The Safest Banks in the World
Canadian banking is widely considered the safest banking system in the world, ranked as the world's soundest for the past four years by the World Economic Forum. However, one’s image of the word “bank” does not equate to safety and security in the minds of many. Recent headlines could have read, Bank of Montreal (BMO) Reports Great Year, Stocks Tumble or might have said TD Bank (TD) Down on Praise from Fitch or something like Royal Bank (RY) Softer after Good News. What is going on here is if your last name is “bank” it does not seem to matter what your first name is or where you live, the perception among investors is that you come from a bad family. That is incorrect when it comes to Canadian banks, which are a world apart from their 2nd cousins elsewhere. However, they are taking an unjustified beating in the stock market, which results in lower prices and makes them good values.
During the recent financial crisis banks in the U.S., Europe and many other regions failed. The same is not true in Canada, as recounted in The American, a publication of the American Enterprise Institute.
And this recent financial crisis isn’t the first time that Canada’s banking system showed greater signs of stability and less exposure to stress than U.S. banks. In the 1930s, when 9,000 U.S. banks failed during the Great Depression, not a single bank in Canada failed. When almost 3,000 American banks failed during the Savings and Loan (S&L) Crisis, only two small Canadian banks failed in 1985, and those were the first bank failures in Canada since 1923. And while almost 200 U.S. banks have failed since the start of the global recession in early 2008, Canada remains the only industrialized country in the world that has survived the last two years of financial and economic stress without a single bank failure. (February 2010)
Apples and Oranges
Both apples and oranges are fruits; however, they are not the same. They have different roots as do the banks of different countries and cultures. While the English were a Canadian influence, Canada had an influx of early settlers from Scotland; Nova Scotia is the name of an Eastern province. Today the Canadian banking system resembles the Scottish system more than English banking. It has 5 big banks, which transact 80% of the banking. They are inclusive in what they offer, from ATM cards, to investment banking services.
The limited number of banks, 23 Schedule I Canadian based banks, is a more stable system, and sounder. The U.S. system, with over 6,000 banking corporations, is quite competitive, but not nearly as strong or as stable. Canada continues to strengthen its system, and a bill to limit investment outside of Canada is under consideration as is a rules change to a higher reserve rate. However, these are not a reaction to a Canadian problem, but a proactive change for continuing troubled times worldwide.
Apples and oranges are so much alike that maybe that metaphor gives the wrong impression. Maybe it is apples and tomatoes, which I understand is botanically a fruit. In general, Canada’s banking system is more conservative and more resilient, while not given to the kind of investments that are akin to gambling. There is no sub-prime mortgage crisis in Canada, nor will there be. No contrived program is fueling a housing bubble. The aggregate of differences between the systems is enough to make them as great as the differences between apples and tomatoes. Let us compare.
Mortgages: In Canada mortgages are full recourse debt instruments. In the U.S. if you cannot or do not make your mortgage payments you simply walk away and the bank takes the house and in most cases you are free and clear of the debt. In Canada, almost all home loans are full-recourse mortgages. If you default, the bank can go after your other assets. In addition, the bank can garnishee your wages and take any other legal means to collect the debt.
Down Payments: The down payment of a house in Canada is 20% of appraised value. With less than that, the mortgage is insured for its full term, unlike in the U.S. system. Not only does the bank have to approve the appraisal to make the loan, the insurer can reject appraisals and require larger deposits. About half of Canadian mortgages are insured, giving the banks a bulwark between them and a defaulting homeowner.
Shorter Terms: In the U.S. the mortgage is often written at a fixed rate for 30 years. In Canada, the more usual term is 5 years, at which time the loan is rewritten at the appropriate current interest rate. The mortgage is more like the U.S. five year adjustable. This reduces the bank’s interest rate risk.
