## 5. The Determinants of Bank Performance during the Financial Turmoil

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---

### Introduction
- Credit turmoil started in 2007 and intensified in 2008, imposing significant strains on banks worldwide.
- Major disruptions originated in markets for complex assets and wholesale funding, affecting countries with sophisticated financial systems (such as most OECD members).
- Impacts extended beyond the financial sector to the real economy via credit crunches, fiscal shortfalls, and balance of payment problems; feedback loops between finance and the real economy were often significant.
- Canada experienced deterioration in funding conditions and reduced profitability, but:
  - Public bank recapitalizations were not needed.
  - Government guarantees on bank funding (precautionary) were not drawn upon.
  - Canadian resilience is attributed to fundamental strengths of Canadian banks.
- Paper objective: understand key sources of Canada’s resilience to the turmoil to assess ongoing risks and draw lessons for other countries.
- Structure:
  - Section 2 analyzes pre-crisis fundamentals (capital, liquidity, deposit ratios) and tracks their impact on bank performance during the crisis using objective and subjective measures (e.g., equity price decline and need for government assistance).
  - Section 3 (reviewed) examines regulatory and structural factors that may have reduced Canadian banks’ risk incentives (stringent capital regulation, limited foreign/wholesale activities, valuable franchises, conservative mortgage market).

### Fundamentals of Canadian Banks — Pre-crisis comparisons (end-2006)
- Data source and sample:
  - BankScope data for end-2006 to capture pre-crisis conditions.
  - Sample: 72 banks with assets exceeding 100 billion euro as of end-2006 (major commercial banks in OECD countries).
  - Equity price declines measured between January 2007 and January 2009.
- Three balance-sheet fundamentals considered:
  - Capital ratios: total equity over total assets.
  - Balance sheet liquidity: liquid assets over total debt liabilities (liquid assets include cash, government bonds, short-term claims on other banks, and trading portfolio where appropriate).
  - Funding structure: depository funding over total assets (deposits vs. wholesale funding).

### Capitalization — empirical observations
- Method: simple equity-to-assets measure used for comparability.
- Findings:
  - The simple capitalization measure identified vulnerabilities from critically low capital.
  - Of the twelve banks with the lowest capital ratio at end-2006:
    - Six lost more that 85 percent of equity value.
    - Four lost between 70 and 85 percent of equity value.
    - Five required significant government intervention due to extreme stress; five more required intervention due to other weakness.
  - Canadian banks’ capital ratios were generally in the third (from the highest) quartile of the sample: "below average, not particularly strong, but high enough to avoid insolvency problems on minor losses."
  - High pre-crisis capital did not guarantee immunity (exhaustion of capital buffers occurred for some highly capitalized banks exposed to troubled assets or acquisitions).
- Specific table examples:
  - Hypo Real Estate Holding AG (GERMANY) capital 2.1 → Value decline 97 → Asset guarantees and public loans.
  - Canadian Imperial Bank of Commerce (CANADA) capital 4.1 → Value decline 54.
  - Royal Bank of Canada RB C (CANADA) capital 4.3 → Value decline 44.
  - Toronto Dominion Bank (CANADA) capital 5.7 → Value decline 43.

### Liquidity — empirical observations
- Measure: balance sheet liquidity = liquid assets over total debt liabilities (BankScope definition).
- Findings:
  - Many U.S. banks had very scarce measured balance sheet liquidity because mortgage-backed securities and municipal bonds were not treated as liquid in this narrow definition.
  - Liquidity levels vary by business model (e.g., asset and wealth management banks tend to be more liquid).
  - Canadian banks had good balance sheet liquidity at onset of turmoil: "above average, being in the second quartile (from the highest) of the OECD sample."
  - Australian banks consistently had low liquidity; all in bottom quartile.
  - Liquidity was a weaker predictor of resilience than capital ratio:
    - Of twelve least liquid banks, eight had equity price declines of more than 70 percent, and four required significant government intervention.
    - Balance sheet liquidity can provide only temporary relief; during protracted turmoil, capital and funding structure become more important.
- Specific table examples:
  - UBS AG (SWITZERLAND) liquidity 65.20 → Value decline 79 → Capital injection.
  - Royal Bank of Canada (CANADA) liquidity 32.11 → Value decline 44.
  - Banque de Montreal-Bank of Montreal (CANADA) liquidity 23.99 → Value decline 53.

