How Safe Is Your Deposit?

Capital and risk, these two factors are what make Canadian banks a safer bet than American ones, especially during this past economic recession.

A Comparison between the Canadian and American Banking Systems

By Tony Ge, Online Staff Writer

Flickr by Andreas Duess

The average person usually thinks of banks as secure places to put one’s money, and most of the times, banks live up to society’s expectations. Indeed, it is hard to imagine how institutions of such nature could fail, unless one knows how they function and the risks they are exposed to.

The reality is that banks CAN and WILL fail without proper governance and prudent management.

In fact, the recent financial crisis in the United States demonstrated just how vulnerable these institutions are. After the housing market collapsed, banks in the U.S. were hit with massive defaults on loans, and the repossessed assets – houses in most cases – could not cover the initial value of the loans. The result? They didn’t have enough cash to keep up with withdrawals (illiquidity), and their total assets weren’t enough to cover their total debt (insolvency).

From 2008 to present, more than 100 banks in the United States went bankrupt.

Fortunately, things are cooler in the north (pun intended). Here in Canada, banks are more resilient and did not succumb to the crisis down south. There are 2 main factors which make our banking system more robust than its counterpart in the States:

Capital

Why is capital important? It provides a cushion for banks when their investments prove to be unsuccessful such as when there are mass defaults. When banks’ assets fall in value, they will still be able to meet their obligations with the depositors provided they have enough capital invested.

In the States, banks are poorly capitalized compared to Canadian banks. This is because there are hundreds of small banks scattered in the U.S. as opposed to 5 large banks in Canada, which allows banks in Canada to pool more capital.

A good measure of capitalization is capital ratio which is the ratio of the banks assets to its invested capital. Canadian banks have a capital ratio of 9.8% — every $1 of asset is backed by ¢9.8, compare to the U.S. banks with a capital ratio of less than 5%. Therefore, Canadian banks were in a far better position to weather the crisis.

[pullquote]Canadian banks were careful in managing the risks associated with their investments, while U.S. banks unwittingly exposed themselves to too much risk.[/pullquote]

Risk

Banks earn money by making investments and making a bigger return than the interest rate they pay out to depositors. One form of investment by banks is housing loans. During the housing boom, American banks were blinded by optimism in the market and sought to loan out as much money as possible. Loans were granted with lower-than-market interest rates to anyone and everyone, regardless of their income and ability to repay the loan. They failed to notice the bubble building up and shot themselves in the foot with their reckless practice.

In Canada, however, loans were always granted with prudence on an individual, case-by-case basis. Moreover, Canadian banks always seek to diversify their investments in different sectors and industries, so that a downturn in any individual sector will not be catastrophic. In other words, Canadian banks were careful in managing the risks associated with their investments, while U.S. banks unwittingly exposed themselves to too much risk.

Much of these differences can be attributed to the governance systems in the two countries because after all, banks are also profit-maximizing businesses, and they need to be regulated in order to best serve public interest. It is evident that the Canadian regulatory body has been very successful because our banking system is currently rated the safest in the world! Lucky us, eh?