The Canadian And Us Banking System Finance Essay - Free Essay Example

Sample details Pages: 12 Words: 3733 Downloads: 7 Date added: 2017/06/26 Category Finance Essay Type Compare and contrast essay Did you like this example? The Canadian banking system began as a nationwide system, which encompassed a miniscule number of banks with numerous branches and allowed for diversification on a larger level. In contrast, American banks were prohibited from nationwide branch banking and from diversifying their portfolios. Many Canadian and American observers have come to view the two systems as distinct and believe that stability is a valid reason as to why the American system should adopt a nationwide banking system as well. Don’t waste time! Our writers will create an original "The Canadian And Us Banking System Finance Essay" essay for you Create order While the Canadian Banking system has proven to be economically stable, it is associated with high barriers to entry and a costly charter that holds an excessive amount of economic power. Regardless of their distinct government regulations and differing response to situations brought about by financial crises, there has been little attempt to compare both systems over a long period. This paper will examine the differences between the United States and the Canadian banking systems. In particular, it will discuss the forces, which spurned the creation of these economic entities; as well as evaluate the effectiveness and efficiency of each system to stand firmly during periods of economic depression. Early banking in Canada suffered from the rippling effects of the Mississippi and South Seas Bubble, which convinced Canadians that paper currency was worthless and could not be trusted. As discussed in class, prior to 1763 paper money issued by the French government in Quebec was not valued; the fall of Quebec in 1759 pushed the situation over top. Staying true to their nature, British aristocrats and seigneurs in Quebec were intolerant of merchants and traders alike and were uninterested in finance or trade.Canada demonstrated little interest towards the idea of a central bank for the half of the 19th century following Confederation. Before Confederation, branch banks were established with little funds and very little skill than required for independent banks. Branch banks served the nations needs for more than a century and Chartered banks printed money required for circulation and met the needs of seasonal or unpredictable demand. The new Dominion Government was granted authority over banking, currency, interest and other related matters under the British North America Act of 1867. A comprehensive act was drafted to replace the expired bank charters of the four original provinces in 1871. The Minister of Finance John Rose, under the Macdonald government, desired a banking system that mirrored the American free banking system. Such a system would allow provinces to hold more power than the federal government, something Macdonald did not want. According to Joe Martin The political goal was financial stability, and the managerial challenge was to create the institutional and regulatory framework to carry it out. (Martin, 2011, p. 22) The first bank of United States - championed by Alexander Hamilton in 1791 in Philadelphia and was built on the view that in order to have a prosperous and powerful nation, an established banking system was necessary. The structure mirrored that of the bank of England and served as both a commercial and central bank. The establishment of the first bank was significant as it served as a model for the Canadian Banking System and mimicked each word and section of the from the banks charter. The constitution on 1787 failed to address whether banking was governed under federal or provincial legislation; this eventually became the deciding factor between the American and Canadian banking system. The constitution did address the right to issue and regulate silver and gold coinage to the Federal government but specifically prohibited the printing and circulation of paper money. The agrarian forces aligned against Hamilton were bankers in New York and Boston who were against the location of t he bank and were suspicious of the northeast elite. Thomas Jefferson was particularly against the notion of a bank and preferred that the United States refrain from navigation or commerce. (Martin, 2011, p. 27) Apart from incorporating the First bank of the U.S., the act also provided a route the government utilize to retain control of the state charted banks. When Jefferson and his supporters came into power, they refused to renew the bank charter in 1811, partly because the bank had accomplished so much. The Second bank of the United States was established in 1816, but was allowed to die after its twenty-year charter had expired. With the absence of a central bank, Americans failed to inject liquidity into the banking system and in turn, failed to combat the economic crisis of the early 1900s. At the time, J.P Morgan, one of the leading financiers of the Era, took on the role of the central bank and single-handedly rescued the nation. Jefferson and his supporters established the F ederal Reserve in 1913 after realizing that a country with such a large economy would not stand on its own without a central bank. According to author Charles Freedman, the Canadian financial system was constructed around five principal pillars: trust and loan companies, the co-operative credit movement, life insurance, securities dealers and chartered banks. (Freedman, 1998) These pillars were characterized by core business activities and government jurisdiction, under which they were incorporated and supervised. Additionally, different institutional types were traditionally separated by functionality, which increased penetration into each others primary focus of business. Trust and loan institutions tend to specialize in residential mortgages and term deposits, whereas Canadian life insurance companies were headed by the federal jurisdiction; meaning that they invested the proceeds of life-insurance in mortgage portfolios and financial assets, such as bonds and equities. (Freedman, 1998) On the other hand, Canadian