The Great Canadian Bank Bail-Out
The Canadian banking system is sound, we didn't have to bail-out our banks - right? Certainly that's what we are continually told:
"...we have not had to put any taxpayers' money into our financial system in Canada, nor do I anticipate that we'll be obliged to do so." Jim Flaherty, Minister of Finance
"Without wanting to appear arrogant or vain, which would be quite un-Canadian...while our system is not perfect, it has worked during this difficult time, I don't want the government to be in the banking business in Canada." Jim Flaherty, Minister of Finance
Then again we were also assured:
"We will not run a deficit." Jim Flaherty, Minister of Finance (Oct. 2008).
So political remonstrances notwithstanding, is any of this true? Doubts did begin to surface early in 2012 but interest in the issue quickly died out. The stability of the banking sector is a critical question. It is worth more than the cursory coverage it has received to date so let's spend a bit of time on it today.
Did we bail-out the Canadian banking system following the 2008 financial crisis and more importantly might we have to bail it out in the future? To set the stage here is some quick background on the Canadian banks then we can move on to the "no bail-out here" premise.
Canadian Banking Sector 101 - Concentrated, Large & Levered: Networks with highly concentrated nodes are not robust - the presence of single points of failure can have huge consequences. The Canadian banking sector resembles such a network in that it is dominated by just five banks. These banks are colloquially referred to as the "Big Five". Given their size and market presence I am sure the names will be familiar to you:
|(approx C$ billions Dec 2011)||Assets|
|Bank of Montreal||$500|
|Bank of Nova Scotia||$575|
|Royal Bank of Canada||$750|
Not only does this small group dominate the Canadian banking sector, the sector itself is very large in relation to domestic GDP. The larger the size of the banking sector, the greater the risk to the domestic economy or more accurately the wallets of the taxpayers in the event that a bailout is required. Of course, beyond a certain size banks are simply too large to be bailed out with domestic capital or to put it in more colourful terms - domestic banks run out of domestic taxpayer subsidies and then usually the game is up - see Greece, Italy and Spain in the list below.
|Bank assets as a percentage of GDP|
It is no secret that banks use leverage to generate returns. Additional leverage creates additional risk but with the hope of sufficiently offsetting profit. The trick is to use enough leverage to generate an attractive rate of return, but one which does not leave the bank susceptible to being rendered insolvent by a high impact event (e.g. housing market collapse). That is the theory. Sadly, given the explicit government support for "too-big-to-fail" financial institutions which removes the consequences of such insolvencies, in practice large banks will tend to carry excessive leverage and mis-priced risk at all times.
An accepted measure for bank leverage is the Tangible Common Equity ratio - "the ratio used to determine how much losses a bank can take before shareholder equity is wiped out. The Tangible Common Equity (TCE) ratio is calculated by taking the value of the company's total equity and subtracting intangible assets, goodwill and preferred stock equity and then dividing by the value of the company's tangible assets. Tangible assets is the company's total assets less goodwill and intangibles."
A rough estimate is that the Big Five TCE ratio hovers around 3-4%. It goes almost without saying that Canadian banking executives reject the TCE test as a measure of their leverage and risk for precisely the reason that TCE tends to show that they are over-leveraged and risky.
In order to ensure a reliable supply of bail-out funds it is critical that banks are able to argue with a straight face that the event that bankrupts them was entirely unforeseeable - at least to them. So despite what Canadian banks say I would argue the Canadian banking system has all the raw material that has made for crises elsewhere - concentration, large size in relation to domestic GDP, high leverage and mis-priced residential real estate risk.
No Bail-out in 2008-2010? The CCPA's study, "The Big Banks' Big Secret: Estimating Government Support for Canadian Banks During the Financial Crisis", convincingly refutes the belief that Canadian banks did not need or receive a bailout during the crisis. Directly from the report: "Canada's banks received $114 billion in cash and loan support between September 2008 and August 2010... They were double-dipping in not only two but three separate support programs, one of them American....At its peak in March 2009, support for Canadian banks reached $114 billion. To put that into perspective, that would have made up 7% of the Canadian economy in 2009 and was worth $3,400 for every man, woman and child in Canada."
Perhaps they did not need the money and just took it because it was offered? That does not appear to be the case. The CCPA study estimates that three of Canada's banks - CIBC, BMO, and Scotiabank - received bailouts that exceeded their market value at the time which does tend to support the conclusion that they were under extreme financial stress.
Mortgages were the usual suspect at the centre of the 2008 Canadian banking bail-out and so mortgages provided the conduit for government assistance. The default risk on approximately 50% of Canadian mortgages is in practice back-stopped by the Canadian government via the Canadian Mortgage and Housing Corporation. Banks do pay to insure their mortgages with the CMHC but at what could be argued are far below market rates given global real estate volatility and the escalation of pricing risks in the Canadian market.
Of course when the Big Five got into trouble the taxpayer CHMC, the Bank of Canada and surprisingly even the US Federal Reserve stepped into breach:
Clearly, no matter how much the Big Five would like us to believe otherwise, they experienced a severe liquidity crisis in 2008-2010 hence the need to sell performing but illiquid CMHC guaranteed mortgages. To fill this liquidity gap they received emergency funding on the order of size on a per capita basis of that received by the US banks. It is worth elaborating on this as it points the way to some serious concerns in the future. Canadian banks needed a bailout that amounted to approximately 7% of GDP when the large part of their asset base - Canadian mortgages - was not in any apparent distress.
What would happen to Canadian banks if the Canadian residential real estate market were to experience a US style correction and instead of a liquidity crisis the Big Five actually had a solvency crisis? For this thought experiment we have to assume a sharp fall in Canadian residential real-estate prices - based on current prices versus long-term historical averages, rents and income all being at highs that does not seem entirely implausible.
House Prices versus Income
House Prices versus Rental Costs
House Prices versus Historical Averages
According to research by Demograhia: "Historically, the Median Multiple has been remarkably similar in Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States, with median house prices having generally been from 2.0 to 3.0 times median household incomes, with 3.0 being the outer bound of affordability. This affordability relationship continues in many housing markets of the United States and Canada. However, the Median Multiple has escalated sharply in the past decade in Australia, Ireland, New Zealand, and the United Kingdom and in some markets of Canada and the United States. Housing in Canada is moderately unaffordable with a Median Multiple of 4.6 in major metropolitan markets." Emphasis mine
In summary, here is the very approximate state of the Canadian banking sector and its core holding, Canadian residential real estate ("RE") mortgages:
- Highly concentrated with the Big Five dominating the sector
- Total assets held by the Big Five are much larger than the size of the Canadian economy
- Big Five are using high leverage based on a conservative measure such as the Tangible Common Equity ratio
- Residential RE prices have an average Median Multiple of 4.6 in major markets versus the historic average of 2.0 to 3.0
- C$1.3 trillion in residential RE mortgages, 50% held by the CMHC, 50% by Canadian banks
- Residential RE mortgages represent approximately 40% of bank assets
I'll leave the final conclusion to you about whether Canadian banks are as robust as they are made out to be, but I believe that given the structure of the Canadian banking sector and the level of residential RE prices there is a higher chance of a crisis and a future bail-out than is commonly perceived.
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