Tuesday, March 7, 2023

Free vs Regulated Banking: Canada’s Post-1935 Success and the USA’s Failures

Click here to read the original Cautious Optimism Facebook post with comments

8 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff explains Canadian banking’s modern day success and stability with a brief summary of how subprime mortgages played out both in the USA and north of the border.

Some 1990's and 2000's U.S. regulations
 that never existed in Canada

Before 1935 Canada possessed the industrialized world’s least regulated banking system yet never experienced a financial crisis. 

By then the United States, with the industrialized world’s most regulated banking system, had already endured fifteen banking panics going back to 1792.

However since 1935 the Canadian government has caught up with the rest of the world and imposed a great deal more control over its banking industry.

The Bank of Canada is now monopoly issuer of the currency, has unilateral control over the banking system’s level of reserves and interbank lending rates, and provides a lender of last resort to member banks.

Federal deposit insurance was introduced in 1967, and today Canadian regulators impose legal capital ratio requirements on banks, inspect merger requests for antitrust violations, and dictate what types of bank investments are too risky.

Yet even as the Canadian banking system increasingly resembles the USA’s Canada has still managed to avoid a financial crisis—ever.

Meanwhile the United States, even with the imperfect but reasonably effective remedy of federal deposit insurance since 1933, has still managed to suffer through the S&L Crisis of the late 1980’s and the Great Financial Crisis of 2008. 

And while American banks received over $400 billion in bailout loans from the U.S. Treasury in 2008 and 2009, Canadian banks remained profitable during the global GFC and didn’t take a penny from the Canadian government.


What’s the difference between these two seemingly similar regulatory regimes? Why has Canadian banking continued to enjoy such stability and served as a model to the world while over 80 countries, the USA included, have suffered 140 financial crises—defined as aggregate failed bank losses greater than 1% of GDP—since 1978 (Calomiris, 2010)?

The answer again lies in good versus bad regulation.

First we’ll concede that a monopoly central bank is generally an example of bad regulation, and Canada has one. The Bank of Canada has even recently done the country the disservice of inflating a huge housing bubble, the final outcome of which remains to be seen.

But although central bank-induced asset bubbles are major contributing factors to financial crises, they usually aren’t enough to induce panic on their own. Most monetary economists know it takes more than just the central bank.

The other critical element, notably absent in Canada, is a lowering of lending standards.

And historically the United States has had a lot of that, imposing lower lending standards on its banks via regulation. 

For America’s first 170 years state-level unit banking laws restricted bank branching making it difficult to impossible for banks to diversify their loan portfolios.

Unlike the USA, Canada has never told its banks they can’t branch. 

Also unlike Gilded Age America, the Canadian government never restricted the national supply of currency based on the level of federal debt its banks held. And also unlike the United States, in recent decades the Canadian government hasn’t imposed regulations to openly force banks to lower lending standards in the name of social justice.


During the years leading up to the 2008 financial crisis U.S. Congress was able to force American banks to either lend $1 trillion directly to uncreditworthy borrowers or to finance lots of subprime mortgages that were originated by mortgage lenders like Countrywide and GMAC.

All of this was mandated by the 1995 Community Reinvestment Act (CRA), a law that was originally passed in the name of anti-racial discrimination.

Supporters of CRA argue Countrywide and other mortgage lenders were never CRA-regulated, only commercial banks. Therefore, they say, the public should blame the free market for the bad loans of the 2000’s.

But it was the regulatory mandate that forced commercial banks to seek out poor-credit borrowers—not the banking industry’s usual clientele—from mortgage companies to begin with. Regulators imposed the mandates, mortgage lenders provided the shaky borrowers, and CRA-regulated banks had to supply the money.

Hence pardoning CRA for bad loans originated by mortgage lenders is tantamount to exonerating the tax code for tens of millions of annual TurboTax and H&R Block tax returns. “After all, the IRS never forced TurboTax and H&R Block to file all those returns” is the twisted logic. 

But of course it’s the complex tax code that drives taxpayers into the arms of tax preparers every year just as CRA drove commercial bank money towards mortgage lenders.

The CRA-regulated bank/mortgage lender relationship has all but disappeared from online marketing websites since the 2008 debacle, but the Economics Correspondent saved one particularly large marketing pitch from the many he saw in that era from large mortgage lenders offering to help banks satisfy CRA regulatory mandates.

From 2004:

"Countrywide's goal is to meet the Six Hundred Billion Dollar challenge, funding $600 billion in home loans to minorities and lower-income borrowers, and to borrowers in lower-income communities, between 2001 and 2010. As of July 31, 2004, the company had funded nearly $301 billion [!] toward this goal."

