Politics

An Unnecessary Evil: How Canada ended up Insuring Bank Deposits

I’ve often drawn attention here to the virtues of the Canadian banking system, especially as it was between the passage of Canada’s first Bank Act in 1871 and the establishment of the Bank of Canada in 1935. After the Scottish banking system that flourished between 1716 and 1845, it is generally regarded, by myself and other members of the Modern Free Banking school, as the next closest thing to a genuinely “free” banking system. We also claim that such systems tended to be more stable than ones in which governments interfered more heavily.

In Canada’s case, this claim inevitably raises several questions. If Canada’s relatively “free” banking system was so stable, why did the Canadian government establish the Bank of Canada in 1935? And why did it establish a Canadian Deposit Insurance Corporation (CDIC) some three decades later? According to Douglas Diamond and Phillip Dybvig, among others, central banks and deposit insurance are solutions to fractional reserve banking systems’ supposedly inherent instability.  Why, then, should Canada have resorted to either unless it was because its banking system was far from being the paragon of stability free bankers claim it to have been?

Mike Bordo and Angela Redish addressed the question concerning the Bank of Canada decades ago.  Instead of finding any support for the view that the Bank was established to serve as a lender of last resort to a banking system that had proven to be unstable without one, they conclude that its creation “reflected a conjuncture of political imperatives”:

Domestically, the government needed to be seen as taking active measures in response to the Depression. The reduced faith in the omnipotence of the market system, coupled with public hostility towards the banking system, meant that the introduction of a central bank was politically popular. Internationally, foreign governments and international organizations were urging nations to create central banks to facilitate international monetary cooperation. It was these factors rather than strict economic efficiency that prompted the establishment of the Canadian central bank.

But what about the establishment of the CDIC? As we shall see, that was another decision in which neither concerns about banking-system instability nor a desire to achieve “strict economic efficiency” played any significant part.

A Remarkable Record

Anyone who knows anything about the history of bank failures in the United States can only envy that of its northern neighbor. What distinguished Canada’s record from our own wasn’t a lower bank failure rate: until the mid-1920s plenty of (mostly new and small) Canadian banks failed. The difference—and it was huge—was that holders of Canadian bank notes and deposits lost relatively little from those failures.[1] For example, as I’ve noted elsewhere, of some 55 Canadian banks that were in business at some point between 1867 and 1895, sixteen failed, but only three very small banks failed to pay their note holders in full. That most Canadian bank failures that led to creditor losses were of small banks was no coincidence: smaller banks were more failure-prone than larger, better-diversified ones. They were also less likely to be absorbed by larger ones, especially if judged to be insolvent.

Because note holders had priority over depositors, the latter tended to fare worse. Even so, the total losses suffered by all Canadian bank creditors during this period amounted to less than one percent of failed banks’ obligations. In contrast, in the United States during roughly the same period 330 national banks failed, with $98,322,170 in accumulated claims against them, of which $35,556,026, or more than 57 percent, remained unpaid at the period’s close. Taking account as well of the failure of another 1,234 state banks. with over half of their $220,629,988 in debts unpaid, one finds that the recovery rate for all U.S. bank failures wasn’t much better than that for some of Canada’s most costly individual bank failures.

Canadian banks’ later safety record also glows in comparison to that of U.S. banks. As a 1932 Federal Reserve study reports,

For the period 1901 to 1920 the assets of suspended banks in Canada amounted to about one-half of one percent of the average yearly banking assets of the country. The corresponding figure for State and national banks in the United States…was about seven times as large, or 36 per cent. For the eleven year period 1921-1931 the assets of suspended banks in Canada were again equal to about one-half of one per cent of the average yearly banking assets of the country, while the corresponding figure in the United States was about twenty times as high, or 10.7 per cent.

As the Great Depression wore on, the U.S. and Canadian records diverged still further. Whereas some 10,000 U.S. banks failed during that episode’s first three years, Canada suffered no bank failures at all throughout the entire depression decade. The 1923 failure of the Home Bank of Canada would prove to be both Canada’s biggest bank failure, and its last, for many decades.