### Funding structure — empirical observations
- Measure: depository funding over total assets (deposit-to-asset ratio).
- Rationale: retail deposits considered "sticky" and less subject to runs than money-market wholesale funding.
- Data limitations: inability to reliably distinguish insured retail deposits/transaction accounts from large-denomination deposits across jurisdictions; total depository funding is the comparable measure available.
- Findings:
  - Funding structure is an important predictor of bank resilience during the turmoil.
  - Of the twelve most vulnerable large OECD banks by deposits measure:
    - Six experienced equity declines of over 85 percent.
    - Four experienced equity declines between 70 and 85 percent.
    - Five required government intervention due to extreme stress; one more due to other weakness.
  - Canadian banks are "positive outliers" on the deposit-to-assets ratio: almost all large Canadian banks are in the top quartile of the sample.
  - Anecdotal evidence: higher fraction of Canadian bank deposits are "core deposits" (transaction accounts and small deposits) compared with the U.S.
  - Institutional reasons:
    - Canadian banks’ universal-banking structure and one-stop services (mutual funds and asset management) likely support deposit supply.
    - In Australia, competition for household savings from superannuation funds contributes to wholesale funding reliance; some Australian deposit-to-assets ratios reflect overseas and money-market-sourced deposits.
- Specific table examples:
  - Royal Bank of Canada (CANADA) depository funding 65.1 → Value decline 44.
  - Banque de Montreal-Bank of Montreal (CANADA) depository funding 65.2 → Value decline 53.
  - Canadian Imperial Bank of Commerce (CANADA) depository funding 68.2 → Value decline 54.
  - Bank of Nova Scotia (The) - CANADA depository funding 71.4 → Value decline 42.
  - Washington Mutual Inc. (USA) depository funding 74.6 → Value decline 100 → Failed, taken over by FDIC.

### Multivariate regression analysis — determinants of bank performance
- Sample and dependent variables:
  - Sample: large commercial banks in OECD countries (assets above 100 billion euro at end-2006), N = 72 (62 for equity-price-based regressions due to non-public banks).
  - Four alternative outcome (dependent) variables:
    1. Dummy for government intervention in response to extreme stress.
    2. Dummy for equity price decline >85 percent.
    3. Dummy for equity price decline >70 percent (median = 70 percent).
    4. Absolute percentage decline of equity price (Jan 2007 to Jan 2009).
- Main explanatory variables:
  - Equity-to-asset ratio (Equity Ratio).
  - Balance sheet liquidity (liquid assets-to-debt-liabilities).
  - Depository funding (deposit-to-asset ratio).
  - Log total assets (bank size).
- Additional specification checks:
  - Dummy variables for critically low levels: Equity Ratio < 4% and Depository Funding < 50%.
  - Interaction term: Equity Ratio * Depository Funding (to capture substitutability).
- Key regression results (Table 5 summary):
  - Depository funding significantly and robustly explains bank performance during the credit turmoil (negative coefficient on depository funding implies higher deposits → better performance).
  - Balance sheet illiquidity predicts particularly rapid deteriorations (significant for government intervention under extreme stress and equity decline >85%).
  - Equity ratio as a continuous variable often appears insignificant as an explanatory variable in main specifications.
  - Critically low capital (Equity Ratio < 4%) is a significant predictor of future bank performance in terms of equity price decline, but not a significant predictor of extreme stress requiring government intervention.
  - Interaction Equity Ratio * Depository Funding enters with a significant positive sign: evidence of substitutability — "a bank with higher capital needs fewer deposits, and a bank with more deposits can sustain lower capital, for the same degree of resilience."
  - Bank size (log assets) is a significant predictor of government involvement — governments more likely to intervene in larger banks.
  - Asset growth over the three years preceding the crisis was not related to bank performance during the turmoil (result reported but not tabulated).
- Regression fit statistics:
  - R-squared values across specifications reported in Table 5 range up to 0.450 in some specifications.
  - N = 72 for government-intervention regressions; N = 62 for equity-price-based regressions.
- Robustness and comparison:
  - Results broadly consistent with IMF Global Financial Stability Report (2009B, April, Chapter 3) though sample and variables differ.
  - Novel highlights: critical undercapitalization, balance sheet liquidity, and depository funding effects.