securities dealers operated under the jurisdiction of provincial legislation. Incorporated and s upervised under federal legislation, Canadas chartered banks remained the dominant deposit taking institution with long involvement in commercial lending. Another major difference between the Canadian and U.S banking system encompasses the sunset clause. The sunset clause is clause that requires the Canadian government to conduct periodic assessments and updates of laws governing its banking system. This re-assessment done once every decade, builds on the present Act by improving the framework to ensure that the objectives of promoting competition more efficiently and effectively are met. (OECD Economic Surveys, 2010) The Sunset Clause gave birth to important legislative amendments in 1980, 1987, 1992, 1997, and 2002. (Allen and Engart, 2007) Consequently, this has led to the creation of more diversified and market oriented activities on the part of Canadian Banks, such as the entry of foreign banks into Canada. Initially, entry by foreign markets into Canada was limited by strict regulations. By allowing foreign banks into Canada, there would be a requirement to implement new regulations and procedures, which may be misaligned with Ca nadas system. This is a distinct phenomenon particularly because a safe and efficient financial system is important for the development and longer-run growth of the economy. (Allen and Engart, 2007) A third distinction in the Canadian banking system is the lack of interest rates on deposits. In Canadian banks, there was an absence of ceiling on interest rates and deposits as well as the elimination of ceiling rates on loans. Having established controls on interest rates, any financial deposits into the United States banking system escaped. As Canadian banks did not have such controls, any deposits made toward the Canadian financial system remained within the country. By the twenty first century, the amount of U.S debt financed outside the country outweighed the internal debt within the traditional financial system. Majority of financing which spawned from short-term deposits could easily turn tail and flee at the first sign of deteriorating investor confidence. (Doren, 2011) The United States has restrictions on the rates of interests that could be paid on deposits. According to Bordo, Rockoff and Reddish, although working to increase profit rates , U.S banks were made sensitive to the dangers of losing deposits when market rates rose which forced them to maintain more reserves. (Bordo, Redish Rokoff, 1994) The low risk of failure in Canada made it possible for the Canadian banks to hold smaller amounts of non-interest bearing assets and to precede to higher asset equity ratios. In addition, Canadian mortgages have fixed rates for a maximum of only five years thus eliminating the problems inherent in linking shorter-term deposits with long term loans. (Doren, 2011) In essence, interest rates paid on deposits were generally higher in Canada, interest income received on securities was slightly higher, interest rates charged on loans were similar and net rates of return to equity were higher in Canada than in the United States. (Bordo, Redish Rokoff, 1994) In contrast, the United States banking system has been fragmented for most of its history; directly pertaining to a Supreme Court case in 1839, which restricted the establishment of bank branches across America. This fragmentation did not support the needs of national corporations or industrialization and was instead reinforced by unregulated financial and commercial paper markets. There are numerous issues surrounding the United States and the limitations surrounding its nationwide banking arrangement. The first reason concerns the fragility of individual banks, in that their portfolios were too small and lacked diversity. This made it difficult to transfer funds across the country. As a result, the system would usually fail during difficult economic times when rural banks attempted to protect themselves by withdrawing funds from their correspondents, which would in turn discourage the crisis. Prior to World War I, the United States experiences major economic crises. These occurrenc es were essentially accredited to the usage of reserved holdings and heavy reliance on securities market to finance investments. (Bordo, Redish and Rokoff, 2008) In the nineteenth century, many communities in the United States became one-bank or few-bank towns because of branching restrictions and consequently, charged monopoly loan rates. (Bordo, Redish and Rokoff, 1994) This was a disadvantage to customers because of the higher costs association. On the other hand, the individual banks were benefiting large sums of money from its inefficient banking arrangement. The nation was in dire need for branch banking arrangements particularly in the interest of the consumers. Both the legislative and regulatory environment heavily influences the banking structure of Canada and the U.S. These characteristics play a part in determining the efficiency and stability of a banking system; in fact, from the 1920s to the 1980s many economists argue that Canadas banking system was more proficient in both stability and efficiency when compared to the United States. This belief was largely due to the prohibition of nationwide (interstate) branch banking in the U.S., which has destroyed the nations ability to successfully combat major issues without experiencing bank failures.