Chapter

X Large Banking Groups and Financial System Soundness

Author(s):
Vladimir Klyuev, Martin Mühleisen, and Tamim Bayoumi
Published Date:
October 2007
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Author(s)
Gianni De Nicolò, Alexander Tieman and Robert Corker 

This section1 uses market-based soundness indicators to assess the stability implications of the rapid growth and shifting business strategies of Canada's large banking groups. Helped by changes in the regulatory framework, a process of mergers and acquisitions led to the emergence of six large banking groups that account for a large share of the Canadian financial system. Over the past 20 years, these banks diversified their income and balance sheets by reducing the share of traditional deposit and lending activities and taking on more exposure to domestic and international financial markets. The soundness measures presented here—based on “distance-to-default” (DD) models— suggest that the rapid growth of the large banking groups during the second half of the 1990s was associated with a significant increase in their overall risk profile. More recently, however, their risk-adjusted returns appear to have improved, and their soundness was further underpinned by ongoing increases in capital adequacy ratios.1

The strong performance of the six large banking groups speaks to a high degree of resilience of the Canadian financial system. In 2001, financial market weakness following the demise of the high-tech stock-market bubble and the global slowdown affected the banks' performance. However, bank profitability recovered, and other financial soundness indicators continued to strengthen from already comfortable levels. Moreover, the relatively modest rise in default risk during the slowdown, compared with that during the Russian, Brazilian, and Long Term Capital Management (LTCM) crises of the late 1990s, suggests a strengthening of risk management practices on the part of the banks.

Banking Sector Trends

The Canadian banking sector is highly concentrated. The six large banking groups account for around 90 percent of Canadian deposits and banking assets. Based on mid-2004 balance-sheet data, the largest of these accounts for almost 25 percent of total banking assets, followed by four institutions each holding close to 15 percent of total assets. The sixth bank accounts for about 5 percent of total assets.

These banks went through a rapid growth spell in the second half of the 1990s, partly in response to legislative changes (Box 10.1). From the end of 1996 to the end of 2001, their deposit bases and total assets expanded by more than 50 percent. On the asset side, investments were channeled in particular into securities and mortgages. After 2001, however, balance sheet expansion slowed dramatically, in part for cyclical reasons.

The investment behavior of these banks since the mid-1990s is the continuation of a longer trend reflecting the expansion of their fee-earning businesses. As part of their growth and diversification strategy, they aquired mortgage loan companies, securities businesses, and trust companies (Calmes, 2004). Through this process, they expanded their links to financial markets and, in particular, their exposure to equity markets. In mid-2004, securities accounted for 27 percent of total assets, compared with 19 percent at the end of 1996 (Table 10.1).2

Table 10.1.Balance Sheet Items of Six Large Banking Groups

(In percent, unless otherwise noted)1

199620002001200220032004
Total assets
In billions of Canadian dollars1,0151,4381,5871,6281,6271,671
Annual percent change29.110.42.6−0.12.7
As percent of GDP121.3133.5143.2140.6133.5129.4
Aggregate balance sheet shares
Assets
Securities19.023.425.224.727.426.8
Non-mortgage loans41.037.236.034.631.032.7
Mortgage loans19.919.319.320.021.221.4
Other20.120.119.520.720.419.1
Liabilities
Deposits68.267.666.666.165.867.1
Other31.832.433.433.934.232.9
Net income before tax31.01.00.80.60.91.2
Net interest income/total net income60.639.540.943.647.947.2
Capital adequacy ratio49.211.712.312.313.313.4
Source: Office of the Superintendent of Financial Institutions.

The six large banking groups also acquired substantial foreign investments. Consistent with many analysts' view that the Canadian market does not offer sufficient banking economies of scale, these banks sought to expand their business abroad. During the 10 years ending in 2004, their foreign securities holdings grew at roughly three times the pace of domestic securities. While accumulating large U.S. dollar exposures in general, they also acquired extensive direct investments in the United States and the Caribbean.

The counterpart to this portfolio shift was a sharp decline in the relative importance of the banks' traditional lending business, excluding mortgages. Increases in nonmortgage lending barely kept pace with inflation after the mid-1990s, notwithstanding rapid growth in the banks' deposit base. This was only partly offset by mortgage lending that expanded in line with, or even faster than, the total asset base. As a result, in 2004 the banks' net interest income accounted for less than half of total net income, compared with about 60 percent in the mid-1990s.

