The Nature of Canadian Banking System - Term Paper Example

? Canadian Banking System of the of the Number Introduction Globalization and liberalization of the world economy has made the state of economic affairs highly complex in nature. The essay describes the precise way in which the Canadian banking system had survived the subprime meltdown in the global economy. The subprime mortgage crisis that had taken place in the economy of U.S. was responsible for a series of events in the global economy. This event is of much importance as the subprime crisis was indirectly responsible for the financial crisis in the global economy and the subsequent recession that had began since 2008. High interest rates in mortgage had increased the lending operations of the commercial banks. The quality of credit started to fall drastically. This had resulted in the collapse of many financial institutions. However, the Canadian banking system had managed to survive these critical conditions. Thus, it is highly rational to realize the underlying cases for this success. The following essay would consider the background, methodology and analysis regarding the topic of discussion (Brender & Pisani, 2010). The goals of the essay are as follows: To understand the nature of Canadian Banking System. To interpret empirical data explaining the various types of banking economic indicators. To analyze the models or the policies those were used by the banking institutions of Canada to protect their economy from the impending danger. To conclude on the overall performance of the Canadian banks in the context of the matter of discussion. Background It was found that during the subprime meltdown, the nation of Canada did not encounter an absolute collapse of its financial institutions. The five commercial banks in Canada had experienced profit during the financial crisis in the money markets of other economies. The commercial banks in Canada did not require any kind of explicit bail outs from their government at that time. It is rather astonishing to notice that even during the period of Great Depression, the commercial banks in Canada did not face any type of financial crisis. The Payments System Advisory Committee, established in Canada in 1996, has the responsibility to keep a check on the various lending and deposit operations of the commercial banks in Canada. There are three characteristics of the monetary authorities in Canada: The different monetary policies which are undertaken by the commercial banks in Canada are introduced by the Bank of Canada. This banking organization is owned by the government of the country and is highly interlinked with the Federal government. However, it should be observed that the federal government is not allowed to interfere in the monetary affairs of the country. The rates of interests charged on different assets in Canada are the same for similar assets in the other regions of the country. The Bank of Canada is the primary organization that engages in the function of issuing money to the economy. There is only a single policy instrument that is adopted by the Bank of Canada. The Bank of Canada often charges the overnight interest rates for the country. By changing the level of overnight interest rates, the bank introduces various changes in the different interest rates in the market. Reasons for the Success Many analysts and economists believe that the strong regulations which are implemented by the commercial banks of Canada were responsible for their successful performance even at the critical situations. Moreover, the commercial banks in Canada were highly united with each other, which in turn had helped them to coordinate and take business decisions jointly. In Canada, if the commercial banks had offered credit to the individuals on 80% of the value of a house loan, then they ensured that the debtor had insurance for the mortgage. The banks only issued loans to those individuals, with a worth of 80% (mortgage value), who could offer the mortgage insurance against the loan. Moreover, the commercial banks also maintain 7% extra reserve over its tier of capital. The leverage restrictions of the commercial banks were also maintained in a manner which assures that the total assets relative to the equity were limited. However, it was also important to analyze that those insurances in the mortgages or the excessive restrictions in the leverage ratios were not the only reasons for success of the commercial banks in Canada. The government of Canada has largely assisted the commercial banks in the country. Even today, a large number of mortgage loans offered by the commercial banks are assured by the government of the country. The commercial banks pay very low amounts to insure the mortgages. The Canadian Mortgage and the Housing Corporation is the organization, established by the government, to tackle the riskiest loans which are offered by the commercial banks. Thus, the risks on the mortgage loans offered by the commercial banks in Canada were tackled by the government. It is estimated that the commercial banks in Canada are entangled with each other in terms of an oligopolistic market structure. This is an imperfect information market structure and under its regime, the commercial banks in Canada charge high prices to its customers. So, they had charged high prices to the customers and had experienced substantial amount of profit in the market even at the time of financial crisis. There was also not much political intervention in the country that could have interrupted the working of the commercial banks. The following section contains the statistics regarding the bank