More than any other episode, the Great Depression drove home the superiority of Canada’s system of large banks, with their nationwide branch networks, compared to the U.S. system at that time, which consisted of many thousands of mostly tiny, single location or “unit” banks. Being less diversified, unit banks, and those in rural areas especially, were poorly positioned to withstand major shocks. Having failed in droves during the relatively prosperous twenties, it’s hardly surprising that many more bit the dust during the subsequent, worldwide economic cataclysm.

Sound Banks, Unsound Banks, and Insurance

That the failure of so many U.S. banks during the early 1930s should have prompted calls for some sort of major reform is hardly surprising. Not for the first time, many argued that U.S. banks should be given greater freedom to branch, like their Canadian counterparts. But as had happened on previous occasions, and would continue to be the case for some decades, their efforts were thwarted by established unit bankers, who instead lobbied for federal deposit insurance. To say that the FDIC was established at the start of 1934 to serve as a crutch for a crippled unit banking system to lean on would not be at all inaccurate.

That Canada did not choose to adopt deposit insurance in the ’30s should also come as no surprise. Having suffered no bank failures or depositor losses from them, and having already improved, with apparent success, its bank inspection and policing procedures following the Home Bank’s failure, the Canadian government was under no pressure to insure bank deposits in the 1930s. On the contrary: the established Canadian banks aggressively opposed any such step, as they had whenever the idea was broached in the past.

Following the failure of the Home Bank, for example, a Parliamentary committee recommended that the Government consider insuring bank deposits. But Canada’s Department of Finance put paid to the idea. As Charles Calomiris and Stephen Haber report (Fragile by Design 2014, p. 311), besides seeing merit in chartered bankers’ complaint that insurance would reward the riskiest amongst them, officials there looked into the record of U.S. state deposit insurance schemes, and saw a parade of misadventures. They concluded, accordingly, that deposit insurance was “basically unsound”:

[I]t means that the conservative and properly operated bank would be called upon to bear the losses through mismanagement, fraud, and otherwise incurred by competitors over whom it has no control. The final outcome would only be a disaster as the public would not be called upon to discriminate between sound institutions, with whom their funds would be safe, and others.

The Canadian government felt compelled nonetheless to do something for the Home Bank’s 50,000 depositors, owing in part to the fact that its Minister of Finance had been told years before that the bank was cooking its books. Ultimately the government chose to partially compensate the Home Bank’s smaller depositors only, without otherwise appearing to stand ready to guarantee any bank’s deposits. It seemed a reasonable compromise, since no other banks were in any danger of failing. And if, like many such compromises, it didn’t really satisfy anyone, it at least proved durable enough to suffice for another 44 years.

Too Close for Comfort

During those 44 years, not a single Canadian bank failed. Yet by the early 1960s trouble was brewing. It wasn’t that more Canadian banks were in danger of failing: the next failures wouldn’t happen until 1985.  Canadian authorities had other concerns. By 1964, consolidation, which had long been whittling away at the number of chartered banks, had left only eight in existence; and this led the Porter Commission—a Royal Commission on Banking and Finance appointed several years earlier—to conclude that Canada needed “a more open and competitive banking system carefully and equitably regulated under uniform legislation.”

The problem wasn’t that chartered banks had no rivals. It was that their closest rivals weren’t subject to the same (“uniform”) regulations. These consisted of 61 trust and mortgage loan companies, all save 20 of which were provincially rather than federally incorporated. Trust and loan companies were able to prosper alongside chartered banks in part because the latter had been altogether prohibited from making mortgage loans until 1954, and could make them only to a very limited extent until 1967. Over time, as Ian Kyer explains in From Next Best to World Class, his 2017 history of the CDIC, despite not being banks, these companies became “so bank-like that they were dubbed ‘near banks’.”  The Porter Commission suggested that they be compelled either to become full-fledged banks (at least by being made subject to the same regulations) or to cease taking deposits. But that plan was deemed unworkable on the grounds that Canada’s constitution only gave federal authorities jurisdiction over “banks” in the official sense of that term.

