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The shocks experienced by Canada in the 80s were enough to galvanise political will to overhaul the system of banking regulation - thus enabling them to dodge the financial collapse, writes Christopher Goodfellow.

Canada was rated number one in the world for soundness of its banks in the latest edition of influential Global Competitiveness Report. By contrast, Ireland’s banking systems rates at the very bottom – 139th out of the 139 countries analysed in 2010/ 2011.

This puts the country’s banking system at the back of the class sitting alongside the likes of Ukraine (137), Mongolia (136) and Zimbabwe (135).

While the Irish banking system has required capital injections of €70bn and counting, the Canadian banking system has escaped relatively unscathed, with no major institutional failures. 

And, in the last quarter of 2010, Canada’s two main banks reported strong growth. Royal Bank of Canada’s earnings hit a record CAN$1.84bn (€1.38bn), up 23% from the same period in the previous year, and Toronto-Dominion (TD) increased its earnings by 19% to CAN$1.54bn (€1.16bn).

It’s easy to beat the hollow green, white and orange piñata that is Ireland’s banking system, but it’s worth remembering that the 2007/ 2008 Competitiveness Report rated Ireland 22 overall, only nine places behind Canada.

For the most part analysts point to the stringent rules governing leverage and capital ratios which cover Canada's banks when trying to explain their resilience to the economic shocks of the downturn.

The regulatory system that put these in place was forged out of a series of disasters experienced through the 1980s when an oil price crash caused several regional banks, trust companies and financial institutions in Western Canada to fail.

What at the time was seen as a curse of the oil rush in Alberta is now referred to as a “blessing” by the analysts that worked through its fallout.

Peter Routledge, an analyst at Canadian investment dealer National Bank Finance, said: “When the oil price crashed everything else went to hell in a handbasket. After that the country put in a progressive series of legislation that gave a lot more regulatory power and authority to the newly created Office of the Superintendent of Financial Institutions (OFSI).”

Paul McCrossan was a member of the Canadian parliament at the time and sat on the multi-party finance committee that recommend the formation of OFSI. He compares the Calgary-based boom of 1981 and 1982 to that of pre-crisis Dublin, albeit on a smaller scale.

“The committee recommended that we develop a single super regulator which became OSFI. This absorbed not only the superintendant of insurance, the inspector general of banks, but the office of the chief actuary, who is responsible for all social security plans in Canada. So it became really a regulatory powerhouse, if you will.”

OFSI opened its doors in 1987, monitoring every federally registered bank, insurer, trust and loan company, and private pension plan. On top of this, if any one entity of an organisation was monitored by OFSI every entity had to be monitored by OFSI. 

Around the time that the OFSI was formed the Canadian government also made the fortuitous decision to let commercial and investment banks merge. Contrary to the sentiment of the oft-lauded Glass-Steagall act this did not increase risks for depositors; rather it brought investment banks under the steely glare of the regulatory body’s commercial banking rules.

This enforced a very conservative leverage ratio of 20:1 (or in exceptional cases 23:1) on investment banks, and helped stop Lehman Brothers-like problems. Although regulatory figures did incur almost two decades of mild ear ache for these rules, investment bankers now recall the story with a wry smile.

While some of the decisions taken by Canada’s government could be cast as merely fortuitous, the size and scope of the OFSI operation provides a very clear contrast with the Irish approach and the methodology of the Irish Financial Services Regulatory Authority (IFSRA), OFSI’s equivalent.

OFSI operates a 400-strong team and its personnel have been daily figures in the offices of the country’s banks for the past two decades. It also has the power of compliance orders within is arsenal.

McCrossan explains: “The Canadian superintendent has the right to order any company to cease and desist any practice which they feel is not in the interest of the Canadian financial system.

 This happened around 1989 to 1990 with commercial mortgages – the superintendent went around the boards of the main banks and asked them to reduce their exposure,” he said, adding that the threat of an order was enough to instigate a change of procedure.

