Saturday, February 20, 2010

Bank Regulation in the Canadian context - Part 2

To paraphrase from my previous post on the subject (link here), the stock prices of Canadian banks outperformed large American banks during two separate periods through the late 90s and the 2000s. One was a benign period from 1998 to 2005, and the other was the period from 2002 to 2009 (which culminated with the Great Recession), i.e. a combined good and bad period. However, Canada all through this period faced tighter banking regulation than the US banks. What worked in the Canadian example?

Per the FT article, there were three factors involved. And extrapolating from these factors, my belief is that it translated to one important difference in the operating philosophy of Canadian banks vis-a-vis US banks, or for that matter, even the ones in the UK and continental Europe.
- The first factor was a simple regulatory framework. The US famously had an alphabet soup of regulatory agencies that were competing for banks' business. Canada by contrast had a very simple set up. One agency to serve as the central bank - responsible for the stability of the overall system, one as a banking supervisor, one agency for consumer protection and the finance ministry that set the broad rules on ownership of financial institutions and the design of financial products.
- The second factor was a set of really simple and easy-to-follow risk guardrails on individual institutions, having little to no room for flexibility. the first such rule as a requirement of 7% of assets to be maintained as Tangible Common Equity or TCE. Now, 7% is quite a conservative number when compared with the 4.5-6% that US regulators have been comfortable at different points in time. Additionally, the OSFI required that the capital maintained be of the highest quality - shareholder equity. The Canadian regulators require that 75% of TCE should be comprised of shareholder equity. There is no room for quasi-equity products like preferred shares (which, incidentally have not turned out to be very useful from a capital standpoint for US institutions). Finally, the third requirement was a leverage cap of 20:1. Compare this with US banks that have consistently maintained higher leverage ratios in an attempt to expand investments and improve returns to stakeholders in an environment supposedly insulated from risk.
- Finally, a third important factor were the dealings between the Canadian bank regulator and the banks when it came to following rules. The Canadian system was based on principles, rather than narrowly following specific rules. It is about the spirit rather than the letter of the law. The head of the OSFI regularly met with the bank CEOs and was a frequent attendee to board meetings, especially in the ones having the non-executive board members attending. The bank CEOs on their part took interest in maintaining a stable system and paid serious attention to the advisement of the regulators.

Now, I am attempting to fill in the blanks beyond this point. My hypothesis on the operating philosophy of Canadian banks is that these simple and non-negotiable guidelines did not leave too much room for adventures such as optimization around edges, getting into illiquid and structurally untested asset classes (like the synthetic ABSs and MBSs), etc. Canadian banks realized that the one safe and reliable way of making money would be to focus on consumer/ business borrowing needs and meet them with simple lending products. The returns from a plain-vanilla banking business which centered around taking deposits and lending them directly to consumers and businesses, were secure and good enough to generate a healthy return on capital for these banks. Which then got captured in a healthy stock price. The creativity and the management talent of the bankers went towards meeting customer needs, as against getting into even more arcane areas of structured finance.

What does this all mean for risk management and its application? There is a myth out there somewhere that tighter regulations tends to dampen shareholder returns. The high-impact downside resulting from tail-events is prevented, but that is at the cost of profits during more normal times. However, that doesn't seem to have been the case considering the performance of Canadian banks. Canadian banks were more tightly regulated than US banks, i.e. risk management was tighter. But the banks clearly did not suffer as a result. Rather a principles-based risk management practice resulted in greater co-operation between banks and the regulators, allowed the banks to focus on the long-term drivers of value in banking and ultimately returned better returns to shareholders.

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