Mortgage Interest Deduction: This income tax deduction, a clever piece of legislation devised to support the housing and banking industries in the U.S., does not exist in Canada. Politicians sometimes portray the tax deduction as a way to increase home ownership. However, the percentage of homeowners in Canada is 69% compared to 67% in the U.S. The U.S. allows the tax deduction on home equity loans too. One can get a much better rate, a longer term, and a deduction if they use the house for collateral. The real purpose of the loan might be a new car or a vacation. The ratio of debt to home equity in the U.S. is about 55% and it is only 30% in Canada.
Mortgage Prepayment: In Canada there are stiffer penalties for prepayment which discourage it, especially at times when house values might be sliding. Here in the U.S., some people refinanced at the beginning of the housing crisis, taking the equity out of their houses and leaving the banks with little when homeowners walked away from the houses and the loans.
Using Banking and Housing to Implement Social Policy: In the U.S., politicians, some perhaps with noble intentions, have used the housing industry and the banking system to provide houses for those with low incomes. It has been called the American mistake of turning good low-income renters into bad homeowners. The Canadian government provides low-income rental housing. Thus, the banks do not have portfolios of mortgages with less-creditworthy customers, which might have made only a 3% down payment.
A Single Regulator: Canada's federal government has sole jurisdiction for banks according to the Canadian Constitution. The Office of the Superintendent of Financial Institutions is the regulatory agency that regulates all banks and life insurance companies. Meanwhile, the regulation of credit unions/caisses populaires, securities dealers and exchanges and mutual funds is largely by provincial governments.
In the U.S., regulation is by several federal government agencies. The Office of the Comptroller of the Currency (OCC) oversees national banks. The Board of Governors of the Federal Reserve System (FRB) oversees state-chartered banks that are members of the Federal Reserve System. Membership in the Federal Reserve System is required for national banks, but it is optional for state-chartered banks. The FRB also regulates bank holding companies. The Federal Deposit Insurance Corporation (FDIC) oversees state-chartered banks that are not members of the Federal Reserve System. The Office of Thrift Supervision (OTS) oversees federal savings and loans and federal savings banks. In addition, the 50 states charter and regulate banks that are not national or federal banks. Compared to Canada, the U.S. system is complex and greatly over-regulated.
Concentration of Banking: Canadian Banking is concentrated in 5 large banks, each with hundreds of branches nationwide. This limited number of banks makes the regulatory task all that much easier. It also makes it more responsive when there is a crisis as all involved parties can sit around a relatively small table in Toronto or Ottawa. The U.S., on the other hand, had regulations against interstate banking until the 1990s. Besides that, in the U.S. the Glass-Steagall Act of 1933, it separated retail banking from investment banking until its repeal in 1999.
Regulation and Politicization
If there is one single thing that is the ruination of American banking, it is its politicization. Programs to influence social change flow through U.S. banks. They support various housing, educational and business goals. For each there are volumes of rules and regulations. This creates a tangle of regulatory bureaucracy, which is ineffective in solving societal problems and a burden on banking. Regulation to manage risk and to protect stakeholders is appropriate; banks are not the venue for social engineering. In addition, there are too many chefs in the regulatory soup. Politicians messing with the system rarely enhance it. Marie-Josée Kravis, a fellow at the Hudson Institute, wrote in the Wall Street Journal,
Canadian banks are not compelled by laws such as our Community Reinvestment Act to lend to less creditworthy borrowers. Nor does Canada have agencies like Fannie Mae and Freddie Mac promoting "affordable housing" through guarantees or purchases of high-risk and securitized loans. With fewer incentives to sell off their mortgage loans, Canadian banks held a larger share of them on their balance sheets. Bank-held mortgages tend to perform more soundly than securitized ones.
Ms. Kravis also made it quite clear that it is not regulation that made the Canadian banks safer. It is good and prudent management.
Early in this decade, Canada's Toronto-Dominion bank was among the world's top 10 holders of securitized assets. The decision to exit these products four to five years ago, Toronto-Dominion's CEO Ed Clarke told me, was simple: "They became too complex. If I cannot hold them for my mother-in-law, I cannot hold them for my clients." No regulator can compete with this standard.
