrictions on the banks involvement in residential mortgage financing. Banks had been permitted to invest in non-insured or conventional mortgages.
1980 – Chartered Banks had been allowed to establish subsidiaries in various financial services such as venture capital and mortgage lending.
Historically in Canada, financial services had been regulated through four distinct pillars; Banks, Trust companies, Securities dealers, and Insurance companies. This is also outlined in Part 3 of the long running series titled The Deregulation of Canada’s Financial Industry.
The amendments brought forth had officially dissolved the traditional “four pillar” system Canada had traditionally relied upon.
This paved the way for banks to become “supermarkets” of financial services that offered far more than simply accepting deposits and offering loans.
Since banks were now able to compete with trust companies and securities dealers, this dramatically affected the nature of the financial sector in Canada.
1987 – Canadian Banks were permitted to invest in corporate securities dealers, and distribute government bonds. Banks were also able to conduct brokerage activities.
As a result of this change, banks were now able to compete effectively with securities dealers and this would later cause intense competition between the traditional securities dealers and the banks and would eventually lead to banks acquiring securities dealers in attempts to increase their market share.
1992 – Banks gained the authority to underwrite insurance through subsidiaries.
Since 1992, the big 5 Canadian banks – Royal Bank, Toronto Dominion Canada Trust (TD Canada Trust), Canadian Imperial Bank of Commerce (CIBC), Bank of Montreal and Scotiabank – had established insurance subsidiaries.
Although it was not within a bank’s legal capacity to sell insurance to customers at this time, it was possible for banks to sell insurance by establishing separate insurance subsidiaries. An example would include;
- TD Insurance Company Subsidiary – TD Life Insurance Company
Thus as we already learn, the banks had now been able to indirectly offer insurance services in addition to acting as trust companies and securities dealers.
The 1992 amendment was also important because the banks were permitted to establish their own trust companies or acquire existing trust companies. This further disintegrated the distinction between the four pillars and accelerated the consolidation of power for the Canadian banks.
1992 also brought Bill C-19 which was introduced under Mulroney’s Conservatives, in which they had begun a process to phase out the Reserve Requirements. Reserve requirements are a regulatory requirement intended to ensure that banks have a certain percentage of their total deposits as cash. By holding reserve requirements, banks ensure that there is money available to cover customer withdrawals.
This should not be confused with Capital Requirements which are used to ensure that banks hold in cash a percentage of the amount of money invested.
1994 – The reserve ratio in Canada had been officially phased out as a result of a process that began in 1992. For the purposes of this article, this is probably the most important point.
2001 – Bill C8 was passed which allowed banks to reorganize into holding companies that could own several subsidiaries each involved in a specific type of financial service (i.e. banking, insurance securities).
On the other hand, the Life Insurance companies and securities dealers had also been given the ability to offer services similar to the banks. The significance of this was that it increased the efficiency of the financial operations of banks and the other financial institutions.
Further details surrounding the Bank Act revisions can be found in Charles Freedman’s report: The Canadian Banking System and J. Allen and W. Engerts review titled: Efficiency and Competition in Canadian Banking
Reserve Ratios In the Past
To understand how the banks assets are calculated today, it is important to understand how they were calculated prior to the elimination of bank reserves in 1994.
The reserve ratios were calculated using a combination of the following methods: Primary reserves, four week calculation period, reserve ratios, and the bi-monthly averaging or maintenance period.
For the purposes of this article we only look at how the reserve ratios were calculated.
Reserve ratios were calculated by combining the ratios of the following:
- Demand deposits with a minimum reserve ratio of 10%
- Notice deposits below $500 million to have a minimum reserve ratio of 2%
- Notice deposits above $500 million to have a minimum reserve ratio of 3%
- Resident’s Foreign Currency deposits to have a minimum reserve ratio of 3%
The chart, found in K. Clinton’s paper titled: Implementation of Monetary Policy in a Regime with Zero Reserve Requirements , depicts the steady elimination of bank reserve requirements over the years from 1980-1994 where they were eventually phased out completely.
So why did Mulroney eliminate the reserve ratios for the Central Bank?
Well one academic thinks it was because of the outstanding debts the private banks were already in.
John McMurtry, a professor at the University of Guelph wrote a paper titled: The Bank of Canada and the Secret of Canada’s Debt.
In his paper he alleged the following,
In 1991, the Mulroney government secretly phased out the requirement of Canada’s banks to hold any currency reserves to cover the money they loaned out to governments and individuals at compound interest rates. The Bank of Canada pushed for this zero-reserve policy
Times Columnist Philip Symons, wrote an article in 1998 titled: There is a solution to our financial woes (Symons, 1998).
