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Oh, Canada!

On Thursday, the federal government will release the results of the “stress tests” performed on the nation’s largest banks. The release of those results likely will trigger a new round of debates over the health of the U.S. banking system and ways of better regulating that system.

According to a recent analysis by scholars at the Brookings Institution, American policymakers looking to better regulate the financial system might want “to consider taking a page or two from a model next door—Canada.”

Despite containing four of North America’s largest banks, Canada has not experienced a banking crisis like the one seen in the U.S. Note the authors:

Indeed, unlike several large U.S. banks these days, the sustained profitability of Canada’s is startling. While shares of Citigroup and Bank of America were trading at lows of around $2 to $4 in February, shares of Royal Bank of Canada and of Toronto-Dominion Bank were in the range of $24 to $37 …. Since the credit crunch began in 2007, write-downs taken by Canadian banks have represented a negligible fraction of the total recorded by banks and brokerage houses worldwide. In 2008, Ottawa had made available to the banks a comparatively modest $125 billion mortgage purchase program. But so healthy are Canada’s institutions, last month they announced that they no longer needed to use any of it.

What explains this stark difference? According to the Brookings’ scholars, the difference results not from Canada’s relatively small size, but from its regulatory system. Explain the authors:

The Canadian regulatory edifice is more centralized. There is no provincial equivalent to America’s state-chartered banks. All of Canada’s banks are federally chartered and overseen by federal agencies. One government-owned entity—the Canada Mortgage and Housing Corporation (CMHC)—plays a dominant role in shaping mortgage default-insurance policy….

Three additional features of the edifice stand out. For starters, over-leveraging is discouraged. The ceiling on leverage ratios (assets to capital) for Canada’s financial institutions is capped well below the U.S. norm (an average of 18:1 compared to over 25:1, respectively).

Second, the requirements for mortgage loans are relatively stringent. Down payments of at least 20 percent are ordinarily required, unless the bank obtains mortgage insurance through the Canada Mortgage and Housing Corporation. The CMHC exerts a prudential influence over mortgage underwriting…. Sub-prime mortgages are not unheard of in Canada, but the stiffer standards for lending have kept them to a minimum. In 2006, for example, sub-primes amounted to less than five percent of the country’s total mortgage originations, compared to over 20 percent in the United States.

Last but by no means least, CMHC, working alongside the banks, transparently plays a role in circumscribing residential mortgage securitization. Indeed, the great bulk of all lending in Canada takes place within the banking system itself, not through a largely unsupervised secondary market for bundles of loans and securities supposedly backed by other bundles of loans and securities—the “shadow banking system” that has burgeoned in the United States.

While economic, political and cultural differences make it impractical to simply replicate the Canadian regulatory model in the U.S.,  some  core features could be adapted to help prevent the kind of fiasco that has driven the U.S. financial system to its knees and  institutions like Bank of America to the brink of insolvency.

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