Are Capital Markets Inherently Risky?

A new NBER paper by Michael Bordo, Angela Redish, and Hugh Rockoff look further into the causes of the superior performance of the Canadian Banking system:

The financial crisis of 2008 engulfed the banking system of the United States and many large European countries. Canada was a notable exception. In this paper we argue that the structure of financial systems is path dependent. The relative stability of the Canadian banks in the recent crisis compared to the United States in our view reflected the original institutional foundations laid in place in the early 19th century in the two countries. The Canadian concentrated banking system that had evolved by the end of the twentieth century had absorbed the key sources of systemic risk—the mortgage market and investment banking—and was tightly regulated by one overarching regulator. In contrast the relatively weak, fragmented, and crisis prone U.S. banking system that had evolved since the early nineteenth century, led to the rise of securities markets, investment banks and money market mutual funds (the shadow banking system) combined with multiple competing regulatory authorities. The consequence was that the systemic risk that led to the crisis of 2008 was not contained.

The superior performance of the Canadian banking system relative to the American one is a well-known fact in the banking literature. The decision by various populists and other forces to regulate American banking in a poor manner remains one of the single largest unforced errors in American economy history. Branch restrictions and other regulations led to a large fragmentation in the American banking sector, while Canadian banks were relatively more centralized. This meant that American banks were strongly undercapitalized and unable to deal with localized geographic agricultural shocks -- leading to chronic bank runs.

Canada avoided that. Even in the Great Depression, they largely avoided bank failure. Nor did they have deposit insurance until the 1960s. So it's not that the maturity transformation that banks do is inherently risky; or that financial systems are inherently prone to collapse. Instead, Canada just opted for a more stable, nationally centralized system that performed much better historically.

This paper adds to that knowledge by pointing out another key factor extending Canada's banking performance - the role of capital markets. American banks compensated for their geographical fragmentation by creating liquid capital markets on which to trade debt and other contracts.

The authors argue that this led to something of an inbuilt American national bias to rely on capital markets -- culminating recently with structured products like mortgage-backed securities. In Canada, comparable lending is still handled by banks extending loans to individuals. "Shadow banks" like Investment Banks have always been around in the US underwriting commercial paper or other offerings. These markets frequently failed during crises.

Interestingly, this difference also pops up in Japan, which I discussed here. The old Japanese school of Finance relied extensively on bank finance through the 80s. At that point, there was a large deregulatory shift in favor of capital markets, and also a financial crisis. That evidence isn't necessarily causal, but it is perhaps another reason to think that banking-oriented finance, as opposed to capital market-oriented finance, may have some advantages.