This Selected Issues paper for Canada presents comprehensive and broad-based analysis of the role of domestic and external shocks. Canada’s economic history illustrates the important role played by external as well as domestic macroeconomic disturbances. Canada’s economy slowed in 2001 because of the global slowdown, although by less than in many other countries. In 2003, the recovery has been interrupted by a series of shocks that moderated growth. Fluctuations in Canadian real GDP are explained by external and domestic cycles.

Abstract

This Selected Issues paper for Canada presents comprehensive and broad-based analysis of the role of domestic and external shocks. Canada’s economic history illustrates the important role played by external as well as domestic macroeconomic disturbances. Canada’s economy slowed in 2001 because of the global slowdown, although by less than in many other countries. In 2003, the recovery has been interrupted by a series of shocks that moderated growth. Fluctuations in Canadian real GDP are explained by external and domestic cycles.

PART IV: FINANCIAL SECTOR ISSUES

VI. Large Banking Groups and Financial System Soundness73

A. Overview

1. This paper 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 has led to the emergence of six large banking groups (LBGs) that account for a large share of the Canadian financial system. Over the past twenty years, the LBGs have been diversifying 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 in this paper—based on so-called “distance-to-default” models—suggest that the rapid growth of the LBGs in the second half of the 1990s was associated with a significant increase in their overall risk profile. More recently, however, LBGs’ risk-adjusted returns appear to have improved, and soundness has been further underpinned by ongoing increases in capital adequacy ratios.

2. The recent strong performance of the LBGs 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 LBG performance. However, bank profitability has since recovered and other financial soundness indicators have continued to strengthen from already comfortable levels. Moreover, the relatively modest rise in default risk during the recent slowdown, compared with that during the Russian, Brazilian and LTCM crises of the late 1990s, suggests a strengthening of risk management practices on the part of the LBGs.

B. Banking Sector Trends

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

4. The LBGs went through a rapid growth spell in the second half of the 1990s, partly in response to recent legislative changes (Box 1). From end-1996 to end-2001, their deposit base and total assets expanded by more than 50 percent. On the asset side, investments were channeled in particular into securities and mortgages. In recent years, however, balance sheet expansion has slowed down dramatically, in part for cyclical reasons.

Changes to Canada’s Financial Sector Legislation

The rapid growth of LBGs 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 non-financial business were also relaxed, together with the introduction of a holding company regime. 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 non-voting 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 once every ten years. In 1992, the review period was shortened to five years and extended to the legislation governing all federal financial institutions.

5. LBGs’ investment behavior since the mid-1990s is the continuation of a longer trend reflecting the expansion of their fee-earning business. As part of their growth and diversification strategy, LBGs have been acquiring mortgage loan companies, securities businesses, and trust companies (Calmès, 2004). Through this process, they have 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 1).74

Table 1:

Balance Sheet Items of Six Large Banking Groups

(In percent, unless otherwise noted)

article image
Source: Office of the Superintendent of Financial Institutions.

As percent of total assets.

In percent of risk-weighted assets.

Average annual percentage change 1996–2000.

6. The LBGs have also acquired substantial foreign investments. Consistent with many analysts’ view that the Canadian market does not offer sufficient banking economies of scale, LBGs have sought to expand their business abroad. Over the past 10 years, LBGs’ foreign securities holdings have grown at roughly three times the pace of domestic securities. While accumulating large U.S. dollar exposures in general, LBGs have also acquired extensive direct investments in the United States and the Caribbean.

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

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

9. Foreign and financial market exposures contributed to significant strains in the banking sector after the bursting of the stock market bubble. Although the downturn of the Canadian economy was relatively mild, non-interest income growth dropped from over 25 percent per year between 1996 and 2000 to virtually zero between 2001 and 2003 (Figure 1). 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 2).

Figure 1.
Figure 1.

Growth of income components of LBGs

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A006

Source: OSFI.
Table 2.

Vulnerability Indicators of the Banking System 1/

article image
Sources: Bloomberg; Canadian Bankers Association; Haver Analytics; and Office of the Superintendent of Financial Institutions.

Unless otherwise indicated, based on data reported by the six largest chartered Canadian banks, which account for some 90 percent of the total market share.

All chartered banks.

10. Nevertheless, throughout both the growth spell and subsequent slowdown, LBGs continued to build up capital relative to risk-weighted assets. Total LBG 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.

11. LBGs have also reduced their off-balance sheet activities. Prior to 1998, LBGs took on increasing exposures in the derivatives markets as well as boosting 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, the LBGs have not expanded—and in some cases made further sizable contractions in—their off-balance sheet activity since 1999.

12. Despite similar features, the business strategies of the six LBGs have not been identical and financial performance has been varied. The largest and one of the mid-tier LBGs 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 LBGs—was quite volatile, culminating in pre-tax losses in 2002. One other LBG—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.

