Tag Archives: 2007-2008 Financial Crisis

Why didn’t Canada have a Banking Crisis?

The structure and performance of financial systems is path dependent. The relative stability of the Canadian banks in the recent crisis compared to the United States, where the recent crisis originated in the shadow banking system and spread to the universal banks, in our view reflected the original institutional foundations laid in place in the early 19th century in the two countries. The Canadian concentrated banking system that had evolved by the end of the twentieth century had absorbed the key sources of systemic risk—the mortgage market and investment banking—and was tightly regulated by one overarching regulator. In contrast the relatively weak and fragmented U.S. banking system that had evolved since the early nineteenth century, led to the rise of securities markets, investment banks and money market mutual funds combined with multiple competing regulatory authorities. The consequence was that the systemic risk that led to the crisis of 2007-2008 was not contained.

The historical origins of the U.S. system go back to the early national period when the states obtained the right to charter and regulate the banks. Supporters of Hamilton’s vision of an active federal government were able to charter the First and Second Banks of the United States, but opposition to federal control from a variety of sources including opposition from advocates of a narrow construction of the constitution, especially in the South, and opposition from the state chartered banks themselves, prevented the development of nationwide branching systems. Each state separately, jealous of its power to charter banks, prohibited branches of banks chartered in other states; an exclusion that was endorsed by the U.S. Supreme Court. The result was a fragile, crisis prone, banking system, but one that for all its weaknesses was deeply entrenched politically. Inadequate financing from a weak and fragmented banking system in turn led to heavy reliance on security markets for industrial finance. This may have contributed to rapid economic growth, but it also contributed to financial instability when stock market crashes and the failure of investment banks triggered financial panics.

Attempts were made to reform the system, but the fundamental structural weaknesses persisted. The national banking system was set up during the Civil War, but the state banks were allowed to continue, and to protect them the national banks were prevented from branching across state lines, resulting in America’s dual banking system. The Crisis of 1907 produced the Federal Reserve System, and the Crisis of 1929-33 produced Federal Deposit Insurance and an end to the gold standard. These were important reforms that contributed to stability, as did the rapid increase in federal debt in the portfolios of financial intermediaries during World War II. But despite these reforms the fundamental structural weaknesses of the U.S. financial system, a fragmented banking system regulated by a patchwork of regulatory agencies, survived intact. Although, some stability was achieved in the 1950s and 1960s, this system was undermined by the inflation of the late 1960s and 1970s. In the 1980s a weakened savings and loan sector collapsed with massive losses, but the crisis did not engulf the financial system as a whole. In this respect the Savings and Loan Crisis was more reminiscent of the troubles that affected, but were largely confined to, the savings bank sector in 1877-1878. Various reforms were put in place to deal with the savings and loan crisis, but again the fragmented banking and regulatory system remained in place. In short, even costly financial crises failed to generate sufficient political pressure for reform to overcome entrenched special interests.

The financial system recovered from the Savings and Loan Crisis and from a number of scares that might in different circumstances have triggered a panic: the Latin American Debt Crisis in 1982, the failure of Continental Illinois in 1984, the failure of Drexel Burnham (the junk bond investment bank) in 1992, and the failure of Long-term Capital Management 1998, among others. But the rapid growth of the “shadow banking system” in the late 1990s and early 2000s produced an environment in which major failures, although addressed by the Federal Reserve, ignited a panic. Opinions on the most important causes for the growth of the shadow banking system tend to diverge along political lines. The Report of the U.S. Financial Inquiry Commission (2011), reflecting the majority of Democrats on the Commission, attributed the growth of the “shadow banking system” to an ideological turn toward less regulated markets and political clout of regulated industries achieved through lobbying and campaign contributions. The dissenting Republicans put more weight on the Federal Reserve’s accommodative monetary policy and government housing policies.

What is clear is that the crisis of 2007-8 was…a return to the full-scale financial crises of the nineteenth century. Once again unregulated or lightly regulated sectors of the financial system, now dubbed the shadow banking system, proved to be the source of trouble. The details in terms of financial institutions and instruments were unique in 2008, but below the surface there were strong parallels with the nineteenth-century crises. True, prompt actions by the Federal Reserve and other agencies mitigated the damage. When a run on the MMMFs threatened, deposit insurance was extended, ending what might have been an extremely destructive run. Nevertheless, the macro-economic consequences of the crisis of 2008 rival those of the nineteenth-century crises. The Canadian story is very different.