### Asset-Side Exposures
- Regression approach and reporting:
  - Regressions involving dummy variables estimated based on Probit, with coefficients transformed to be interpreted as probability change (0 to 1).
  - Other regressions estimated with OLS.
  - T-statistics adjusted for clustering of residuals by countries are reported in parenthesis.
  - Symbols ***, **, * indicate statistical significance at the 1%, 5%, and 10% level, respectively.
- Analytical focus and findings:
  - Analysis examines banks’ balance sheet structures, not banks’ asset-side risk exposures.
  - Two asset-side exposures identified as key sources of bank losses during the crisis: exposures to troubled U.S. assets, and exposures to inflated domestic housing markets and over-leveraged consumers.
  - Asset investment decisions considered endogenous to the choice of funding structures; reference to Huang and Ratnovski (2008) for theory that banks match wholesale funding with arms’ length assets such as mortgage-backed securities and derivative structured products.
- Empirical observations for Canadian banks:
  - Canadian banks had limited exposure to troubled U.S. assets.
  - Possible explanations: sound risk-management, regulation discouraging non-core foreign activities, and potentially low gains from diversification into a closely correlated economy.
  - Limited exposure to troubled U.S. assets contributed to stability of Canadian banks during the turmoil.
  - Canadian house prices appear not to be over-inflated (except locally for some provinces, see Tsounta, 2009).
- Implications:
  - Ability to predict the most vulnerable banks without asset-side exposure information highlights importance of asset and liability structure.
  - Strategic business model choices likely more explanatory of poor performance than tactical investment mistakes.
  - Observable structural indicators may be easier for regulators to monitor than complex asset-side risk exposures.
  - Sound structural fundamentals can mitigate the impact of risky exposures (example: Canadian Imperial Bank of Commerce — relatively strong depository funding ratio helped withstand material exposure and raise capital).
  - Weak structural fundamentals can pose risks even with limited risky exposures (example: Northern Rock had no material exposures to the U.S. subprime sector but failed).

### Regulatory and Structural Environment in Canada
- Overview:
  - Sound fundamentals of Canadian banks were complemented and in part caused by regulatory and industry structure that discouraged excessive risk-taking.
  - Key features described: capital regulation, liquidity framework, and banking market structure.

- A. Capital Regulation
  - Two key thresholds: minimum risk-based capital ratios and a maximum assets-to-capital multiple (inverse leverage).
  - Risk-based capital:
    - Basel Accord requires internationally active banks to hold tier 1 capital of at least 4 percent and total capital of at least 8 percent of risk-weighted assets.
    - Canada imposes capital requirement targets higher than Basel minima: tier 1 capital of 7 percent and total capital of 10 percent.
    - Targets are explicit and identical for all banks, implemented as part of Basel II Pillar 2 requirements.
    - Targets were put in place in 1997 (all large domestic banks were in compliance with regulation at the time of its introduction) and were retained after the implementation of Basel II in 2008.
    - Canadian capital regime requires at least 75% of tier 1 capital be formed of common equity, and restricts innovative instruments to 15 percent of tier 1 capital.
    - Thresholds were recently temporarily relaxed to 40 percent to allow banks extra flexibility in the face of possible funding pressures, as a means of counter-cyclical capital policy.
  - Assets-to-capital multiple:
    - Calculated by dividing the institution’s total assets by total (tiers 1 and 2) capital.
    - Maximum multiple is set at 20 (leverage ratio of 5%).
    - Exemptions for the multiple of up to 23 may be granted on an individual basis by the Office of the Superintendent of Financial Institutions (OSFI).
    - Allowed multiple may be reduced at OSFI discretion, for example for rapidly-growing institutions.
  - Effects of stringent capital requirements:
    - Provide enhanced capital cushion.
    - Restrict rapid balance sheet expansion that may lead to reckless investments.
    - Banks constrained in balance sheet size engage less in wholesale operations as retail operations can satisfy a greater fraction of investment needs.
    - Banks subject to more rigorous capital requirements than elsewhere are less competitive internationally and have lower incentives for foreign expansion except when they have distinct competitive advantages.

