Up to this point, we have been describing the Canadian banking system⁵ and how it works. To fully understand that system, however, it is helpful to understand how and why it was created—a story that is closely intertwined with the story of how and when things went wrong, either here at home or abroad. The twenty-first-century Canadian banking system wasn’t created out of thin air; it emerged in response to deeply troubling historical and financial developments, such as global war and depression. This pattern of change in response to negative events has continued. For example, the financial crisis of 2008 has propelled modern financial reform to the forefront and opened the discussion about change to both the regulations that govern banking and the Bank of Canada. This discussion promises to continue reshaping the financial system well into future years.

Many Canadians are aware that Canada “came of age” during World War I (1914–1918). This phrase usually refers to Canada’s military and political contribution to the war effort. What is less well known is how Canada matured financially at this time.

Before World War I, Canada was on the gold standard, a complex fixed exchange rate arrangement in which member nations’ money was backed by, and exchangeable for, gold. Private Canadian banks in this era were allowed to issue their own banknotes as long as they held a sufficient amount of gold to back their value. These notes circulated along with Dominion of Canada notes to constitute the currency of the country. Also important during this period of our history is the fact that Canada did not have a central bank. In the days just before war was declared, Canadian banks experienced large demands for conversion of currency and deposits into gold, which led to concerns of bank runs. With no lender of last resort, banks were required by law to close if they could not meet depositor demand for gold or Dominion notes.

Rumours that a bank had insufficient gold or Dominion notes to satisfy demands for withdrawal or conversion could quickly lead to a bank run. A bank run could spark a contagion, setting off runs at other nearby banks, sowing widespread panic and devastation in the local economy. So, to protect the banks, the government enacted several laws. First, the government ordered that all the notes issued by Canadian banks were now legal tender. This is important as it gave these notes the same legal status as gold, Dominion of Canada notes, and all metallic coins minted in Canada when it came to settling transactions. Next, the government allowed banks to issue more notes. At the same time, the lender of last resort function was introduced, so the Treasury Board was allowed to make advances, which are loans made to private banks in Dominion notes, against securities these banks pledged as collateral to the minister of finance. Lastly, the government suspended the conversion of Dominion notes into gold—Canada left the gold standard. Now Canada had a floating exchange rate along with a lender of last resort. It was on its way toward creating a full-fledged central bank.

Canada did return to the gold standard temporarily, from 1926 to 1933, but this new standard differed from the pre-war version. Now, private banknotes were no longer legal tender, but the Treasury Board continued to function as the lender of last resort. Thus, banks could use securities that were not backed by gold to obtain Dominion notes, which were backed by gold. As a result, in the late 1920s, quantities of Dominion banknotes grew more quickly than the gold reserves that backed them, leading to a precarious recipe for sustainable currency valuation.

When the Great Depression hit the world in 1929, Canada stuck with the gold standard and the fixed exchange rate it created via international movements of gold. But Canada did try to discourage exports of gold. In 1931, the United Kingdom abandoned the gold standard and let the pound float in currency exchange markets. This created significant turmoil on world financial markets. The world money market froze up, as potential lenders became so fearful of making bad loans they declined to enter into almost all loan requests. Canada found that it could not obtain even short-term loans and the Canadian dollar came under significant downward pressure on foreign exchange markets. Finally, in 1933, Canada once again abandoned the gold standard, and the convertibility of Dominion notes into gold ended.

Following the Wall Street stock market crash of 1929, the Canadian economy shrank significantly. If the federal government had advanced more money to banks, the money supply would have increased; but, as it was, the government provided little or no voluntary monetary stimulus to help the economy recover. Commercial banks were allowed to request advances from the government, but chose not to do so. This was because the government did not lower the interest rate on advances, causing banks to fear that they might not be able to repay them. Consequently, the money supply contracted, instead of expanding. Nor did sticking with the gold standard, even notionally, allow the Canadian dollar to depreciate enough to stimulate net exports sufficiently to help expand the economy and create jobs.

Unfortunately, as is now well understood by economic historians, the falling money supply and shrinking trade balance of the early 1930s acted to significantly worsen and prolong the economic slump now known as the Great Depression. By 1933, the government had realized some of its policy mistakes and attempted to correct them. In this year, Canada left the gold standard, lowered the rate of interest on advances, and set up a royal commission to study the financial system and to consider whether Canada should establish its own central bank.