Box 10.1.Changes in Canada's Financial Sector Legislation

The rapid growth of the large banking groups has been facilitated by changes to Canada's financial sector legislation:

  • Amendments to the regulatory framework in 1987 and 1992 removed legal barriers separating the activities of various types of financial institutions, allowing Canadian financial institutions to develop into financial conglomerates (Freedman, 1998).

  • In 2001, limitations on investment in nonfinancial business were relaxed, and a holding company regime was introduced. At the same time, a new merger review policy was introduced, mainly in response to the government's 1998 decision not to allow two mergers involving four of Canada's largest banks (Ministry of Finance, 1998; Group of Ten, 2001).

  • The new policy raised the ownership limit to 20 percent for voting shares and 30 percent for nonvoting shares and loosened the requirement that large banks be widely held, while retaining the requirement that no investor hold a majority share in the bank (Daniel, 2002).

The Canadian regulatory and supervisory regime is subject to regular reviews in order to keep pace with the changing technological and market environment. Canada's financial legislation contains sunset clauses that prescribe periodic reassessments and updating of the regulatory framework that governs the financial system. In the past, the review used to take place every 10 years. In 1992, the review period was shortened to five years and extended to the legislation governing all federal financial institutions.

These trends and strategies are not unique to large banking groups in Canada. Most of the large financial institutions in the United States and elsewhere also expanded their securities and mortgage businesses and consequently derive a greater share of their income from fees and other non-interest sources (IMF, 2004c).

Foreign and financial market exposures contributed to significant strains in the banking sector after the stock market bubble burst in the early 2000s. Although the downturn of the Canadian economy was relatively mild, non-interest income growth dropped from over 25 percent a year between 1996 and 2000 to virtually zero between 2001 and 2003. With impaired assets and loan loss provisions up sharply, return on equity for the banking system as a whole fell from 15.8 percent in 1999 to 9.4 percent in 2002, but has since rebounded (Table 10.2).

Table 10.2.Vulnerability Indicators of the Banking System1
1997199819992000200120022003
Balance sheet
Total loans to assets (percent)62.858.458.757.755.855.653.8
Total loans to deposits (percent)92.590.286.884.284.583.181.3
Impaired assets/total assets0.680.660.590.600.840.900.64
Loan loss provision (in percent of total assets)0.180.200.230.270.370.570.23
Total foreign currency assets/total assets241.546.440.240.542.741.436.2
Total foreign currency liabilities/total assets243.547.742.442.244.743.837.7
Total foreign currency deposits/total assets230.732.231.329.530.428.925.6
Profitability
Return on total shareholders' equity (percent)16.413.415.815.313.99.414.7
Return on average assets0.710.570.710.720.660.440.69
Average intermediation spread2.92.62.72.93.03.03.1
Net interest income (in percent of average total assets)2.11.81.81.81.92.01.9
Sources: Bloomberg; Canadian Bankers Association; Haver Analytics; and Office of the Superintendent of Financial Institutions.

Nevertheless, throughout both the growth spell and subsequent slowdown, Canada's large banking groups continued to build up capital relative to risk-weighted assets. Their total capital increased by about 70 percent between 1996 and 2001, translating into a rise in the average capital ratio from 9.2 percent to 12.3 percent. Following a drop in both capital and risk-weighted assets in 2002, the average capital ratio increased to 13.3 percent in 2003, boosted by increases in capital and a further decline in risk-weighted assets. Throughout the period, all banks remained substantially above the minimum capital requirements set in the 1988 Basel capital accords.

The banks have also reduced their off-balance-sheet activities. Prior to 1998, they took on increasing exposures in the derivatives markets and also boosted other off-balance-sheet exposures. These were scaled back in subsequent years, following the Russia and Brazil crises and the LTCM collapse. With one exception, these banks have not expanded—and in some cases made further sizable contractions in—their off-balance-sheet activity since 1999.