- B. Liquidity Framework in Canada
  - Guidelines specify banks must maintain a stock of highly liquid assets appropriate for their cash flow and funding profile.
  - Banks with more than 10 percent of funding coming from wholesale sources are required to put in place internal limits on short-term (e.g., next day, 2-7 days and 8-30 days) funding requirements and actively measure and monitor actual requirements against those limits.
  - Current guidelines have no quantitative liquidity minimum, emphasizing stress-testing and contingency planning instead.

- C. Banking Market Structure
  - Structural factors contributing to stable retail deposit base and lower risk-taking:
    - Sector dominated by six large banks with an integrated nation-wide branch network.
    - National franchise is highly profitable and valuable; banks are keen to preserve it and avoid excess risks that could compromise the franchise.
    - Demand for nation-wide bank branch network serves as a barrier to contestability of banking services, especially in deposit and debt card products; limited external competition reduces pressure to defend or expand market share.
    - Retail funding supply and retail loan demand appear well-matched, reducing banks’ need to engage in wholesale borrowing or lending.
    - Larger corporations typically borrow directly from capital markets or from syndicates often led by foreign banks, possibly because higher capital requirements increase local banks’ cost of capital and reduce competitiveness in syndicated loans market.
  - Mortgage market characteristics:
    - Less than 3 percent of mortgages are subprime.
    - Less than 30 percent of mortgages are securitized (compared with about 15 percent and 60 percent respectively in the United States prior to the crisis).
    - Mortgages with a loan-to-value ratio of more than 80 percent need to be insured for the whole amount (rather than the portion above 80 percent as in the United States).
    - Mortgages with a loan-to-value ratio of more than 95 percent cannot be underwritten by federally-regulated depository institutions.
    - To qualify for mortgage insurance, mortgage debt service-to-income ratio should usually not exceed 32 percent and total debt service 40 percent of gross household income.
    - Few fixed-rate mortgages have a contract term longer than five years.

### Conclusions
- Main findings:
  - Ample retail depository funding was the key factor behind the relative resilience of Canadian banks during the turmoil.
  - Sufficient capital and liquidity were also important but played a less distinctive role.
  - A number of regulatory and structural factors reduced Canadian banks’ incentives to take risks.
- Projection/conjecture:
  - Strong structural fundamentals of Canadian banks will remain a source of their resilience as the financial turmoil and economic recession persist.

*Source — _wp09152 - 5. The Determinants of Bank Performance during the Financial Turmoil (end-2006 data; equity-price declines Jan 2007–Jan 2009); BankScope and staff calculations; sample: large OECD banks with assets above 100 billion euro at end-2006._*

### References  ............................................................................................................

### _wp09152 - References  ............................................................................................................

### References
- References ........................................................................................................................19

### Tables
- 1. Subsample of Banks.................................................................................................6
- 2.         Capital         Ratio ............................................................................................................7
- 3.         Balance         Sheet         Liquidity ...........................................................................................9
- 4.         Depository         Funding ...............................................................................................11

