Why Canada Can Avoid Banking Crises and U.S. Can’t

In populist democracies, the regulation of banking is used as a political tool to favor some parties over others

Since 1790, the United States has suffered 16 banking crises. Canada has experienced zero — not even during the Great Depression

ByVictoria McGrane

It turns out Canada can thank the French for their stable system, according to a paper by Columbia University’s Charles Calomiris, presented at the Atlanta Fed’s 2013 Financial Markets Conference.

When it became a British colony, the majority of Canada’s population was of French origin — and the French inhabitants hated the British government.

So to keep the colony firmly within the Empire, British policymakers steered toward a government structure that would limit the power of the French-majority while also giving Canada more and more self-government. The eventual result was a highly-centralized federal government which controlled economic policy making and had built-in buffers for banker interests against populist forces, the paper argues.

That anti-populist political system — known in political science as liberal constitutionalism or liberal democracy — is a key ingredient in Canada’s stable banking track record, Mr. Calomiris contends in his paper, which is a summary of a much longer book he’s written with Stephen Haber due out in September. That’s because this kind of political system makes it difficult for political majorities to gain control of the banking system for their own purposes, the authors contend.

Populist democracies like the U.S., on the other hand, tend to create dysfunctional banking systems because a majority of citizens gain control over banking regulation that steers credit to themselves and to their friends at the expense of the citizens that are excluded from the banking system, he said.

The contrast between the U.S. and Canada was part of Mr. Calomiris broader argument that dysfunctional banking systems — which are by far the norm rather than the exception around the world — are the result of political factors.

“Whether societies have dysfunctional banking systems is really not a technical issue at all. It’s a political issue,” Mr. Calomiris said at the conference, introducing his premise as “we do know how to avoid dysfunctional banking but that we make political choices – you might even say consciously” not to have functional banking systems for most of the modern era in most countries of the world.

The history of the U.S. banking system is one in which the government forms partnerships with different interest groups at different points in history, and those coalitions jointly influenced the way the banking system was regulated, Mr. Calomiris argues.

“In populist democracies, such as the United States, the regulation of banking is used as a political tool to favor some parties over others. It is not that the dominant political coalition in charge of banking policy desires instability, per se, but rather, that it is willing to tolerate instability as the price for obtaining the benefits that it extracts from controlling banking regulation,” he writes in his paper.

Backing up their argument: Only six countries – including Canada — have been crisis-free and at the same time have banking systems that provide abundant credit. Three of these – Singapore, Malta and Hong Kong – are small, island-bound city-states where the homogeneity of the population makes it politically difficult to create losers. The other three – Canada, Australia and New Zealand – all share histories of liberal democracy.

Mr. Calomiris argues that in the U.S., a coalition that emerged in the 1990s of government, big banks and activist consumer groups came helped fuel the housing crisis. Regulatory changes opened the door to a wave of mergers and acquisitions that created today’s megabanks. But banks still had to get approval – usually from the Federal Reserve – to complete those mergers and outside groups were able to weigh in on the wisdom of the deal as part of the Fed’s decision-making process.

Community groups, with the Clinton administration’s encouragement, used the Fed’s approval process to extract binding concessions from banks to loosen underwriting standards for poor, urban communities – concessions to which the Fed agreed, Mr. Calomiris argues. The banks had to apply the looser standards to everyone. That helped fuel an explosion in poorly underwritten mortgages that contributed to the depth and severity of the housing crisis, he contends.

All in all, Mr. Calomiris’ theory is a bleak one for the ability of financial reform efforts to make much of a difference.

“Smart economists with their regulatory ideas are sort of dead on arrival,” he said. “Political coalitions will decide — not whether you’ve got the right VAR model — [but] whether a banking system is going to be set up with rules that will lead it to be stable and have abundant credit or not.”