Why Canada Didn't Have a Banking Crisis in 2008

In Canada the banking system was ... a system of large financial institutions whose size and diversification enhanced their robustness.

When European and North American banks teetered on the brink of meltdown in 2008, requiring bailouts and extraordinary central bank intervention, Canadian banks escaped relatively unscathed. History explains why, according to co-authors Michael Bordo, Angela Redish, and Hugh Rockoff in Why Didn't Canada Have a Banking Crisis in 2008 (or in 1930, or 1907, or ...)? (NBER Working Paper No. 17312). Starting in the nineteenth century, Canada and the United States took divergent paths: Canada set up a concentrated banking system that controlled mortgage lending and investment banking under the watchful eye of a single, strong regulator. The United States allowed a weak, fragmented system to develop, with far more small (and less stable) banks, along with a shadow banking system of less-regulated securities markets, investment banks, and money market funds overseen by a group of competing regulators.

"[T]he stability of the Canadian banking system is not a one-off event," the authors note. "In Canada the banking system was created as a system of large financial institutions whose size and diversification enhanced their robustness.... In the [United States] the fragmented nature of the banking system created financial institutions that were small and fragile. In response the [United States] developed strong financial markets and a labyrinthine set of regulations for financial institutions."

The contrast is striking. While in 2008 and 2009 the United States experienced bank failures, bailouts, and the worst recession since the 1930s, Canada had no bank failures, no bailouts, and its recession was less severe than either that of the early 1980s or early 1990s. Long before 2008 in the United States, there were the failures of the private investment bank Jay Cooke and Co. (the 1873 crisis), the Knickerbocker Trust (the 1907 panic), and the runs on banks that deepened the Great Depression. Although Canada's economy suffered a collapse equally as dramatic as America's in the 1930s, not one of its banks failed.

"The twin weaknesses of the American financial system -- a commercial banking system divided along state lines and volatile financial markets in which a 'shadow banking system' of unregulated or lightly regulated investment banks and other financial intermediaries participated -- produced a series of financial panics," the authors write. "There were major banking panics in 1837, 1857, 1873, 1893, and 1907, and minor panics in 1839, 1884, and 1890."

One important factor, the authors argue, is that from the outset Canada's federal government had the authority to charter and regulate banks while the U.S. Constitution did not specifically reserve that power for the federal government. That led to constitutional disputes, an on-again-off-again national bank, and a dual system of federal- and state-chartered banks that were smaller, geographically confined, and thus more exposed to local economic conditions. The inherent weakness of the banks led to the development of stock and other securities markets that were far more robust than Canada's and to the rise of other intermediaries -- the so-called shadow banking system -- that were overseen by a patchwork of regulators.

Financial crises, particularly the Great Depression, spurred reforms to strengthen regulation. In the 1930s, the government created federal deposit insurance, the Securities and Exchange Commission to regulate securities markets, and stricter bank rules encompassed in the Glass-Steagall Act, which among other things separated commercial from investment banking.

For more than a century, the Canadian system has proven itself far more stable than its U.S. counterpart, the authors conclude. "[B]ut there is a caveat to keep in mind: greater stability may have come at a cost. A more concentrated and regulated financial system may have been slower to innovate, may have been slower to invest in emerging sectors, and may have provided services at monopoly prices."

--Laurent Belsie