ÂÂ   Tailored to nationwide service Canadian banks proceeded to establish an oligopolistic financial system with limited entry. Because of this, Canadian broker-dealer and securities market systems were limited in expansion, as banks possessed the financials capable of sustaining industrial development. Although many economists refer to the mid-1800s as a period of free banking in the U.S, this is somewhat of a misnomer, as the reference was less literal and more towards several banking systems founded on free banking regulations. Banks were prohibited from establishing branch networks and had to either purchase or yield eligible securities from banking authorities in order to secure notes. The depreciation of securities, including authorized government bonds were deemed the source of bank failures during this period. This restriction on nationwide branch banking gave way to discounted bank notes at fluctuating rates the further they travelled from their sources. In summary, the defective banks and their supply of paper money proved the imminent danger of unauthorized and romantic ideas of regulation. Current regulation outlined by the McFadden Act of 1927, the Banking Act of 1933 and the Bank Holding Act of 1956 permits individual states to create its own policies regarding the allowance of outer state banks to operate within its borders. Prior to the 1907, as a contingency tool branch banking was used to minimize the occurrence of future economic downturns but lost to the establishment of a central bank. The 1907 post-panic debate involved three distinct parties: New York banks, Midwestern city banks and country banks; of these three groups, only the Midwestern banks were in favor of positive structural reform. (Horowitz Selgin, 1987) This group dominated the American Banking Association (ABA) and proposed deregulation through reform and interstate branch banking. The goal of New York banks was to maintain the status quo and aimed to accomplish this by preventing a transfer of power to midwestern banks. On the other hand, country banks were adamant on prohibiting any branch ban king scheme that would have them competing with the city banks; in turn they ironically aligned themselves with Wall Street which preened any reform actions proposed by the ABA. Supporters of branch banking promoted economists and authors who believed that the panic of 1907 was preventable if interstate banking was allowed. Many highlighted the successful avoidance of crises in Canadian systems, where nationwide banking was encouraged. Thought regulations approved in 1913 favored Federal Reserve Banks, central banking was a compromise erected in response to the New York banks desire for continued hegemony. (Horowitz Selgin, 1987) This became evident when the depression of the 1930s unveiled the instability of the banking system. In 1933, during a nationwide commercial bank failure and the Great Depression Senator Carter Glass and Representative Henry SteagallÂÂ  championed the Glass- Steagall Act. (ValueClick Inc, 2003) This act divided and forestalled commercial and investment banking activities in order to prevent future economic crises. During this period, the stock market crashed due to improper banking activities carried out by commercial banks and their excessive involvement in the stock market. Commercial banks became greedy and took big risks by investing large amounts of capital into assets; buying new issues and reselling them to the public. Banks granted fallacious loans to companies with which they owned a stake and clients were encouraged to invest in those stocks. As a solution, a regulatory firewall was established, separating commercial and investment banks by controlling their activities. Banks had to make a choice between specializing in commercial or investment banking and only ten pe rcent of commercial banks total income could stem from securities. (ValueClick Inc, 2003) Directly targeted and forced to reduce their services, numerous financial giants such as J.P Morgan and Company, lost their main source of income. Over a period of extended prosperity in the early 1900s, a significant percentage of unit banks failed due to declining agriculture prices. Although Canada practiced branch banking and its financial structure for commercial banking mirrored that of the United States, the nation did not encounter significant bank failures. Glass eventually concluded that little banks were hazardous to stable banking and contributed to the condemnation of depositors. Glass also desired an integrated banking system supervised by the Federal Reserve and claimed that the dual system (shared by state and federal authorities) was an abomination to the nation. As part of Federal Reserve Act, all national banks were required to become members of the Federal Reserve System, wh ereas commercial banks had the option to join in or opt out. (Wessel, 2009, p. 97) This was to minimize the competing views of regulators governing the affiliated and unaffiliated banks. In addition, the Act was delayed until Glass adjusted the legislation to prohibit nationwide branch banking within states that encourage this. Proposals made by larger banks were considered attempts to sabotage the state banking system that provided financial services to small towns. This resulted from the anxiety to preserve the dual banking system between the state and federal authorities. Unfortunately, these small towns accounted for ninety percent of failures in the U.S and deposit insurance arose as a hasty alternative to branch banking, which would ensure the safety of the banking system. (Wessel, 2009, p. 50) Deposit insurance was not a new concept and had been around since the panic in 1907; however, in each case problems quickly arose following its introduction to several states. First, by asking banks to deposit their assets into a fund, an incentive problem emerged. Banks began to hold more risky portfolios because they held only a fraction of risks contributing to failures. Second, deposit insurance could contribute very little to save banks when the economy took a turn for the worst. Despite the negativity ass ociated with deposit insurance plans, unit banks claim that there is a possibility for effectiveness when handled properly. Now that we have highlighted several differences within each system and discussed the forces behind this historic establishment, we will now examine the efficiency and effectiveness of both systems to combat economic depression and inflation. As previously mentioned, the structures of both the United States and Canadian banking systems substantially differ. However, an efficient banking system is important in order to maintain long-term growth and productivity within the economy. The Canadian banking system has remained relative stabile throughout history despite the concentration of the overall banking industry. In contrast, the relative fragmentation historically rooted in the United States banking