The role of bank capitalization in the Great Recession

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The Canadian financial system was highly acclaimed at this time due to its consideration by many leading economic research organizations as being the safest in the world and for effectively withstanding the impact of the Great Recession. However, it is important to note that the Canadian government facilitated the purchase of roughly $125 billion in mortgage assets through the Canada Mortgage and Housing Corporation, which is a Canadian Crown Corporation.  However, this was not a bailout as the CMHC was already insuring these mortgages. Indeed, the CMHC securitization guarantee programs insure all interest and principal payments on mortgage backed securities sold by approved financial institutions consisting of eligible mortgages. At this time, Canadian banks were profitable and well-capitalized, and only 7 banks in the world obtained an AAA rating from Moody’s, two of which were Canadian. It is also important to note that Canadian banks did not issue toxic mortgage backed securities. However, they had an acute degree of exposure to them which effectuated their incursion of $20 billion in losses. CIBC in particular had to book a $3.5 billion loss on its MBS portfolio. Indeed, the main reason for which the Great Recession did not inhibit the fortitude of the Canadian financial system to a great degree is thought by many to be a derivative (no pun intended) of the fact that the Canadian financial system is subject to a much greater degree of regulatory oversight than its American counterpart. For example, Canadian financial institutions must retain at least $7 out of every $100 they’ve lent out in tier 1 capital (retained earnings, the bank’s profit after having paid shareholder dividend, and the value of its common stock) in order to be considered to be well-capitalized, whereas American banks must only retain the equivalent of 6% of their lent capital as common equity, published reserves, and equivalents. Though, Canadian banks typically retain 10% of their lent-out funds in tier 1 capital. Although financial institutions would indeed like to supplement their balance sheets with some margin of safety with that regard, the sheer magnitude of the excess reserves also instigates the notion that such a significant degree of capitalization also intended to facilitate the completion of some set of commercial objectives, which may include, but are not limited to, the acquisition of stellar credit ratings and the reassurance of future venture partners of the robust nature of Canadian financial institutions. Furthermore, in the 10 years preceding the start of the financial crisis, there was no large-scale deregulation of the US financial system in the first place which would have served to invigorate incentives for US financial institutions to issue toxic mortgage backed securities, and the Canadian regulatory framework did allow for the issuance of such securities which comprised 7% of the Canadian market in 2008. Though, one could point out that American banks at this time were much more leveraged than their Canadian counterparts and that as a function of an abysmal degree of fortitude with regards to their capital position, they were prone to failure. Though, increasing tier 1 capital requirements would not have necessarily capacitated the evasion of American financial institutions of failure, as it would have only served to bolster incentives for securitization.