Found within the article Symons revealed,
Banks were once forced to keep at least 10 per cent of their money “in the vault,” as it were, as a reserve in the event of a sudden need for cash. But banks don’t like keeping money in the vault because it’s not earning interest there. “In 1991,” Biddell tells us, “the Mulroney government phased out all requirements for such reserves.” The banks now rely entirely on real estate and other property of collateral.
In other words Symon’s argument had been that due to the elimination of the reserve requirements this paved the way to create a systemic risk issue for Canada in the mortgage market. As we learn in Part 7 of the long running series on Deregulation of Canada’s Financial Industry – the mortgage market posed a serious risk to the health of the Canadian economy.
Another explanation for why the reserve requirements had been phased out is that the government had been pressured by the chartered banks primarily in the form of lobbying.
Unlike other Deposit taking institutions, chartered banks had been the only institutions that had to maintain the minimum primary reserves up until 1994. Deposit taking institutions are corporations that are authorized to take deposits from customers. This includes chartered banks, building societies, and credit unions.
The banks interpreted this requirement mean that it was restricting their bank’s efficiency and essentially constituted as an “unfair tax” on them since the legislation had not been extended to other deposit taking institutions.
However, simply because the banks did not have reserve requirements did not mean that they were able to issue limitless amounts of notes. As will soon be presented, banks did have to conform to another set of requirements in order to issue loans.
The elimination of the reserve ratios had not only eliminated the banks deposits to the central bank, but it had also increased the amount of money they could loan because those deposits that were originally within the Bank of Canada had now been loaned out.
Implications from Financial Deregulation
As a result of the steady deregulation surrounding the banks and other financial institutions, the banks have become significantly over-leveraged. Before the amendment of 1968, chartered banks were only able to charge interest rates of 6%. In addition, chartered banks were only able to offer loans of up to 4 years. This is why the trust companies at the time were the source of lending for mortgages since they were able to extend loans beyond 4 years.
The 1981 amendment to the bank act is proof alone of the increasing banking influence over the Canadian economy. This amendment meant that the banks were able to act as trust companies and securities dealers, and as a result, they were able to muscle into the mortgage market and offer loans extending far longer and at much higher interest rates than they were able to previously.
Just looking into the case presented by the U.S. banks, one can already see the amount of risks that were associated with banks being able to provide mortgage services and acting as trusts and securities dealers at the same time. This risk was plainly evident as a factor that led to the housing market collapse of 2008.
In the aftermath of the crisis, it was revealed that the banks had abused their privileges in order to offer mortgages to individuals that would not be likely to pay the loans in the attempts to inflate the assets on their balance sheets and increase executives annual bonuses.
Although Canada may not see a full blown sub-prime mortgage crisis due to the differences in the way that the Canadian mortgage market had operated, as analyzed in Part 8 of the long standing series of Deregulation of Canada’s financial industry – ,
Canada could however see a systemic risk issue that could develop into a mortgage crisis because banks and mortgages are closely intertwined.
Is the Canadian Economy at risk?
The popular web based blog Zero Hedge published an article titled: “Is the Next Domino To Fall…. Canada?” in which the author Tyler Durden made claims that Canada was about to face its own systemic banking crisis.
Durden outlined the risky positions that the Canadian banks had on their balance sheets.
His argument presented the case that 30% of the banks in Canada held a Tangible Common Equity (TCE) ratio of less than 4%. The TCE is a ratio that is used to determine the amount of losses a bank can withstand before the shareholder equity is wiped out.
The TCE is calculated by: Taking the total equity of a bank, subtracting its intangible assets + goodwill + preferred stock equity and then dividing it by its tangible assets.
The chart below shows the Tangible common equity of banks around the world that hold less than 4% TCE.
According to this chart, 30% of the banks listed are Canadian, and this includes the big five banks; RBC, BMO, CIBC, TD, and Scotiabank
As clearly evident, 4 out of the big 5 Canadian banks (excluding BMO) have a TCE ratio of less 4%.
The relevance of this figure for our discussion, is that if there was a small reduction (4% or less) in the value of their banks assets it would completely wipe out their entire equity.
This of course would have disastrous consequences for shareholders and the Canadian public.
Durden’s article challenged the widely held belief of the stability in the Canadian banks, and attracted much public scrutiny even so far as attracting the attention of Canada’s biggest newspaper – the Globe and Mail.
Here, Boyd Erman published his own rebuttal of their article under the title: “Canada’s Banks: Next Dominos to Fall?”