Tighter leverage limits in Canada may have dimmed the incentives for its banks to pursue securitization as brashly as their American counterparts. But regulations cannot take all the credit. Even with leverage ratios held on average at 18 to 1 (versus 26 to 1 for U.S. commercial banks and up to 40 to 1 for U.S. investment banks), Canadian banks would not be as healthy as they are had they not disposed of their more problematic securitized assets four to five years ago. Nothing in Canada's regulations banned risk-taking. Good, prudent management prevented excess.
Those who blame financial deregulation for the breakdown of U.S. markets should note that Canada shed its version of Glass-Steagall more than 20 years ago. Major banks thereafter rapidly bought and absorbed investment banks.
At that time, Canada established the Office of the Superintendent of Financial Institutions (OSFI) to provide common, consistent and more centralized regulation for federally regulated banks, insurance companies and pension funds. To this day OSFI is almost obsessively concerned with risk management, leaving social and economic objectives, such as access to affordable housing and diversity, to institutions better-suited to attain those goals. Those desirous of importing Canadian banking regulations to the U.S. should first delve more deeply into the actual practices of our northern neighbor's housing and financial system. Choosing selectively often leads to choosing poorly.
[May 7, 2009]
Rating the Banks
Global Finance is an organization that ranks the safest banks in the world each year. It is not surprising that the list of top 50 includes #11 Royal Bank of Canada, #13 Toronto Dominion Bank and #18 Bank of Nova Scotia (BNS), all before any U.S. banks. Bank of Montreal is #30 and #31 is Commercial Bank. These are 5 great banks, but it says little about the system.
Let us get the words of an expert, a respected scholar and economist:
Canada’s banks are generally ranked as the safest and soundest in the world, and their non-politicized banking system could provide a model for banking reform in the United States. Moving towards the Canadian banking system could go a long way towards stabilizing our mortgage, credit, and housing markets and make us less vulnerable to financial shocks in the future.
Mark J. Perry is a professor of economics in the School of Management at the Flint campus of the University of Michigan, and a visiting scholar at the American Enterprise Institute.
The World Economic Forum, in Geneva, Switzerland is the author of the World Competitiveness Report (.pdf). This annual report ranks the competitiveness of business environments of most countries in the world. The exhaustive report involves surveys of 14,000 executives worldwide. In the summary of “Soundness of Banks”, Canada is #1 of 142 countries.
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How to Invest in Canadian Banks
I believe that investing in Canadian Banks is a way to add safe financial sector investments to your portfolio.
Royal Bank of Canada (RY) stands out in the field of investment banking, and it is also the largest. This is a great institution with a proud history. Fairly valued.
Toronto Dominion Bank (TD) is likely the best growth prospect and has the most aggressive and perhaps the overall best management. It is expanding in the U.S.
Bank of Nova Scotia (BNS) has a strong international presence with dominance in the West Indies and profitable inroads in Latin America.
Bank of Montreal (BMO) and is a well-rounded and able organization, which does great wealth management and securities analysis. Down after great year, missing by $ -0.04.
Canadian Imperial Bank of Commerce (CM) is strong and sound but there has been some unsteadiness in its direction and performance in the past.
These are 5 great dividend paying banks, working within a great banking system in one of the greatest countries in the world. I believe that makes them great investments. These are recent prices and statistics.
Please see my earlier article for more insights concerning these banks. Other ways to invest include the Canada Fund, iShares MSCI Canada Index Fund (EWC) and the new Canadian preferred financial offering, Global X Canada Preferred ETF (CNPF), as well as Canadian Sovereign debt and bonds of these and other Canadian companies. The Canadian dollar is strong, and Canadian investments are a good hedge against the U.S. dollar.
Disclosure: I am long BMO.