Ironically, the very weakness of some trust companies came to the government’s aid when, in 1965, the Ontario-based British Mortgage & Trust Company (BM&T) found itself on the brink of failure, causing the Ontario government to offer to support it if that’s what it took to save it from a run that kept the chartered banks “busy opening new accounts for BM&T depositors who came with bulging purses and paper bags full of money.” BM&T was able to avoid bankruptcy, but only by agreeing to merge with another trust company. Its close call, and the heavy losses its shareholders suffered, softened the industry’s resistance to deposit insurance, while suggesting to the federal government a way to subject trusts to bank-like regulations without running rough-shod over Canada’s constitution.

The government’s solution, inspired in part by our FDIC, consisted of a deposit insurance scheme involving a flat-rate premium that would be mandatory for federally incorporated trust and loan companies, but optional for provincially incorporated trust and loan companies. The catch was that all participants had to abide by bank-like regulatory provisions. The strategy called for deliberately under-pricing the proffered insurance to make it attractive. Because insured trust and loan companies would then have an edge over their rivals, they could all be expected to join, as all in fact did. Insurance was, in short, trust and loan companies’ reward for subjecting themselves to federal regulation.

As for the chartered banks, they at first renewed their usual complaint that deposit insurance would favor riskier firms. That now meant the trust and loan companies, which were, according to John Wagster ( p. 1677), 21.74% riskier than banks! However, Kyer explains, on this occasion, instead of heeding their pleas, the government decided that the feared subsidy “was not a bad thing” after all, because it

wanted to encourage competition in financial services and that was hard to do if people feared putting their money on deposit with smaller, less well-established institutions.

In fine, the Canadian government was now willing to embrace deposit insurance, not to make Canada’s banking system safer, but to make it more competitive, even if that meant making it less safe.

Seeing the handwriting on the wall, and not wishing to let trust and loan companies gain an advantage over them, the chartered banks shifted from lobbying against the proposed insurance scheme to lobbying to be included in it. In the agreed-upon plan, in return for subsidizing their weaker rivals, they were to be allowed, for the first time, to compete with those rivals in the mortgage business. The Ministry of Finance announced its plan in mid-1966. Before Parliament could consider it in its usual, deliberate way, a run on another large trust company triggered an emergency sitting during which the measure was rushed through. It became law in February 1967.[2]

So the federal government achieved its goal. Or so it seemed, until the new arrangement started to have just the consequences bankers had predicted all along.

Told You So

Initially, the CDIC insured individual deposits at all member institutions for up to CA$20,000, charging them a flat-rate premium of one-thirtieth of one percent of covered deposits.[3] Just as the chartered bankers had warned, charging all institutions the same flat rate regardless of the risks they took meant that the safest ones could either subsidize the rest or become just as risky. The general under-pricing of coverage in turn gave all participants in the government’s scheme an incentive to take greater risks than before, while allowing them to operate on slimmer capital cushions. In other words, it created a serious moral hazard.

Canada’s post-1967 experience fits the conventional moral-hazard theory to a “T.”  As Wagster (p. 1655) reports, empirical tests “provide strong support for the moral-hazard hypothesis.” The CDIC’s establishment, he says, led to “a significant increase in the incentives for bank managers to increase financial leverage and asset volatility, produc[ing] a significant increase in the banks’ actuarially fair deposit-insurance premium.” Banks and trust and loan companies alike increased their leverage and took on riskier assets, with banks becoming just as risky as their formerly more risky rivals. The tendency of the insured companies to allow their capital ratios to fall was such that, within less than two years of the introduction of insurance, the federal and Ontario governments both felt obliged to dramatically increase bank and trust companies’ minimum capital requirements (Carr, Mathewson, and Quigley 1995, p. 9).[4]

When financial institutions take on more risk and become more leveraged, they also become more likely to fail. Sure enough, the decades following the CDIC’s creation saw more bank and trust and loan company failures than any preceding decade. A trust company failed in 1970, and another in 1972. But far worse was to come. Between 1980 and 1986, 21 more trust and mortgage companies failed, mostly owing to bad loans. Worse still, in 1985 Canada experienced its first bank failures—two of them—since 1923. Notably, both failures were of western banks founded after the CDIC’s establishment. Both banks were also small, with combined assets amounting to just three-fourths of one percent of chartered banks’ total assets. This, too, was in keeping with theory, which predicts that smaller institutions, being more likely to have high percentages of insured deposits, are most likely to take on more leverage and riskier loans. The deposits at almost all of the trust and loan companies that failed with assets insufficient to cover their liabilities were more than 90 percent insured (Carr, Mathewson, and Quigley 1995, Table 4).