rate, bond yield and guaranteed investments in Canada. Table 1: Bank Rates Year Bank Rate 2005 3.5 2006 4.5 2007 4.5 2008 1.75 2009 0.5 2010 1.25 2011 1.25 2012 1.25 (Source: Bank of Canada, 2013) Figure 1: Bank Rates of Canadian Bank from 2005 to 2012 (Source: Bank of Canada, 2013) Table:2 Bond Yield (Source: Bank of Canada, 2013) Figure 2: Bond Yield in Canada (Source: Bank of Canada, 2013) Table 3: Guranteed Investments In Canada (Source: Bank of Canada, 2013) Figure 3: Falling Guaranteed Investments in Canada (Source: Bank of Canada, 2013) Figure 4: Risk Management Tools (Source: Deloitte, 2011) Table 4: Variance of the Bank Rates (Source: Bank of Canada, 2013) Figure 2: Variance in the Bank Rates in Yearly Basis (Source: Bank of Canada, 2013) Methodology The researcher has used data collected from secondary sources for the purpose of the research and analysis. A data is a set of empirical observations that helps to analyze several economic theories. The researcher has adopted the technique of historical data analysis to analyze the above statistics. This means that the entire research work by the researcher is based on the data of previous years. For the purpose of the historical data analysis, the researcher has primarily utilized the data from the year 2005 to 2012. This is because the mortgage crisis in the global economy had taken place between this time span. By observing the data models in the above context, it can be stated that the researcher has used a time series data for the purpose of the historical data analysis (Hulster, 2009). A time series data is also known as a micro data. It explains the value of a particular variable for a number of years or for different time dimensions. This type of data provides a detailed analysis of the performance of the concerned variable. It is assumed by the researcher that the time series data collected on the above statistics are completely stationary series. This means that for repeated samples, the means and the variances of the probability distribution are constant and time invariant. The researcher has utilized various graphical models to explain the tabulated data sets. These graphic models are mainly line diagrams that show the correlated relationships between the time dimensions and the economic variables. Towards the end, statistics shows a graph of the variance of the bank rate. Variance is a measure of dispersion, which shows the degree by which the collected data is scattered. With a greater variance of a given data set, the variability of the observations is greater with respect to the mean value (Agatha, 2011). While introducing the bank rate variance model, the researcher has calculated each value of the variance on basis of twelve observations in a year. The formula used for the calculation of the variance is: Variance = 1/N ?(X-X’)^2. Where N is the total number of observations = 12 in each year. X= All the observations. X’ = is the mean value of all the observations. The data is collected from the official website of Bank of Canada, which sets the different regulations for all the other banks in the country. It should not be ignored that the underlying cause for the success of the Canadian banking institutions is the oligopolistic market structure in which they operate. Thus, the researcher has also used the model of Oligopolistic market structure to examine the nature of the banking functions of the Canadian Banks. Figure 3: Oligopolistic Market Structure (Source: Boyes & Melvin, 2012) The above graph shows the market demand (d), Marginal Revenue (MR), Marginal Cost (MC) and Average Total Cost (ATC) faced by an oligopolistic firm. In an oligopolistic market structure, the firms in the market face cut throat competition with each other. The price and the quantity of supply of each firm are subjected to the assumption of strategic behavior of the rivals in the industry. Thus, if these banks of Canada are assumed to be the oligopolistic sellers, then it can be also assumed that the credit offered by them in the market are the services sold by them (Brian & Vane, 2002). Analysis It is assumed by the researcher that the time series data collected is stationary in nature. The global financial crisis had triggered the financial emergency in most of the economies in the world. It was found by the financial institutions in these economies that the rates of deposits in the banks were less than that of the availability of credit in the markets. Most of the banking institutions in Europe and United States offered easy credit to the investors. The supply of easy credit in these economies had reduced the quality of the creditworthiness of the borrowers. This had in turn increased the number of failed projects in these economies. Extensive amount of implicit bail outs offered by the public authorities had increased the overall threshold of budget deficits of the government. As a result, the public authorities were not able to counter the impending risks of the commercial banks. This had become an era in which many commercial banks from the developed countries like, J P J Morgan Chase and Lehman Brothers had collapsed (Joshua, Jurek & Stafford, 2009). However, when the above statistics explaining the economic indicators of the commercial banks in Canada are observed, it is found that they had survived even at the time of the subprime economic meltdown. The underlying cause is actually the strong regulations of the commercial banks in Canada. As stated in figure 4, the banks always scrutinized the probability of upcoming risks. As shown in the figure, there were several types of risk measures adopted by the banks. The