*Source: _wp09152 - References  (page listings as provided)*

### 5. The Determinants of Bank Performance during the Financial Turmoil ................14

### 5. The Determinants of Bank Performance during the Financial Turmoil

### Introduction
- Credit turmoil started in 2007 and intensified in 2008, imposing significant strains on banks worldwide.
- Major disruptions originated in markets for complex assets and wholesale funding, affecting countries with sophisticated financial systems (such as most OECD members).
- Impacts extended beyond the financial sector to the real economy via credit crunches, fiscal shortfalls, and balance of payment problems; feedback loops between finance and the real economy were often significant.
- Canada experienced deterioration in funding conditions and reduced profitability, but:
  - Public bank recapitalizations were not needed.
  - Government guarantees on bank funding (precautionary) were not drawn upon.
  - Canadian resilience is attributed to fundamental strengths of Canadian banks.
- Paper objective: understand key sources of Canada’s resilience to the turmoil to assess ongoing risks and draw lessons for other countries.
- Structure:
  - Section 2 analyzes pre-crisis fundamentals (capital, liquidity, deposit ratios) and tracks their impact on bank performance during the crisis using objective and subjective measures (e.g., equity price decline and need for government assistance).
  - Section 3 (reviewed) examines regulatory and structural factors that may have reduced Canadian banks’ risk incentives (stringent capital regulation, limited foreign/wholesale activities, valuable franchises, conservative mortgage market).

### Fundamentals of Canadian Banks — Pre-crisis comparisons (end-2006)
- Data source and sample:
  - BankScope data for end-2006 to capture pre-crisis conditions.
  - Sample of major commercial banks in OECD countries: 72 banks with assets exceeding 100 billion euro as of end-2006.
  - Equity price declines measured between January 2007 and January 2009.

- Three balance-sheet fundamentals considered:
  - Capital ratios: total equity over total assets.
  - Balance sheet liquidity: liquid assets over total debt liabilities (liquid assets include cash, government bonds, short-term claims on other banks, and trading portfolio where appropriate).
  - Funding structure: depository funding over total assets (deposits vs. wholesale funding).

### Capitalization — empirical observations
- Simple equity-to-assets measure used for comparability.
- Findings:
  - The simple capitalization measure identified vulnerabilities from critically low capital.
  - Of the twelve banks with the lowest capital ratio at end-2006:
    - Six lost more that 85 percent of equity value.
    - Four lost between 70 and 85 percent of equity value.
    - Five required significant government intervention due to extreme stress; five more required intervention due to other weakness.
  - Canadian banks’ capital ratios were generally in the third (from the highest) quartile of the sample: "below average, not particularly strong, but high enough to avoid insolvency problems on minor losses."
  - High pre-crisis capital did not guarantee immunity (exhaustion of capital buffers occurred for some highly capitalized banks exposed to troubled assets or acquisitions).
- Specific table examples (capital ratios and outcomes cited in source):
  - Hypo Real Estate Holding AG (GERMANY) capital 2.1 → Value decline 97 → Asset guarantees and public loans.
  - Canadian examples: Canadian Imperial Bank of Commerce (CANADA) capital 4.1 → Value decline 54; Royal Bank of Canada RB C (CANADA) capital 4.3 → Value decline 44; Toronto Dominion Bank (CANADA) capital 5.7 → Value decline 43.
  - (Source lists multiple banks and outcomes in Table 2.)

### Liquidity — empirical observations
- Balance sheet liquidity measured as liquid assets over total debt liabilities (BankScope definition).
- Findings:
  - Many U.S. banks had very scarce measured balance sheet liquidity because mortgage-backed securities and municipal bonds were not treated as liquid in this narrow definition.
  - Liquidity levels vary by business model (e.g., asset and wealth management banks tend to be more liquid).
  - Canadian banks had good balance sheet liquidity at onset of turmoil: "above average, being in the second quartile (from the highest) of the OECD sample."
  - Australian banks consistently had low liquidity; all in bottom quartile.
  - Liquidity was a weaker predictor of resilience than capital ratio:
    - Of twelve least liquid banks, eight had equity price declines of more than 70 percent, and four required significant government intervention.
    - Balance sheet liquidity can provide only temporary relief; during protracted turmoil, capital and funding structure become more important.
- Specific table examples (liquidity and outcomes cited in source):
  - UBS AG (SWITZERLAND) liquidity 65.20 → Value decline 79 → Capital injection.
  - Royal Bank of Canada (CANADA) liquidity 32.11 → Value decline 44.
  - Banque de Montreal-Bank of Montreal (CANADA) liquidity 23.99 → Value decline 53.