Erman critiqued Durden’s article by claiming that it was a “bearish” take on the Canadian banks.
Erman had argued that when the banks disclose their financial statements with their TCE ratios, they compare their TCE ratio to risk weighted assets, which is not the same method of calculation that Durden had used because he compared the TCE to total assets without risk-weighting.
Whether one believes in the method of calculation used by the banks or by Durden, one thing remains clear; the Canadian banks have been in a more leveraged position now than ever before.
For example, if the value of Canadian bank assets were to decline significantly, it would not matter which reporting methodology is used because the total equity of all the banks would be in jeopardy.
The situation in Canada shows that the biggest chunk of bank assets is in the form of mortgages, thus the most significant danger that lies in the decline of bank assets and by extension their equity, is a correction in the housing market as has been discussed previously.
It is important to note, that some academics and industry professionals have already been warning about a housing market correction that is to be expected in the near future.
Despite the more leveraged position of the Canadian banks, there is still a strong call for more regulation surrounding these financial institutions.
Even the Central bank governor Mark Carney has publicly agreed that Canadian banks are over-leveraged.
The Bank of Canada governor said in an interview with The Canadian Press that [banking] reforms should continue until the structural changes needed to eliminate irresponsible risk-taking are completed.
What is interesting to note is that, back in 1988, Canada had already undertaken measures to decrease the risky positions of the Canadian banks through the adoption of the Basel Accords.
The Basel accords are a set of international recommendations on banking regulations issued by the Basel Committee on Banking Supervision (BCBS).
The Basel I framework, as part of the Basel Accords, had been enforced into law in 1992 by the G-10 countries.
It is interesting to note that the Basel Accords were enacted into law on the same year that the reserve requirements were phased out in Canada : 1992
Under the framework of Basel I, a set of minimum capital requirements was established for the banks. Another term for this is known as Capital Adequacy Requirements.
Capital Adequacy Requirements (CAR)
Essentially capital adequacy requirements were a way to ensure that financial institutions were not participating or holding investments that would increase the risk of default. The requirements also ensured that the banks would have enough capital to sustain operating losses while honoring their depositor’s withdrawals.
In this sense, capital adequacy requirements were requirements that had been in place for banks and other depository institutions to determine how much capital would be required to be held in the bank’s balance sheets for a certain amount of assets.
The capital adequacy requirement was also outlined in the bank act below;
Subsection 485. (1) of the Bank Act and subsection 473. (1) require banks, trusts, and loan companies to maintain adequate capital.
These requirements were determined by the Office for the Superintendent on Financial Institutions (OSFI) because OSFI is the financial regulator that oversees the enforcement of banking regulations in Canada.
They have determined the requirements via two methods. Asset to Capital Multiple Test (ACM) and Risk-Based Capital Ratio (RBCR)
1. Assets to Capital Multiple Test (ACM)
Under this method, banks are required to meet the ACM Test in order to operate on a continual basis. Also, under the ACM test, total assets should be no greater than 20 times the capital of the banks.
In other words Canadian banks should not exceed an asset to capital ratio of 20:1 or 23:1 (The latter ratio is only permissible under the approval of OSFI).
2. Risk-Based Capital Ratio (RBC)
Under the RBCR Ratio, institutions are expected to meet minimum risk-based capital requirements for exposure to credit risk, operational risk, and market risk should they have significant trading activity.
So if the banks were to engage in risky speculative bets on the markets, they should have an adequate amount of capital to cover those losses.
The RBC Ratio is calculated as;
As a result of the changes of the bank act, the general trend has been pointing towards the deregulation of the financial industry in Canada.
This has been evident in the amendments to the bank act in 1913, 1954, 1967, 1980, 1992, and 2002.
Still, there are strong calls from individuals such as the Governor of the Bank of Canada Mark Carney to reduce the leveraged positions of banks.
The Basel Accords first adopted in 1988 have been steps to manage the over-leveraged positions that the financial institutions hold.
It is ironic that the Basel Accords that were legalized in 1992 had been implemented on the same year as Mulroney’s PC government had phased out the reserve requirements for commercial banks.
In today’s dynamic financial industry, the Basel requirements are constantly being updated to accommodate the kinds of financial innovations that are being introduced.
Basel III which will be adopted in 2012 (but it will be enforced by 2019) have been measures brought forward to strengthen the capital requirements of banks and to introduce new regulatory requirements on the bank liquidity and leverage.
It is not certain whether the changes brought forward by Basel III will be sufficient in order to sustain economic growth, it is however, a step at least in the right direction.