In all, since 1967 43 of the CDIC’s members have gone belly-up, though thanks to significant reforms in the late 1980s and again in the mid-1990s, none have done so since 1996. In 2004, the Chairman of the CDIC’s Board of Directors himself summed up the record of its first three decades as a series of “costly and bitter experiences” (Kyer 2017, pp. 1-2).

A Pointless Reform

What made Canada’s deposit insurance gambit especially tragic is the fact that it didn’t even succeed in permanently increasing the chartered banks’ competition. At first it seemed to work according to plan, with 62 new trust and mortgage companies, or roughly two-thirds of those in existence in 1985, entering between 1968 and then, as well as several new banks. But, as Jack Carr, Frank Mathewson, and Neil Quigley point out (p. 7), the combined bank, trust, and loan company failures of the 1980s took such a toll that by the end of that decade chartered banks had fewer competitors in the retail deposit market than they’d had in 1967!

Some readers may be tempted, despite this outcome, to sympathize with Canadian government authorities. How else, they may wonder, could those authorities have prevented Canada’s chartered banks from taking advantage of their market power to exploit consumers other than by confronting them with more, albeit riskier, rivals?

Yet the temptation ought to be resisted, for several reasons. First of all, as Carr, Mathewson, and Quigley point out (ibid., p. 22), even in the absence of any other change, “the evidence weighs heavily against the claim that deposit insurance was required to promote competition.” Entry into chartered banking, though difficult, was by no means impossible; and, the 1965-6 troubles of a few trust companies notwithstanding, the strength of most others, and the growth of the industry up to that time, suggest that they would have been fully capable of competing with banks even without the benefit of insurance.

Second, popular accusations notwithstanding, it’s doubtful that Canada’s chartered banks ever commanded any considerable monopoly power. Although the complaint that they command such power has been looked into many times, the banks have always been found innocent. Back in 1932, for example, a Federal Reserve committee found that, despite the already small number of chartered banks at the time (the Home Bank’s failure had left 10 in existence), and despite their seemingly uniform policies, they competed keenly with one another through their branch networks, with every bank vying “to do its share of business in every settled community” (p. 102). “If by monopoly is meant the abolition of competition between banking institutions,” the committee concluded, “then clearly it does not exist in Canada.”

More recent studies find that little has changed since the 1930s. Comparing Canadian interest rates with those in the United States between 1920 and 1979, Mike Bordo, Hugh Rockoff, and Angela Redish find that Canadian bank deposit rates were above those in the United States throughout the whole period, and especially after the mid-1960s, when unregulated Canadian rates moved up with inflation, while regulated U.S. rates stayed put. The story for lending rates was similar. Bordo, Rockoff, and Redish could find “no evidence of a sustained differential in favor of the Canadian banks that would indicate significant welfare losses from monopoly behavior on the part of the Canadian banks.” “Evidently,” Bordo, Rockoff and Redish conclude, “the government-enforced cartel in the United States was more potent than whatever monopoly power large Canadian banks were able to exercise.”

Nor did further consolidation of the Canadian financial industry during the 1980s, brought about by that decade’s bank and trust company failures, change things. According to Sherril Shaeffer, tests of Canadian banks’ market power between 1965 and 1989 yield results that are “generally consistent with perfect competition,” while strongly rejecting the alternative “hypothesis of joint monopoly.” Finally, a 2007 survey of studies of monopoly power in various banking systems, including Canada’s, finds that they consistently rate Canada’s market for banking services “among the most contestable in the world.”