### Funding structure — empirical observations
- Funding structure measured as depository funding over total assets (deposit-to-asset ratio).
- Rationale: retail deposits considered "sticky" and less subject to runs than money-market wholesale funding.
- Data limitations: inability to reliably distinguish insured retail deposits/transaction accounts from large-denomination deposits across jurisdictions; total depository funding is the comparable measure available.
- Findings:
  - Funding structure is an important predictor of bank resilience during the turmoil.
  - Of the twelve most vulnerable large OECD banks by deposits measure:
    - Six experienced equity declines of over 85 percent.
    - Four experienced equity declines between 70 and 85 percent.
    - Five required government intervention due to extreme stress; one more due to other weakness.
  - Canadian banks are "positive outliers" on the deposit-to-assets ratio: almost all large Canadian banks are in the top quartile of the sample.
  - Anecdotal evidence: higher fraction of Canadian bank deposits are "core deposits" (transaction accounts and small deposits) compared with the U.S.
  - Institutional reasons:
    - Canadian banks’ universal-banking structure and one-stop services (mutual funds and asset management) likely support deposit supply.
    - In Australia, competition for household savings from superannuation funds contributes to wholesale funding reliance; some Australian deposit-to-assets ratios reflect overseas and money-market-sourced deposits.
- Specific table examples (deposit ratios and outcomes cited in source):
  - Royal Bank of Canada (CANADA) depository funding 65.1 → Value decline 44.
  - Banque de Montreal-Bank of Montreal (CANADA) depository funding 65.2 → Value decline 53.
  - Canadian Imperial Bank of Commerce (CANADA) depository funding 68.2 → Value decline 54.
  - Bank of Nova Scotia (The) - CANADA depository funding 71.4 → Value decline 42.
  - Washington Mutual Inc. (USA) depository funding 74.6 → Value decline 100 → Failed, taken over by FDIC.

### Multivariate regression analysis — determinants of bank performance
- Sample and dependent variables:
  - Sample: large commercial banks in OECD countries (assets above 100 billion euro at end-2006), N = 72 (62 for equity-price-based regressions due to non-public banks).
  - Four alternative outcome (dependent) variables:
    1. Dummy for government intervention in response to extreme stress.
    2. Dummy for equity price decline >85 percent.
    3. Dummy for equity price decline >70 percent (median = 70 percent).
    4. Absolute percentage decline of equity price (Jan 2007 to Jan 2009).
- Main explanatory variables:
  - Equity-to-asset ratio (Equity Ratio).
  - Balance sheet liquidity (liquid assets-to-debt-liabilities).
  - Depository funding (deposit-to-asset ratio).
  - Log total assets (bank size).
- Additional specification checks:
  - Dummy variables for critically low levels: Equity Ratio < 4% and Depository Funding < 50%.
  - Interaction term: Equity Ratio * Depository Funding (to capture substitutability).
- Key regression results (Table 5 summary):
  - Depository funding significantly and robustly explains bank performance during the credit turmoil (negative coefficient on depository funding implies higher deposits → better performance).
  - Balance sheet illiquidity predicts particularly rapid deteriorations (significant for government intervention under extreme stress and equity decline >85%).
  - Equity ratio as a continuous variable often appears insignificant as an explanatory variable in main specifications.
  - Critically low capital (Equity Ratio < 4%) is a significant predictor of future bank performance in terms of equity price decline, but not a significant predictor of extreme stress requiring government intervention.
  - Interaction Equity Ratio * Depository Funding enters with a significant positive sign: evidence of substitutability—"a bank with higher capital needs fewer deposits, and a bank with more deposits can sustain lower capital, for the same degree of resilience."
  - Bank size (log assets) is a significant predictor of government involvement—governments more likely to intervene in larger banks.
  - Asset growth over the three years preceding the crisis was not related to bank performance during the turmoil (result reported but not tabulated).
- Regression fit statistics (selected):
  - R-squared values across specifications reported in Table 5 range up to 0.450 in some specifications.
  - N = 72 for government-intervention regressions; N = 62 for equity-price-based regressions.
- Robustness and comparison:
  - Results broadly consistent with IMF Global Financial Stability Report (2009B, April, Chapter 3) though sample and variables differ.
  - Novel highlights: critical undercapitalization, balance sheet liquidity, and depository funding effects.