The Canadian banking system began with note issuing branching banks which were more robust than their neighbours to the south. The system became stronger when double-liability was required to get a bank charter and as entry restrictions produced an oligopoly. By 1920 five large banks dominated the system and while new banks could enter the market they faced a formidable challenge in competing with the incumbents. Later in the twentieth century the Canadian chartered banks were able to absorb both the mortgage banks and investment dealers and become true universal banks. These institutions were regulated by an overarching regulator, OFSI, which basically contained the development of an unregulated shadow banking system and restricted the proliferation of securitization and off balance sheet entities. In terms of stability, to put it somewhat differently, the Canadian system benefitted from the “Grand Bargain” in which the Canadian banking oligopoly was protected from competition, especially from American banks, in return for tough regulation.

An attempt was made beginning in the 1980s to encourage the U.S. system to move in the direction of the Canadian system, but this did not happen. This reflected the legacies of the nineteenth century: a dual banking system, a strong shadow banking system, heavy reliance on financial markets, and multiple competing regulators. Even more basically it reflected longseated opposition to allowing the financial system to be dominated by a tightly regulated oligopoly. This opposition to the establishment of a British style oligopoly (which is embedded in the Canadian grand bargain) goes back to the beginnings of the Republic and once that option was rejected political economy considerations prevented it from ever being adopted.

References:

  1. Bordo, Michael D., Angela Redish, and Hugh Rockoff. “Why Didn’t Canada Have a Banking Crisis in 2008?” The Economic History Review 68.1 (2014): 218-43. Web.
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The 10 essential causes of the global financial crisis

I. Credit bubble. Starting in the late 1990s, China, other large developing countries, and the big oil-producing nations built up large capital surpluses. They loaned these savings to the United States and Europe, causing interest rates to fall. Credit spreads narrowed, meaning that the cost of borrowing to finance risky investments declined. A credit bubble formed in the United States and Europe, the most notable manifestation of which was increased investment in high-risk mortgages. U.S. monetary policy may have contributed to the credit bubble but did not cause it.

II. Housing bubble. Beginning in the late 1990s and accelerating in the 2000s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. Many factors contributed to the housing bubble, the bursting of which created enormous losses for homeowners and investors.

III. Nontraditional mortgages. Tightening credit spreads, overly optimistic assumptions about U.S. housing prices, and flaws in primary and secondary mortgage markets led to poor origination practices and combined to increase the flow of credit to U.S. housing finance. Fueled by cheap credit, firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mortgages and to make prudent financial decisions. These factors further amplified the housing bubble.

IV. Credit ratings and securitization. Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies erroneously rated mortgage-backed securities and their derivatives as safe investments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages.

V. Financial institutions concentrated correlated risk. Managers of many large and midsize financial institutions in the United States amassed enormous concentrations of highly correlated housing risk. Some did this knowingly by betting on rising housing prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions.

VI. Leverage and liquidity risk. Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their balance sheets. Many placed their firms on a hair trigger by relying heavily on short-term financing in repo and commercial paper markets for their day-to-day liquidity. They placed solvency bets (sometimes unknowingly) that their housing investments were solid, and liquidity bets that overnight money would always be available. Both turned out to be bad bets. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. Firms were insufficiently transparent about their housing risk, creating uncertainty in markets that made it difficult for some to access additional capital and liquidity when needed.

VII. Risk of contagion. The risk of contagion was an essential cause of the crisis. In some cases, the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance-sheet losses in its counter-parties. These institutions were deemed too big and interconnected to other firms through counter party credit risk for policymakers to be willing to allow them to fail suddenly.

VIII. Common shock. In other cases, unrelated financial institutions failed because of a common shock: they made similar failed bets on housing. Unconnected financial firms failed for the same reason and at roughly the same time because they had the same problem: large housing losses. This common shock meant that the problem was broader than a single failed bank–key large financial institutions were undercapitalized because of this common shock.

IX. Financial shock and panic. In quick succession in September 2008, the failures, near-failures, and restructurings of ten firms triggered a global financial panic. Confidence and trust in the financial system began to evaporate as the health of almost every large and midsize financial institution in the United States and Europe was questioned.

X. Financial crisis causes economic crisis. The financial shock and panic caused a severe contraction in the real economy. The shock and panic ended in early 2009. Harm to the real economy continues through today.

References:

  1. Causes of the Financial and Economic Crisis pages 417-419 (http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_hennessey_holtz-eakin_thomas_dissent.pdf)

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