At the time that the crisis hit, Ireland had a lethal cocktail of a principles-based regulatory system that was both under-resourced and operating in a fragmented structure. When the IFSRA was established in 2003, it split the regulator from the Central Bank. Ray Kinsella, Professor of Banking and Financial Services at University College, Dublin, said: “At the time [that the IFSRA was formed] I was very, very specific; splitting the Central Bank into a financial regulator and a central bank makes no sense. If you are responsible for monetary policy you should be responsible for the stability of the institutions through which monetary policy is transmitted.”

Canada requires its bank’s Tier 1 capital ratio – the core measure of a bank's financial strength –to be higher than 7%. Further, behind closed doors the executives of Canada’s large, systemically important banks had been told that they needed to have Tier 1 capital ratios of more than 9%.

That said, in 2007, before the Irish economy began to shrink, Ireland’s big banks also had substantial Tier 1 capital ratios, all meeting the stringent Canadian requirement. AIB had a ratio of 7.5%, the Bank of Ireland 7.5% (year ending 31 March 2007), Permanent TSB 10.4% and RBS, which operates Ulster Bank as a division, 7.3%.

The simple truth is that even with high Tier 1 ratios, the capital held by Irish banks was nowhere near enough to absorb the losses that were ultimately realised.

Professor John McHale, Head of Economics at the National University of Ireland, said: “Huge vulnerabilities were built up in terms of both underlying bank solvency and the risk the banks would not be able to fund themselves as footloose wholesale funding fled.”

In October last year Julie Dickson, superintendent at OFSI, explained why regulatory systems needed to go further than simply looking at capital ratios: “Capital is one area which many have focused on. Capital is extremely important, but it is not a panacea. An institution will never have enough capital if there are material flaws in its risk management processes.”

According to Peter Nyberg’s report on the Irish banking system; “The long upswing in the property market, accompanied by relentless media attention, eroded the risk awareness both of banks and their customers in Ireland. Banks, citing the long sequence of good years, generally saw little problem in expanding their lending by allowing credit quality and risk management to gradually erode.”

It is difficult to quantify the extent to which quality of management at the two countries’ financial institutions affected the outcome of the crisis, but Canadian management has, at times, been famed for its conservatism.   At one point in the early 2000s Canada's TD bank was among the world's top holders of securitised assets. The decision to exit the non-North American structured products business in 2005 was taken not due to excessive regulation, but management prowess.

Ed Clark, TD’s chief executive officer, told the Wall Street Journal: "They became too complex. If I cannot hold them for my mother-in-law, I cannot hold them for my clients." A TD spokesperson explicated: “We made the decision to exit the structured products business because, simply put, we didn’t like the risk embedded in these complex, financially engineered investment vehicles.” Canadian banks also benefited from a lack of domestic competition. Having two main banks which significantly outgunned their nearest competitors created a consolidated oligopoly in which the two providers sold the bulk of mortgages.

“They had no incentive to stretch out along the credit curve for loan growth, and were happy to grow loans, perhaps at a slower rate than what they were seeing south of the border, and still make a lot of pretty decent return,” said Routledge.

The Nyberg report also highlighted the level of competition in Ireland as a root cause of its banks’ failure. It said that the willingness to accept higher risks by providing “more and shockingly larger loans” was due in part “because of the emergence of strong foreign and domestic competitors within both the residential and commercial property lending markets.

“…In other banks, boards seem to have simply decided on higher target growth rates, with little apparent realisation of the attendant risks; implementation (and risk policy) was implicitly left to staff.”

Contrasting the intricacies of these two banking system and the infinitely complex micro-economic climates in which they operated is difficult – and may require something more akin to the weighty tome that is the 172-page Nyberg report.

What is clear though is that the shocks experienced in Canada during the 1980s resonated loudly enough to galvanise political opinion and will to overhaul the system.  The Canadian government used the opportunity to establish a robust and commonsensical regulatory authority. This authority was formed on a principle of alleviating depositor risk – its central concern is that institutions focus on sound risk management – and created a banking system which performed exceptionally well during the global recession.

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