### Implications and contributing structural/regulatory factors (summary of Section 3 review)
- Factors identified as reducing Canadian banks’ incentives to take excessive risks and contributing to resilience:
  - Stringent capital regulation with higher-than-Basel minimal requirements.
  - Limited involvement of Canadian banks in foreign and wholesale activities.
  - Valuable bank franchises.
  - Conservative mortgage product market.
- Policy-relevant insight:
  - Funding structure (higher reliance on depository funding, especially core retail deposits) was the most robust pre-crisis predictor of resilience across the OECD sample.
  - Critically low capital (Equity Ratio < 4%) and low balance sheet liquidity were important indicators of vulnerability.
  - Interactions between capital and deposits suggest policy attention both to capital adequacy and to encouraging stable deposit funding.

*Italic: Source — _wp09152 - 5. The Determinants of Bank Performance during the Financial Turmoil (end-2006 data; equity-price declines Jan 2007–Jan 2009); BankScope and staff calculations; sample: large OECD banks with assets above 100 billion euro at end-2006._*

### 2006. The regressions involving dummy variables are estimated based on Probit, with coefficients transformed to be inter

### _wp09152 - 2006. The regressions involving dummy variables are estimated based on Probit, with coefficients transformed to be inter

### Asset-Side Exposures
- Regression approach:
  - Regressions involving dummy variables estimated based on Probit, with coefficients transformed to be interpreted as probability change (0 to 1).
  - Other regressions estimated with OLS.
  - T-statistics adjusted for clustering of residuals by countries are reported in parenthesis.
  - Symbols ***, **, * indicate statistical significance at the 1%, 5%, and 10% level, respectively.
- Key analytical focus:
  - Analysis examines banks’ balance sheet structures, not banks’ asset-side risk exposures.
  - Two asset-side exposures identified as key sources of bank losses during the crisis: exposures to troubled U.S. assets, and exposures to inflated domestic housing markets and over-leveraged consumers.
  - Asset investment decisions considered endogenous to the choice of funding structures; reference to Huang and Ratnovski (2008) for theory that banks match wholesale funding with arms’ length assets such as mortgage-backed securities and derivative structured products.
- Empirical observations for Canadian banks:
  - Canadian banks had limited exposure to troubled U.S. assets.
  - Possible explanations: sound risk-management, regulation discouraging non-core foreign activities, and potentially low gains from diversification into a closely correlated economy.
  - Limited exposure to troubled U.S. assets contributed to stability of Canadian banks during the turmoil.
  - Canadian house prices appear not to be over-inflated (except locally for some provinces, see Tsounta, 2009).
- Implications:
  - The ability to predict the most vulnerable banks without asset-side exposure information highlights importance of asset and liability structure.
  - Indicates strategic business model choices likely more explanatory of poor performance than tactical investment mistakes.
  - Observable structural indicators may be easier for regulators to monitor than complex asset-side risk exposures.
  - Sound structural fundamentals can mitigate the impact of risky exposures (example: Canadian Imperial Bank of Commerce—relatively strong depository funding ratio helped withstand material exposure and raise capital).
  - Weak structural fundamentals can pose risks even with limited risky exposures (example: Northern Rock had no material exposures to the U.S. subprime sector but failed).

### Regulatory and Structural Environment in Canada
- Overview:
  - Sound fundamentals of Canadian banks were complemented and in part caused by regulatory and industry structure that discouraged excessive risk-taking.
  - Section describes key features: capital regulation, liquidity framework, and banking market structure.