industry, has led to a sharp decline of commercial banks by approximately forty five percent over the last eighty-five years. (Mayer, 2004, p. 57) However, the fact that the United States is more market concentrated than Canada, means that U.S banks do not heavily influence the nations f inancial industry. There are numerous opinions on both the economic and political reasons, some generally shared, about why the financial crisis occurred. Governments failed to properly regulate markets and minimize a financial meltdown. Many observers suggested that various government policies aided the emergence of the crisis and credits fours main factors to this: (1) accessibility of credit resulting from artificially low rates, (2) government policies favored housing and in turn prompted subprime risk-taking, (3) government regulations related to corporate policies in large financial institutions and (4) failure to supervise the economy. (Roberge, 2010) Like other countries, Canada was impacted on some level by the global financial crisis over the past few years. Thanks to the equilibrium of systems within the financial service sector and the nature of its policies, Canada managed to emerge in good shape. As mentioned earlier, Canada financial structure is divided into several jurisdictions. The Federal government is in charge of banks; securities and investment firms as well as trust companies are under provincial authority; insurance is governed by both jurisdictions. The late 1900s and onwards brought with it drastic change to the Canadian system. A system once operated according to pillars was dismantled in 1987, allowing banks to own firms in investment, insurance and trust. As a result, large five banks dominated across all pillars due to changed policies. Under federal jurisdiction, there was a simultaneous centralization of political, supervisory and regulatory authority within Canadian banks. (Roberge, 2010) The 1980s witne ssed the last bank failure in Canada and the system has remained stable ever since, thanks to the oligopolistic banking system in Canada. Canadas response to this crisis was threefold. First, both definitive and pragmatic measures were established to ease the credit crunch. The government purchased $125,000,000 worth of mortgage bonds to increase their lending capacity. Second, the Federal government amended the Bank Act of Canada, which provided banks more power to manage the financial crises. Regulating investment contracts with guaranteed rates and guarantying investors that no money would be lost on their assets, was also part of the effort. Third, the Canadian government seized the opportunity and established a national securities board. Canada remained under control whereas other countries, such as the U.S., required major bailouts. Canadas resilience to this event is largely attributed to the structure and workings of their policy network within the financial sector. This policy networks mode of operation in the financial sector has remained generally small and obstinate, despite the networks expansion. The Fina ncial Institutions Supervisory Committee (FISC) is compromised of all important government personnel and ensures that lines of communication that exist across sectors remain clear. The Canadian system has one potential weakness, the absence of a definite authoritative figure overlooking the stability of the financial services sector. The tenacity of the Canadas policy network becomes increasingly evident when compared to the United States. Because of such cohesiveness and stability Canadas only experience with controls occurred in the late 1970s as a response to relatively high inflation rates. Controls are any type of government policy, which influences the overall pricing and wage structure in the economy. These controls place extensive restrictions on the maximum rate of which wages and prices can increase during various periods. Two characteristics that distinguish price controls from other types of government controls are: (1) these policies are adopted for the sole purpose of controlling inflation, not to accomplish economic efficiency or equity; (2) they influence numerous economic sectors rather than focusing on primarily one market. The anti-inflation act created by the Federal government spelled out a three-year control system. (Wirick, 2012) Firms with 500 plus employees were restricted by wage guidelines; these guidelines also applied to federal as well as a majority of public-sector employees. Price restri ction and cost markups were restricted by controls placed on large corporations. Overall, the controls program helped to restrict high inflation and keep it below certain levels. The historic background of Wall Street has demonstrated the obscure relationship between the government and the financial markets in the U.S., particularly the relationship between Washington and Wall Street. With division among regulatory and supervisory authority, an opportunity to pit one regulator against another showed itself. Following the Wall Street Crash of October, 1929, the United States entered into, what is now called The Great Depression. This period was marked by a series of bank failures and high unemployment, reaching as high as 25% in 1932. (Woodward, 2000, p. 72) In response to this great economic crisis, the newly elected Roosevelt administration began The New Deal, a series of economic programs, reforms, and regulations enacted between 1933 and 1938. Some of these programs included the Social Security Act, the Federal Emergency Relief Administration, which provided millions of dollars in relief operations, and the Works Progress Administration, which made the fed eral government the single largest employer at the time. The bursting of the U.S. housing bubble in 2006 and current ongoing global recession has led to the worst financial crisis in the United States since The Great Depression. Under the Bush administration, the United States government issued a limited bailout of the housing market, giving out close to a trillion dollars in loans with over half going to Fannie Mae and Freddie Mac. (Wessel, 2009, p. 178) Moreover, the United States has experienced a recessionary period every twenty years