Should we follow Canada's example in banking?

In February Paul Krugman compared Canadian and American banking systems and argued that by following the example of the Canadian system, where there was no real mortgage crisis, we could solve many of the problems with US banks, and directly contradicted those who argued against big banks. Now some momentum is growing to regulate US banks after the Canadian fashion and encourage large "mega-banks." In the New York Times this week Peter Boone and Simon Johnson argued that the Canadian example is not the answer. They cite many of the same facts as Krugman, noting that while regulations for lending and leverage are stricter in Canada, in fact Canadian banks are as leveraged or even more leveraged than US banks. They content the only real difference is that Canadian mortgages are nearly all guaranteed by the Canadian government. That in actuality Canadian banks are just as inclined to risk taking as US banks and are even more certain of being able to receive a government bailout should that be necessary. The article even asserts that it is only a matter of time until Canadian banks start failing. These interesting points once again bring into question what exactly was responsible for the most recent financial crisis and exactly how to prevent it from occurring again. It seems that strong regulation could still be advisable at least for things like sub-prime mortgages and oversight into the sorts of risky behavior that government agencies like Fannie Mae and Freddie Mac engage in. The question of large or small banks doesn't seem to have an obvious answer however. While it could be argued that large banks can be more diversified and better able to handle market instability, especially in a well regulated market, the failure of such a large bank could prove catastrophic. On the other hand, with many smaller banks regulation is more difficult and in a crisis many banks could fail, which might not be as severe generally but could have just as dramatic local consequences and increase the amount of distrust in the banks and banking which would have severe consequences for long term economic growth.


Hunter said...

I don't agree with turning our banking system into one like the Canadian system. Our financial crisis is due to some of our major banks having all their eggs in one basket (housing). If I've learned anything from basic investing it's that diversifying yourself can save your investment if one were to collapse. Having only a few banks serving the entire country just seems like a prelude to a major disaster.

Dr. Tufte said...

Both Spencer and Hunter are probably right.

I do think that one of the problems with the U.S. banking system is lack of diversification.

But, that is mostly because we have so many local banks. I'd be in favor of anything that got us down to 100-200 banks nationally.