- A. Capital Regulation
  - Two key thresholds: minimum risk-based capital ratios and a maximum assets-to-capital multiple (inverse leverage).
  - Risk-based capital:
    - Basel Accord requires internationally active banks to hold tier 1 capital of at least 4 percent and total capital of at least 8 percent of risk-weighted assets.
    - Canada imposes capital requirement targets higher than Basel minima: tier 1 capital of 7 percent and total capital of 10 percent.
    - Targets are explicit and identical for all banks, implemented as part of Basel II Pillar 2 requirements.
    - Targets were put in place in 1997 (all large domestic banks were in compliance with regulation at the time of its introduction) and were retained after the implementation of Basel II in 2008.
    - Canadian capital regime requires at least 75% of tier 1 capital be formed of common equity, and restricts innovative instruments to 15 percent of tier 1 capital.
    - Thresholds were recently temporarily relaxed to 40 percent to allow banks extra flexibility in the face of possible funding pressures, as a means of counter-cyclical capital policy.
  - Assets-to-capital multiple:
    - Calculated by dividing the institution’s total assets by total (tiers 1 and 2) capital.
    - Maximum multiple is set at 20 (leverage ratio of 5%).
    - Exemptions for the multiple of up to 23 may be granted on an individual basis by the Office of the Superintendent of Financial Institutions (OSFI).
    - Allowed multiple may be reduced at OSFI discretion, for example for rapidly-growing institutions.
  - Effects of stringent capital requirements:
    - Provide enhanced capital cushion.
    - Restrict rapid balance sheet expansion that may lead to reckless investments.
    - Banks constrained in balance sheet size engage less in wholesale operations as retail operations can satisfy a greater fraction of investment needs.
    - Banks subject to more rigorous capital requirements than elsewhere are less competitive internationally and have lower incentives for foreign expansion except when they have distinct competitive advantages.

- B. Liquidity Framework in Canada
  - Guidelines specify banks must maintain a stock of highly liquid assets appropriate for their cash flow and funding profile.
  - Banks with more than 10 percent of funding coming from wholesale sources are required to put in place internal limits on short-term (e.g., next day, 2-7 days and 8-30 days) funding requirements and actively measure and monitor actual requirements against those limits.
  - Current guidelines have no quantitative liquidity minimum, emphasizing stress-testing and contingency planning instead.

- C. Banking Market Structure
  - Structural factors contributing to stable retail deposit base and lower risk-taking:
    - Sector dominated by six large banks with an integrated nation-wide branch network.
    - National franchise is highly profitable and valuable; banks are keen to preserve it and avoid excess risks that could compromise the franchise.
    - Demand for nation-wide bank branch network serves as a barrier to contestability of banking services, especially in deposit and debt card products; limited external competition reduces pressure to defend or expand market share.
    - Retail funding supply and retail loan demand appear well-matched, reducing banks’ need to engage in wholesale borrowing or lending.
    - Larger corporations typically borrow directly from capital markets or from syndicates often led by foreign banks, possibly because higher capital requirements increase local banks’ cost of capital and reduce competitiveness in syndicated loans market.
  - Mortgage market characteristics:
    - Less than 3 percent of mortgages are subprime.
    - Less than 30 percent of mortgages are securitized (compared with about 15 percent and 60 percent respectively in the United States prior to the crisis).
    - Mortgages with a loan-to-value ratio of more than 80 percent need to be insured for the whole amount (rather than the portion above 80 percent as in the United States).
    - Mortgages with a loan-to-value ratio of more than 95 percent cannot be underwritten by federally-regulated depository institutions.
    - To qualify for mortgage insurance, mortgage debt service-to-income ratio should usually not exceed 32 percent and total debt service 40 percent of gross household income.
    - Few fixed-rate mortgages have a contract term longer than five years.

### Conclusions
- Main findings:
  - Ample retail depository funding was the key factor behind the relative resilience of Canadian banks during the turmoil.
  - Sufficient capital and liquidity were also important but played a less distinctive role.
  - A number of regulatory and structural factors reduced Canadian banks’ incentives to take risks.
- Projection/conjecture:
  - Strong structural fundamentals of Canadian banks will remain a source of their resilience as the financial turmoil and economic recession persist.

*Source: IMF working paper content provided in the content unit.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp09152.pdf_