The eyes on the banks

The real reason Canada’s banking system is so solid

Photograph by Andrew Tolson

That Canada’s banks withstood the global credit meltdown of 2008 better than lenders in the U.S. and Europe is widely known, and not only because the bankers and the federal politicians responsible for regulating them never tire of boasting about it. U.S. President Barack Obama paid tribute to Canadian financial-sector stability; so did Paul Volcker, the august former U.S. Federal Reserve Board chairman. Despite those kudos from on high, though, Canada’s top bankers are now worried that they might be hurt badly by new international rules designed to curtail the risky practices that brought their foreign rivals to the brink. Scotiabank CEO Rick Waugh said he fears Canadian banks will suffer “as others try to cover the failures of their own financial sectors.”

The key figure behind the highly praised Canadian regulatory system sympathizes with the bankers he used to keep in line. John Palmer was federal superintendent of financial institutions from 1994 to 2001, the stretch when Canada’s financial sector went from shaky to solid. Palmer, 66, works from Toronto these days, spreading the gospel of sound regulation to developing economies. Last year, the World Bank commissioned his advice on bank supervision. And when it comes to the Canadian model, he says, its crucial advantage is being missed. Outsiders assume tough regulations make all the difference. But Palmer contends the key to the reforms of the 1990s was less the rule book itself than in-your-face oversight by federal supervisors armed with discretionary powers over financial companies. “We changed the culture toward a kind of pre-emptive approach, a more judgmental approach,” he says. “We told ourselves that we couldn’t take risks.”

Since then, the shadow of the Office of the Superintendent of Financial Institutions has loomed heavy over Canadian banks. Under reforms passed by the Liberals in 1996, OSFI was charged with making precautionary calls as risky lending patterns or vulnerabilities on a bank’s balance sheet took shape. “It included a responsibility to intervene early in the affairs of a financial institution where OSFI detected weaknesses or possible problems,” Palmer said. “We couldn’t wait until all the evidence was in.” That clout is usually exercised behind closed doors, but occasionally a banker grumbles in public. Last month, National Bank chief executive Louis Vachon said OSFI was blocking banks from boosting dividends to shareholders out of concern for keeping up their capital levels.

These days, OSFI enjoys a high degree of credibility in such clashes. But until the global slump, critics had complained Canadian banks were being kept too staid, compared with the swashbuckling Americans and Brits. “Each country sets the balance point at a different location on the spectrum from wild unrestrained innovation at one end and constipated static financial activities at the other,” Palmer says. “Canada has chosen a point that is more conservative than the U.S. and far more conservative than the U.K.”

He ushered in a hands-on system. OSFI’s routine approach is to set up shop for months on end in the offices of the banks or other financial companies. Based on what they observe, the supervisors enjoy wide leeway to issue orders. Their insistence on being physically present might seem anachronistic in an age of digital data and virtual meetings. But Palmer explains: “To be honest with you, whenever supervisors do on-site examinations, they find errors. Often they occur in grey areas where there’s room for interpretation.”

Regulators in Europe don’t camp out in the spare offices of financial institutions they oversee and they don’t enjoy what Palmer approvingly calls “judgmental supervision” powers. In Britain, the sheer manpower required makes that Canadian way impractical. “Virtually every bank in the world is there in London,” Palmer observes. “The cost of introducing a Canadian-style model of supervision would be more than they are prepared to step up to.” U.S. regulation, though, looks more like Canada’s, making its failures harder for Palmer to explain. Though he hasn’t studied U.S. lapses in detail, he suspects economic doctrine might have made regulators less likely to intervene. “Their belief in the self-correcting nature of markets reached ideological proportions,” he says.

Economic ideology, business culture and even national character tend to be invoked often in the debate about what went wrong in the global credit collapse of 2008. Observers have speculated that Canadian financial executives were saved by their own congenital cautiousness. But that tends to ignore fairly recent history. The recession of the early nineties made Canada’s finance sector look anything but stolid. Troubled trust companies were swallowed one after another by the big banks, and the failure of Confederation Life stunned investors and consumers alike. Against this backdrop of instability, then-finance minister Paul Martin recruited Palmer, who was managing partner and deputy chairman of the accounting firm KPMG at the time, to apply discipline.

Palmer freely admits that he thought the next crisis was around the corner—and insisted that banks behave accordingly. “We felt sure,” he says, “that at some point we were going to have another recession and a banking crisis of whatever severity—mild, serious, we didn’t know.” As it turned out, the big test took longer to materialize than Palmer guessed, but no matter. “I’m a bit skeptical,” he says, “of the ability of authorities to determine with any precision where we are in the cycle.”

Fast-forward, then, to the U.S. subprime mortgage crisis of 2007, the global credit crisis of 2008, and the recession of 2009. After more than a decade of tough regulation, Canadian banks sailed into the storm holding plenty of so-called Tier 1 capital—solid stuff like common shares—to offset the risks inherent in lending money. Their leverage ratios—the amount of the banks’ loans relative to their readily available capital—stood at around 18:1. Regulators in Europe and the U.S. had allowed some banks to do business with ratios twice that. The outcome: the multi-billion-dollar bank bailouts required to avoid catastrophe in Europe and the U.S. weren’t needed in Canada.

Palmer doesn’t dispute that capital rules were a factor in that Canadian success story. But he sees heavy requirements now being proposed in international talks as a burden Canada has proven it doesn’t need. “Indeed, because we have, and will continue to have, much more robust supervision in Canada than exists in most European countries,” he argues, “our banks should be able to operate with less capital than those in countries with weak supervision.”

The proposed rules he worries about are being hammered out under what’s called the Basel III process. Last fall’s Pittsburgh summit of the G20 club of rich countries and emerging economies set the stage. “We have agreed to tough new financial regulations,” Obama said then, “to ensure that the reckless few can no longer be allowed to put the global financial system at risk.” The G20 leaders agreed to finalize reforms by late 2010 and implement them in 2012. The topic is expected to dominate the upcoming G20 summit in Toronto in June.

When the “reckless few” were targeted, Canadian bankers might well have imagined they were in the clear. But a wide net is being cast. Alistair Darling, Britain’s chancellor of the exchequer, is even pushing for a coordinated international tax on banks to pay for future bailouts. Canadian Finance Minister Jim Flaherty opposes the idea—not surprisingly, since Ottawa didn’t have to pay for any bailouts. Even if the tax dies, fresh regulation is certain. Nancy Hughes Anthony, president of the Canadian Bankers Association, says the rules aren’t her only worry—there’s also how they will be enforced. “We may have overly onerous, complex regulations that some countries will not be able to implement,” she said. “Those that do will be at a disadvantage.”

Palmer agrees the question of supervision is worryingly missing from the debate on new rules. His frame of reference is not limited to the Canadian scene. After leaving OSFI, he spearheaded a review of Australian regulation and then oversaw banks and insurers in Singapore, before coming home to head the Toronto Centre for Leadership in Financial Supervision, which is funded by the World Bank and the Canadian government to promote sound regulation, especially in emerging economies.

But if he’s a stride removed from Basel III, his philosophy is being championed by Julie Dickson, his successor as the current federal superintendent of financial institutions. She also presses for supervision, not just regulation, to be part of the new world order. As she put it in a speech last month in New York: “The rules are important, but ultimately it is the referees that control the flow of the game.”

Looking for more?

Get the Best of Maclean's sent straight to your inbox. Sign up for news, commentary and analysis.