C. Market-Based Financial Soundness Indicators

13. Business strategies of the LBGs affect both the financial soundness of the individual institutions and that of 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 lower capital or profitability, or increased earnings volatility, financial soundness may not necessarily improve—as reflected in the recent performance of individual banks. Moreover, were all LBGs to diversify in the same direction, systemic vulnerability (i.e., the risk of several banks experiencing distress at the same time) to large, common shocks could increase even if each bank individually was better hedged against risks.

14. This section evaluates trends in Canada’s financial system vulnerability using a market-based soundness indicator. The indicator, which was estimated for the period 1991–2003, is based on distance-to-default (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.75 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.76 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.77

15. The analysis provides a number of conclusions regarding the impact of evolving business strategies on LBGs’ financial soundness:

  • There appears to be no trend movement in the average DD for the six LBGs since 1990 (Figure 2). Although distance to default narrowed sharply in the late 1990s as a substantial deterioration in the risk-adjusted return outweighed rising capital ratios, the LBGs’ average risk profile has again improved significantly in the last few 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 LBGs.

  • 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 LBG’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 (Figure 3). However, it dropped in 2002, owing to a substantial reduction in the market valuation of two of the largest LBGs.78 The spike highlighted risks in two of Canada’s important banks, even though average soundness measures for the sector remained satisfactory.

  • Risk profiles of the LBGs do not appear to have converged. The standard deviation of DD indicators for the six individual LBGs does not exhibit a trend over the past 15 years (Figure 4). In fact, a rising standard deviation suggests that banks’ risk profiles have diverged somewhat in the last few years.

  • LBGs appear resilient to common shocks. A “system” DD can be computed using market measures of return and volatility for the aggregate LBG subsector and its capital-asset ratio. As such, it measures the default risk of an entity whose balance sheet is the aggregate of the LBGs’ balance sheets. The system DD is almost always substantially higher than the average DD, indicating that correlations between the portfolios of the different LBGs are low, and hence that the group of LBGs as a whole remains well diversified (Figure 5). 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 LBGs. However, the difference between the system and average DD has since rebounded to above its long-term average.

  • However, high correlation of DD measures across sectors suggests 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 6).79 In effect, most of the time, the fortunes of the LBGs and other financial institutions are expected to follow similar paths. Risks in the banking sector and the non-financial 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 7).

Figure 2.
Figure 2.

Average Distance to Default of LBGs

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A006

Source: Fund staff calculations.
Figure 3.
Figure 3.

Risk Concentration in LBGs

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A006

Source: Fund staff calculations.
Figure 4.
Figure 4.

Standard Deviation of Distance to Default of LBGs

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A006

Source: Fund staff calculations.
Figure 5.
Figure 5.

System DD minus Average DD of LBGs

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A006

Source: Fund staff calculations.
Figure 6.
Figure 6.

Correlation between Banking and Insurance Sector DDs

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A006

Source: Fund staff calculations.
Figure 7.
Figure 7.

Correlation between Banking and Non Financial Sector DDs

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A006

Source: Fund staff calculations.

16. The relatively strong performance of financial soundness indicators for Canadian LBGs in recent years likely reflects improvements in risk management. Perhaps surprisingly at first sight, given LBGs’ 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 Russia default, Brazil crisis and LTCM collapse in 1998 and 1999 when market volatility of bank valuations increased substantially. This observation is consistent with anecdotal evidence that Canadian LBGs, 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 (e.g., Bank of International Settlements, 2002).

D. Soundness Indicators in Canada and the United States

17. 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 8).80 Since the beginning of the current decade, DDs in both countries have been volatile, although on average 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 LBGs in both countries have come through the recent testing period of economic downturn and financial market distress with strengthened soundness indicators.

Figure 8.
Figure 8.

Average DD in Canada and the United States

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A006

Source: Fund staff calculations.

18. 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 9). In essence, the Canadian system has remained dominated by the same number of broadly equalsized players 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 9.
Figure 9.

Risk Concentration in Canada and the United States

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A006

Source: Fund staff calculations.

E. Summary

19. This paper suggests that substantial growth and structural change in the Canadian banking sector have not, over time, added to systemic risk. 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, LBGs’ individual risk profiles have remained relatively uncorrelated, notwithstanding their business strategies sharing many common features, and risk concentration has not on average increased. However, with a relatively small number of players, each individual LBG 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.

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73

Prepared by Gianni De Nicoló, Alexander Tieman, and Robert Corker, with research assistance from Marianne El-Khoury. All were in MFD at the time of writing.

74

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

75

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.

76

Two caveats apply. First, the DD as employed in this paper 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 banks face, risks might be underestimated in the 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 LBGs can be subject to large fluctuations, which tend to be associated with the business cycle and ‘expectation cycles’ regarding future earnings prospects.

78

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 as the objective is to capture the market’s assessment of risk.

79

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

80

For more analysis of distance-to-default measures in the United States, see IMF (2004).

Canada: Selected Issues
Author: International Monetary Fund