Despite similar features, the business strategies of the six large banking groups have not been identical and financial performance has been varied. Two of these, the largest and one of the mid-tier banks, deviated from the other institutions in that they built up their securities portfolio share more rapidly and reduced their share of mortgage loans. The financial performance of these two institutions has been quite different. The largest bank appeared to weather the post-2000 slowdown relatively comfortably, whereas profitability in the other bank—which had the fastest growing balance sheet and the most rapid buildup of securities investments of all six large banks—was quite volatile, culminating in pretax losses in 2002. One other bank—the one with the fastest growing exposure to the mortgage market—also saw its profits fall to a very low level in 2002, whereas the other three institutions experienced only mild dips in profitability.

Market-Based Financial Soundness Indicators

The large banking groups' business strategies affect the financial soundness of both these individual institutions and the financial system as a whole. Increased diversification, both internationally and across different business lines, should in principle yield better risk profiles for financial institutions. But when diversification takes place at the expense of either lower capital or profitability, on one hand, or increased earnings volatility, on the other, financial soundness may not necessarily improve—as reflected in the performance of individual banks. Moreover, were all the large banks to diversify in the same direction, the system's overall vulnerability to large, common shocks (that is, the risk of several banks experiencing distress at the same time) could increase even if each bank were individually better hedged against risks.

This subsection evaluates trends in the vulnerability of Canada's financial system using a market-based soundness indicator. The indicator, which was estimated for the period 1991–2003, is based on DD models commonly used in the finance literature and increasingly reported in central bank financial stability reports. DD is a composite measure computed as the sum of the return on the estimated market value of assets and the capital-to-assets ratio at market prices, divided by the volatility of assets.3 It thus combines measures of profitability, balance sheet strength, and market uncertainty. A higher DD indicates an improvement in financial soundness at the company level, for example, because of improved profitability, a higher capital ratio, or reduced volatility—or a combination of all three.4 Although DD measures are sensitive to variations in the underlying assumptions, they have been shown to predict supervisory ratings, bond spreads, and rating agencies' downgrades.5

The analysis provides a number of conclusions regarding the impact of evolving business strategies on large banking groups' financial soundness:

  • There appears to be no trend movement in the average DD for the six large banking groups (LBGs) since 1990 (Figure 10.1). Although the DD narrowed sharply in the late 1990s, as a substantial deterioration in the risk-adjusted return outweighed rising capital ratios, the average risk profile improved significantly in subsequent years. Overall, this suggests that shifting business strategies and changing balance sheet structures have not led to a noticeable increase or decrease in average default probabilities for the large banking groups.

  • With one notable exception, there has been no tendency for risk to concentrate in the largest banks. Risk concentration can be measured as the difference between the weighted and unweighted average of DDs over all six institutions, with weights given by each bank's share of total market valuation. A decline in this measure indicates a concentration of risk in the largest banks, and vice versa. For most of the period observed, this measure of concentration was unchanged. However, it dropped in 2002, owing to a substantial reduction in the market valuation of two of the largest LBGs.6 The subsequent spike highlighted risks in two of Canada's important banks, even though average soundness measures for the sector remained satisfactory (see Figure 10.5).

  • Risk profiles of the large banking groups do not appear to have converged. The standard deviation of DD indicators for the six banks does not exhibit a trend over the past 15 years. In fact, a rising standard deviation suggests that banks' risk profiles have diverged somewhat in the last few years.

  • The large banking groups appear resilient to common shocks. A “system” DD can be computed using market measures of return and volatility for the aggregate subsector and its capital-asset ratio. As such, it measures the default risk of an entity whose balance sheet is the aggregate of all the large banking groups' balance sheets. The system DD is almost always substantially higher than the average DD, indicating that correlations between the portfolios of the different banks are low, and hence that the group of large banks as a whole remains well diversified (Figure 10.2). The exception was around 2000, when a relatively high correlation among individual DD measures—reflecting the broad-based decline in equity prices—implied that the system as a whole fared no better than individual large banks. However, the difference between the system and average DD subsequently rebounded to above its long-term average.

  • However, high correlation of DD measures across sectors suggests that the broader financial system typically has a high degree of common risk exposure. In particular, the correlation between system DDs of the banking and insurance sectors is mostly around unity, suggesting that risks across the financial sector are closely aligned (Figure 10.3).7 In effect, most of the time, the fortunes of the large banking groups and other financial institutions are expected to follow similar paths. Risks in the banking sector and in the nonfinancial sector also tend to be positively correlated—with the notable exception of the period between 1999 and 2001, when market sentiment turned against financial institutions well ahead of the general fall in the stock market.