Finally, if Canadian authorities wanted to encourage entry into Canada’s market for banking services whether it was needed to counter banks’ monopoly power or not, they could have done so without creating a moral hazard problem, to wit: by lowering barriers to foreign bank entry. In fact, they eventually did just that. The 1980 Bank Act revision allowed foreign banks to establish Canadian subsidiaries. Within just five years, 50 such subsidiaries were established. Then, in 1999, foreign banks were allowed to establish branches in Canada, provided those only accepted wholesale deposits with a minimum value of $150,000. As a result of these measures, Statistics Canada tells us, it is now “almost as easy to do business at a foreign bank as it is at one of the major domestic chartered banks.” Today, besides the five remaining “big” chartered banks and 28 smaller domestic banks, Canada has 12 foreign bank subsidiaries and 22 foreign bank branches.

In what seems an ironic twist in retrospect, foreign banks that stick to wholesale (<$150,000) deposits can opt-out of CDIC coverage. Many have done so in fact, presumably because they felt it was unnecessary. As it happens, I feel the same way.

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[1] In his dogged determination to deny that the pre-1923 Canadian banking was relatively stable and safe, John Turley-Ewart overlooks this crucial distinction, treating the mere failure of many (mostly new and small) Canadian banks since 1871 as sufficient proof of the system’s inadequacy. “Canadians raised to believe their banking system has always been characterized by calm placidity,” he says,

should understand that the Big Five Canadian banks are not so much the product of a 150-year-old oligopolistic system as they are survivors of a Darwinian financial contest in which they proved more politically adept, smarter, faster, better risk-managers and far more competitive than new rivals that are now long-forgotten footnotes in Canada’s financial past.

Although this is quite correct so far as it goes, Turley-Ewart fails to mention that in general few if any Canadians suffered when Canadian banks went extinct, the Home Bank case being the exception that proves the rule. He is nevertheless correct when he notes that government bank inspections, begun in 1925, may have been instrumental in halting Canadian bank failures until the post-insurance era.

Having already written an excellent, though unpublished, history of the Canadian Bankers Association, Turley-Ewart has been at work on a new history of Canadian banking. If his Financial Post op-ed is any indication of that work’s perspective, yours truly anticipates having his work cut out for him when it appears! For the time being suffice to say that any attempt to portray Canada’s banking experience, or its experience at least until 1925, as either a free for all or a failure, should at very least prompt the retort, “compared to what”?

[2] In light of the overwhelming influence of the Diamond-Dybvig model, it bears emphasizing that Parliament’s precipitous action had nothing to do with fear that the run—on the Ontario-incorporated York Trust and Savings Corporation—posed any systemic risk. York Trust had been a victim of bad management; and while depositors, upon discovering the fact, rushed to withdraw funds from it they did not stage runs on other Canadian trust companies or banks—just as had been the case when BM&T got in trouble. As Jack Carr, Frank Mathewson, and Neil Quigley report (1995, p. 6), of the 60 other trust and loan companies in existence at the time of the run on York Trust, only 5 experienced net withdrawals for the 1966 calendar year. The rest “experienced rapid growth,” with an average increase in their public liabilities of almost 39 percent. It should be unnecessary to say that the chartered banks were completely unaffected. In fine, contrary to conventional wisdom and the assumptions informing certain popular banking models, Canadian “[d]epositors displayed an impressive ability to discriminate between the remainder of the industry and York Trust.”

[3] The Canadian and U.S. dollars were identical units until 1950. Afterwards they  floated against one another until 1962, when the Canadian dollar was fixed as 92.5 U.S. cents. In 1970 Canada allowed its dollar to float once again, as it has done ever since. The CDIC’s coverage limit was raised to CA$60,000 in 1983 and to CA$100,000 in 2005; and it finally switched from a single flat-rate premium to risk-based (“differential”) premiums in March 1999. Because CA$100,000 today are worth considerably less than CA$20,000 in 1967, these changes have all contributed to a reduction in the Canadian arrangement’s tendency to breed moral hazard.

[4] As Wagster (p. 1671) notes, although underpriced deposit insurance made both banks and trust and loan companies riskier, it also reduced “systematic” risk—meaning the risk that any one institution’s failure would cause others to fail. Because insurance eliminates insured depositors’ incentive to run for any reason, this result is hardly surprising. But as bank and trust and loan run contagions were extremely rare in Canada even before the advent of deposit insurance, it is also unimportant.

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