What Makes the Canadian Financial System So Different?

An article in Friday's Financial Times discussed Canada's banking system. According to World Economic Forum, Canada has the world's "soundest" banking system. It is the only country in the G7 that did not have to come to the aid of its financial sector with a state sponsored bailout. So what makes the Canadian financial system different? The FT claims that first and foremost its a function of Canadian culture,

Depending on your degree of fondness for Canucks, this thesis comes down to the notion that Canadians are either too nice or too dull to indulge in the no-holds-barred, plundering capitalism that created such a spectacular boom, and eventual bust, in more aggressive societies.

According to the article, there seems to be some consensus revolving around this cultural argument. In general, the authors make the claim that Canada is a more egalitarian society and less hierarchical in nature. They tend to spend less on discretionary goods and are not as "flashy" as their southern neighbors. This culture difference my even trickle down to their business practices: Canadian banks are more conservative at managing credit and market risk. There is a difference in the actual regulatory structure of the Canadian banking system itself. Canadian regulators have higher capital requirements, higher quality of capital, and higher leverage ratios than the banking systems of the UK and US.

We had a tier one capital target of 7 per cent going back to 1999,” ...referring to the proportion of the bank’s equity considered to be of the highest grade. “We also paid attention to quality of capital, so 75 per cent of that tier one had to be in common shares [as opposed to preferred stock, which is considered a hybrid of equity and debt]. And our leverage ratio [of debt to equity], of 20 to 1, was very important, we think.

The structural advantage also extends to Canada's more straightforward and coordinated regulatory frameworks. The regulator sees its job as setting the rules for the industry, not as a partner in helping the industry grow. Canada, unlike many other financial centers of the world does not seem interest in competing to become the heaven for financial capital.

The central bank, which is responsible for the stability of the overall system; the superintendent, responsible for the stability of the financial institutions; a consumer protection agency, which looks out for individuals; and the finance ministry which sets the broad rules on ownership of financial institutions and the design of financial products such as mortgages and tax-deferred investment vehicles. The four actors meet regularly. As a result, says Robert Palter, director at McKinsey in Toronto, “there are no gaps.”

In addition, Chief Executives are held accountable to meet regulatory rules, essentially doubling as the CEO and Chief Risk Officer to some degree. Does their more conservative attitude have some merit? Is the interest in the Canadian banking system just a reaction to the recent financial crisis? Its obvious that those companies that took less risk fared better during the spectacular meltdown, but at the same time may fare worse during the booms. However, that argument does not necessarily hold weight in this instance. Since 2005, Canadian bank shares have thoroughly beaten their UK and US counterparts.
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Royal Bank of Canada (RY) has smoked JP Morgan (JPM) over the last year, generating nearly twice JPM's return. One investment strategy could be to buy individual Canadian bank stocks. Another could be to hold a diversified ETF with heavy exposure to Canandian banks. The iShares MSCI-Canada (EWC) has 33% of its assests invested in Canadian financial services companies with 21% invested in Canada's 5 largest banks (Royal Bank of Canada, TD, Bank of Nova Scotia (BNS), Bank of Montreal (BMO) and CIBC (CM))
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Disclosure: No Positions