Figure 10.1Average Distance to Default (DD) of Large Banking Groups

Source: IMF staff calculations.

Figure 10.2System DD Minus Average DD of Large Banking Groups

Source: IMF staff calculations.

Note: DD = distance to default.

Figure 10.3Correlation between Banking and Insurance Sector DDs

Source: IMF staff calculations.

Note: DD = distance to default.

The relatively strong performance of financial soundness indicators for large Canadian banks likely reflects improvements in risk management. Perhaps surprisingly at first sight, given the banks' increased exposure to stock markets, the deterioration of DD indicators after 2000 was relatively modest. In particular, the decline in the average DD—signaling a rise in vulnerability—was much less than the drop following the Russian default, Brazil crisis, or LTCM collapse in 1998 and 1999, when market volatility of bank valuations increased substantially. This observation is consistent with anecdotal evidence that large Canadian banks, like other large and internationally active banks, have improved their risk-management capabilities in recent years, strengthening their ability to absorb the impact of shocks on their balance sheets (see, for example, Bank of International Settlements, 2002).

Soundness Indicators in Canada and the United States

The broad trends in financial soundness indicators in Canada have much in common with those in the United States. Large banking groups in both countries have undergone rapid growth and similar structural shifts in their balance sheets. During the second half of the 1990s, this expansion was accompanied by almost identical declines in average DD measures for U.S. and Canadian large banking groups (Figure 10.4).8 Since 2000, DDs in both countries have been volatile, although on average they have increased by a greater amount in the Canadian case—which may reflect a somewhat stronger build-up of capital ratios. Nonetheless, differences between the two countries are small, and large banking groups in both countries have come through the recent testing period of economic downturn and financial market distress with strengthened soundness indicators.

Figure 10.4Average DD in Canada and the United States

Source: IMF staff calculations.

Note: DD = distance to default.

In contrast to the United States, structural change does not appear to have led to an increase in risk concentration in the Canadian banking system. In Canada, the risk-concentration measure (weighted minus unweighted average DD) has been relatively unchanged since the beginning of the 1990s (Figure 10.5). In essence, the Canadian system has remained dominated by the same number of players, broadly equal in size and with relatively independent risk profiles. By contrast, risk concentration in the United States increased markedly in the second half of the 1990s, owing in part to consolidation—on the same scale, the temporary increase in risk concentration in the Canadian system in 2002 noted above is much smaller.

Figure 10.5Risk Concentration in Canada and the United States

(Difference between weighted and unweighted average of DDs)

Source: IMF staff calculations.

Note: DD = distance to default.

Conclusions

This analysis suggests that substantial growth and structural change in the Canadian banking sector have not added to systemic risk over time. Default risk did rise significantly when balance sheets expanded rapidly in the second half of the 1990s. However, helped by the ongoing buildup of additional capital and seemingly improved risk management practices, risk profiles have subsequently recovered. Moreover, the large banking groups' individual risk profiles have remained relatively uncorrelated, notwithstanding that their business strategies have shared many common features, and risk concentration has not on average increased. However, with a relatively small number of players, each individual large bank is of systemic consequence. A close correlation of risk profiles between banks and insurance companies implies that the financial sector as a whole remains exposed to common sources of risks.

Prepared with research assistance from Marianne El-Khoury.

This reflects an increase in the share of assets devoted to securities for all except one bank.

Estimates of the market value of assets are based on the structural valuation model of Black and Scholes (1973) and Merton (1974) and were computed using the estimation procedure described in Vassalou and Xing (2004) using daily market and annual accounting data.

Two caveats apply. First, the DD as employed here does not take into account the stochastic interest rate risk stemming from the correlation between the risk-free rate and the value of a company's assets. As this is potentially another important source of risk for banks, risks might be underestimated in this analysis. See Liu, Papakirykos, and Yuan (2004) for an extension incorporating interest rate risk. Second, as the DD is based on market data, the DDs for large banking groups can be subject to large fluctuations, which tend to be associated with the business cycle and “expectation cycles” regarding future earnings prospects.

If balance sheet valuations of assets are used to weight the DDs, the downward spike largely disappears. However, the use of market valuations seems preferable for diagnostic purposes because the objective is to capture the market's assessment of risk.

Correlations are computed using daily data and a one-year rolling window.

For more analysis of DD measures in the United States, see IMF (2004c).

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