"The result of these efforts is an enormous pipeline of mortgages to low-and moderate-income buyers. With this pipeline, Countrywide Securities Corporation (CSC) can potentially help you meet your Community Reinvestment Act (CRA) goals by offering both whole loan and mortgage-backed securities that are eligible for CRA credit."

-Countrywide marketing website (now defunct)


The Clinton and George W. Bush White Houses ordered Fannie Mae and Freddie Mac, via Department of Housing and Urban Development directive, to purchase more and more low quality mortgages from U.S. banks including CRA loans, bundle them into securities, and sell them off with an implied taxpayer guarantee—all in the name of “affordable housing.”

From the 2000 American Bankers Association Conference:

"We will take CRA loans off your hands–we will buy them from your portfolios, or package them into securities–so you have fresh cash to make more CRA loans. Some people have assumed we don’t buy tough loans. Let me correct that misimpression right now. We want your CRA loans because they help us meet our housing goals.”

-Jamie Gorelick, Fannie Mae Vice Chairman

By the dawn of the financial crisis a minimum of 56% of Fannie and Freddie’s annual mortgage purchases were mandatory “below median income” via HUD directive, and 24% of all mortgages were mandated “special affordable” which was defined as “very low income.” 

(see top chart for visual and note mandate increases in 1996 and 2001)


True to the historical pattern, Canada avoided the 2008 crisis by never having any such laws let alone on such immense scale. 

There is a smaller version of Fannie Mae in Canada –the Canada Mortgage and Housing Corporation or CMHC—but it guarantees less than half the mortgages of Fannie Mae and Freddie Mac as a share of the market. To compare…

By December 2007 Fannie and Freddie held or guaranteed $5.4 trillion in mortgage assets, about half the $11 trillion U.S. mortgage market at the time, and were holding or guaranteeing $3.5 trillion in mortgage backed securities, most of which they had packaged themselves from their low-to-moderate and very-low income purchases (see regulator OPHEO's 2007 chart).

While CMHC is not in the business of holding lots of mortgages, in December of 2007 it did guarantee CA$165 billion or 20.8% of Canada’s then CA$792 billion of mortgage debt (source: CMHC and Statistics Canada).

The United States GSE’s and the Canadian CMHC: Half vs 20.8%. Big difference.

But the biggest difference of all is CMHC’s role. Unlike the 2000’s Fannie and Freddie, CMHC more resembles the pre-Clinton administration Fannie: guaranteeing quality mortgages instead of encouraging unsound lending by buying up huge quotas of junk mortgages in a political social engineering scheme.

All throughout the housing bubble years and beyond, Canadian credit quality was and remains high. Just ask any Canadian homeowner about mortgage lending standards.

Canadian homeowners have to reapply and requalify for their mortgages every five years, effectively making all mortgages adjustable-rate.

There’s no such thing as a 30-year fixed mortgage in Canada which is an almost uniquely American invention—created by FDR with government mortgage guarantees during the Great Depression.

2% down, 1% down, and zero-down mortgages are unheard of in Canada, and the absolute minimum down payment in Canada has only recently been lowered to 5% for balances under $500,000 (10% above $500,000 and 20% above $1 million).

(Note to Cautious Optimism’s Canadian readers: Never having bought a house in Canada, if the Correspondent has slipped up anywhere please post your thoughts in the comments section.)


So how have Canadian banks managed to keep lending standards so high while the U.S. government has beaten American lending standards down? 

Simple. Even though for decades there have been many populist bills floated in the Canadian House of Commons to force banks to lower lending standards, they have consistently been blocked by the more level-headed Canadian Senate.

Now before Canadian readers roll their eyes at the idea of their senators being “level headed,” I only ask them to compare their banking legislative edicts and public demeanor of their senators to that of U.S. senators past and present like Bernie Sanders, Elizabeth Warren, Corey Booker, John Fetterman (may his health improve), Al Franken, or even Senator Barack Obama.

Over many decades the U.S. Senate has passed countless laws that forced or rewarded American banks for lowering lending standards including the creation of the GSE’s, Federal Housing Administration, and the CRA.

But the Canadian Senate, which like the U.S. Senate prior to the U.S. Constitution's 17th Amendment (1913) is not directly elected by Canadian voters, has been far less populist when it comes to tinkering with bank regulation. 

Which is why it was possible for American loan applicants with no job and no income to access vast pools of mortgage credit in the 2000’s while Canadian banks were still allowed to tell such borrowers “no”—and did.

The Economics Correspondent doesn’t know if Canada’s winning streak will last forever. The Bank of Canada has inflated a housing bubble of its own, and should it deflate the banking industry will incur higher loan losses. But the size of such losses is less likely to be catastrophic when lending to more creditworthy borrowers – something Parliament has so far allowed the industry to keep doing.

In our last installment we’ll discuss the question of Glass-Steagall restrictions and Canadian financial stability.

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