The importance of intragroup funding – 19th century Canada

This is a quick follow-up post on intragroup funding, as promised in the one focusing on the US experience during the 19^th century.

The Canadian case is interesting, because Canada is also a ‘recent’ country that experienced its own banking development at the same time as its close, also ‘recent’, neighbour, the US. Though the contrast cannot be starker; while the US was prone to recurrent financial crises during the 19^th century, Canada’s financial system remained pretty stable throughout the period, and continued to do so until today.

The main difference between the Canadian and the US banking systems was their fragmentation and regulation. The US, as described earlier, had a very fragmented and highly regulated (though much less than today…) banking system, whereas Canada had a lightly regulated and quite concentrated one (some could argue that it was pretty much an oligopoly). In the US, a multitude of unit banks with no branches and local monopolies prevailed. In Canada, large nationwide banks with multitude of branches prevailed. This was due to the specific political and institutional arrangements in Canada: unlike in the US, where states had most of the powers to charter banks, the Canadian government was the one who decided whether or not to grant a bank charter, not the provinces. In 1890, there were 38 chartered banks in Canada and around 8000 in the US.

It is easy to understand why the Canadian banking system was more stable: nationwide branch network allowed banks to move liquidity around and continue to accept each others’ notes at par, and loan books were much more diversified and less prone to local asset quality deterioration. When branches in the West of the country were experiencing a liquidity shortage, it was easy to provide them with extra liquidity from their cousin in the East in order to avoid contagion as banks tried to protect their name and reputation. Moreover, the fact that only a few banks had large market shares in the country made it a lot easier to coordinate a response in times of financial tension, pretty much like the US clearinghouse system, but on a much larger scale.

The consequences of this design were that banks operated on thinner liquidity and capital buffers than banks in the US, as credit and liquidity risks could be consolidated and diversified away. Furthermore, credit was as available in Canada as in the US and deposit rates were higher, while banks were nonetheless more profitable thanks to centralised back office functions on a nationwide basis (i.e. economies of scale).

In the end, Canada experienced not a single bank failure during the Great Depression, despite having no central bank nor deposit insurance, the two tenets of current banking regulatory ‘good practices’.

What is striking from my series of posts on intragroup funding is that history is crystal clear: it is large, diversified, banking groups that represent a more stable ideal than insulated, but reinforced, smaller local banks. Unfortunately, most regulators and economists don’t seem to know much banking history…