In his Budget speech in July 2009, the finance minister had labelled bank nationalisation as visionary and revolutionary since, according to him, bank nationalisation ensured that India did not suffer from the financial crisis like the other parts of the world. Was that an economically sound argument that is supported by facts? Or was that a politically motivated statement where the minister used the financial crisis as a stick to beat up proponents of privatisation of public sector banks?
Contrasting the banking system between Canada and the US is very informative in this context since there were some significant differences between Canada and the US during the recent financial crisis. Consider the following facts illustrated with charts. Canada didn?t have nearly the real estate bubble and subsequent corrective crash in home prices as the US. Canada has had nowhere near the problems with mortgage delinquencies and home foreclosures as the US. Yet Canadian banks were the most profitable during the period 2005-09 and reported positive return on equity even in the worst year of the meltdown, 2008, when banks in the US, UK and Europe reported negative returns on equity.
And this recent financial crisis isn?t the first time that Canada?s banking system showed greater signs of stability and less exposure to stress than US banks. In the 1930s, when 9,000 US banks failed during the Great Depression, not a single bank in Canada failed. When almost 3,000 American banks failed during the Savings and Loan (S&L) Crisis, only two small Canadian banks failed in 1985, and those were the first bank failures in Canada since 1923. And while almost 200 US banks have failed since the start of the global recession in early 2008, Canada remains the only industrialised country in the world without a single bank failure.
Since the Canadian banking system is not dominated by government-owned banks, bank nationalisation cannot explain this difference in the fortunes of Canadian and US banks. Thus, it turns out that the finance minister?s arguments in his speech were empty rhetoric.
If it is not bank nationalisation, what features of the Canadian banking system lent it greater stability? First, almost all Canadian home mortgages are ?full recourse? loans. Thus, the borrower has to fully repay the loan using his other assets/income even if the loan is foreclosed because the market value of the home is lower than the current value of all future payments that are owed on the home loan. The full-recourse feature of Canadian home mortgages results in more responsible borrowing, fewer delinquencies, and significantly fewer home foreclosures than in the US.
Second, shorter-term rates are fixed in Canada. Canadian home mortgages carry a fixed interest rate for a maximum of five years, and rates are then re-negotiated for the next five years, similar to a five-year adjustable rate. This practice allows banks to achieve a better maturity match between their assets (mortgages and loans) and interest income, and their liabilities (deposits) and interest expense, which protects them from the kind of maturity mismatch and interest rate risk that resulted in the S&L crisis in the US and almost 3,000 bank failures in the 1980s and 1990s.
Third, though prepaying of home mortgages is allowed, the prepayment penalties are much stiffer than in the US, which discourages home refinancing of the order that took place in the US leading up to the housing meltdown. Fourth, Canada never had branching restrictions like the US laws that prevented interstate banking up until 1994. This historically allowed Canadian banks to achieve geographical diversification for their deposits and loans portfolios. It was largely this difference in geographical diversification that help explains why the US had 9,000 bank failures during the Great Depression (each operating within only one of the 48 states, due to the prohibition on interstate branching) and not a single Canadian bank (all with branches nationwide) failed in the 1930s.
Taken together, the features and regulations of banks in Canada create a healthy and sound ?pro-lender? environment absent of political motivations for outcomes like greater homeownership, compared to the often politically motivated ?pro-borrower? and ?pro-homeowner? policies of the US. While Canada?s banking system has promoted responsible borrowing and prudent lending and underwriting practices with little politically motivated interference, the US banking system seems to have encouraged excessive lending to risky borrowers because of the political obsession with homeownership.
Since the obsession with priority sector lending, which is primarily to the more politically sensitive classes in India, is similar to the obsession with homeownership in the US, the difference in the experiences between Canada and the US offers important lessons to India: priority sector lending in India must be slowly dismantled to avoid crisis of the kind witnessed in the US lately.
The author is a PhD in finance from the University of Chicago and is currently faculty in finance at the Indian School of Business