gearing ratios of the commercial banks in this nation were subjected to high restrictions. The derivative counterparty risks faced by the commercial banks in these nations were also reduced. As stated in the data of table 3 and the figure 3 in the above context, the rate of worthy investment loans offered by the commercial banks in Canada were lowered during the period of 2008 to 2010. This means that the Canadian banks did not offer loans to the investors who did not possess the capability to pay them back (Admati & Hellwig, 2013). The decisions made by the banks to offer loans to the investors in Canada were made after calculating the risk associated with each loan. The levels of the creditor appraisal tools were also high for these commercial banks. The Basel rules of the banking operations had helped these commercial banks to decide over their lending and deposit activities. These rules had helped the commercial banks to check the powers and authorities of the corporate business firms. The Dodd Frank Act has established a special committee for risk management that had to regulate the risk offers of the commercial banks in Canada. Thus, it can be stated that commercial banks in Canada had adopted a risk averse policy to check on the losses in their lending operations (Gorton, 2012). However, it is also true that the oligopolistic market structure of the commercial banks in Canada is responsible for its survival at the time of subprime crisis. This is because most of the above restrictions were also imposed by the commercial banks in Europe and United States. The primary reason for the survival of the banks in Canada was its clustered mega banking structure that had resulted in the formation of an oligopolistic banking structure (Acharya & Richardson, 2009). The bank rate explains the rate of interest at which the central bank of a country offers loans to the other commercial banks in that nation. In the case of Canada, the central bank is the Bank of Canada. As shown in Table 1 and Figure 1 in the above context, at the time of the subprime crisis, the bank rate charged on the loans issued by the Bank of Canada to the other banking institutions in the country had been lowered. This means that at the time of the financial crisis in the global market, the government of Canada had supported the commercial banks (Ragan, 2011). The government helped the stability of the commercial banks by offering them a higher supply of credit. In this way, the commercial banks in Canada had proper financial reserves to cover up the bad debts at the time of the subprime meltdown. As shown in Table 4 and Graph 4 in the above context, the variability in the bank rates was much higher in Canada during the crisis. However, the Table 2 and Figure 2 in the above context, clearly explain that the bond yields started to fall at the time of subprime meltdown in Canada. This means that the interest rates that were charged by the commercial banks in Canada on the investors were higher at the time of the crisis. Thus, it is empirically proved that the commercial banks in Canada had survived at the time of financial meltdown due its oligopolistic nature, strict risk reducing measures and the support given by their government (Boyes & Melvin, 2012). Conclusion Thus, after the entire analysis it can be concluded that the greatest achievement of the commercial banks in Canada was its survival at the time of the financial meltdown. However, the oligopolistic market structure in the financial system of the country had reduced the net social welfare of the economy. The interest rates charged on the loans were so high in Canada that productive investments in the country had significantly decreased at this point of time. This was responsible for its lower growth rates in terms of the national income aggregates. This had adversely affected the country’s competitive advantage in the global market. Thus, though the financial sector in Canada had survived the crisis, it could not significantly augment its economic growth after the subprime crisis. References Acharya, V. & Richardson, M. (2009). Restoring financial stability: how to repair a failed system. New York City: John Wiley & Sons. Admati, A. & Hellwig, M. (2013). The bankers’ new clothes: What’s wrong with banking and what to do about it? Princeton: Princeton University Press. Agatha, E. J. (2011). How Lehman Brothers Used Repo 105 to Manipulate Their Financial Statements. Journal of Leadership, Accountability and Ethics 8(5), 44 – 55. Bank of Canada. (2013). Rates & Statistics. Retrieved from http://www.bankofcanada.ca/rates/ . Boyes, W. J. & Melvin, M. (2012). Microeconomics, 9th ed. Connecticut: Cengage Learning. Brender, A. & Pisani, F. (2010). Global Imbalances and the Collapse of Globalised Finance. CEPS. Retrieved from http://www.ceps.eu/ceps/dld/2923/pdf. Brian, S. & Vane, H. R. (2002). An encyclopaedia of macroeconomics. Massachusetts: Edward Elgar Publishing. Deloitte. (2011). Global Risk Management Survey. Deloitte Global Services Limited. Retrieved from http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/us_fsi_grms_031711.pdf. Gorton, G. (2012). Misunderstanding financial crises: Why we don’t see them coming. Oxford: Oxford University Press. Hulster, K. D. (2009). The Leverage Ratio. World Bank. Retrieved from http://www.worldbank.org/financialcrisis/pdf/levrage-ratio-web.pdf. Joshua, C., Jurek, J. & Stafford, E. (2009). The Economics of Structured Finance. Journal of Economic Perspectives, 23(1), 3-25. Ragan, R. G. (2011). Fault lines: How hidden fractures still threaten the world economy. Princeton : Princeton University Press. Read More