There were plenty of arguments against a central bank: Canada’s existing financial structure was sound but its debt was too high; Canada lacked the constitutional authority to launch such an entity; creating a central bank during an economic crisis was unwise; such an institution might act as an impediment to the eventual return to the gold standard; the American central bank had been unable to counteract the Depression in the United States; Canada lacked the expertise to operate such as institution; Canada lacked the proper domestic money market that a central bank needs to function; Canadian banks were stable and did not need a central bank to help support them; and so on. In particular, Canadian banks opposed the idea because they feared their profits might fall once a central bank became the sole issuer of domestic banknotes.

However, the commission did recommend the creation of a central bank, and in 1935 the Bank of Canada was established. Now Canada had a single institution with the authority to conduct monetary policy, issue all Canadian banknotes, manage the finances of the federal government, regulate the financial system, and act as the lender of last resort. Authority over monetary policy allowed the central bank to change interest rates via interventions in the money market, initiate loans to banks, intervene in the foreign exchange market to influence the exchange rate, and promote the economic and financial welfare of the nation by attempting to support full employment and stable prices.

It is interesting to note that in 1933 the United States introduced deposit insurance owing to widespread bank runs during the Depression. Why didn’t Canada also introduce deposit insurance then? It’s because at that time Canada’s banking system was much different: our system spread financial risks out more evenly across the nation. As a result, Canada had fewer severe banking disruptions than the U.S. This is why Canadians felt deposit insurance was not needed to stabilize the banking sector, and deposit insurance was not introduced in Canada until 1967.

The financial crisis of 2008 had some of the same features of the earlier financial crises. It involved U.S. institutions that were not as strictly regulated as deposit-taking banks, excessive speculation, and a U.S. government that was reluctant to take aggressive action until the scale of the devastation became clear. In addition, by the late 1990s, advances in technology and financial innovation had created yet another systemic weakness that played a central role in 2008. The story of Long-Term Capital Management, or LTCM, highlights these problems.

Long-Term Capital (Mis)Management Created in 1994, LTCM was a U.S. hedge fund, a private investment partnership open only to wealthy individuals and institutions. In the United States, hedge funds are virtually unregulated, allowing for much riskier investments than with mutual funds, which are open to the average investor. Using vast amounts of leverage—that is, borrowed money—to increase its returns, LTCM used sophisticated computer models to make money by taking advantage of small differences in asset prices in global financial markets to buy at a lower price and sell at a higher price. In one year, LTCM made a return as high as 40%.

LTCM was also heavily involved in derivatives, complex financial instruments that are constructed—derived—from the obligations of more basic financial assets. Derivatives are popular investment tools because they are cheaper to trade than basic financial assets and can be constructed to suit a buyer’s or seller’s particular needs. Yet their complexity can make it extremely hard to measure their value. LTCM believed that its computer models allowed it to accurately gauge the risk in the huge bets that it was undertaking in derivatives using borrowed money.

However, LTCM’s computer models hadn’t factored in a series of financial crises in Asia and in Russia during 1997 and 1998. Through its large borrowing, LTCM had become such a big player in global financial markets that attempts to sell its assets depressed the prices of what it was trying to sell. As the markets fell around the world and LTCM’s panic-stricken investors demanded the return of their funds, LTCM’s losses mounted as it tried to sell assets to satisfy those demands. Quickly, its operations collapsed because it could no longer borrow money and other parties refused to trade with it. Financial markets around the world froze in panic.

The Federal Reserve realized that allowing LTCM’s remaining assets to be sold at panic-stricken prices presented a grave risk to the entire financial system through the balance sheet effect: as sales of assets by LTCM depressed asset prices all over the world, other firms would see the value of their balance sheets fall as assets held on these balance sheets declined in value. Moreover, falling asset prices meant the value of assets held by borrowers on their balance sheets could fall below a critical threshold, leading to a default on the terms of their credit contracts and forcing creditors to call in their loans. This in turn would lead to more sales of assets as borrowers tried to raise cash to repay their loans, more credit defaults, and more loans called in, creating a vicious cycle of deleveraging.

The Federal Reserve Bank of New York arranged a $3.625 billion bailout of LTCM in 1998, in which other private institutions took on shares of LTCM’s assets and obligations, liquidated them in an orderly manner, and eventually turned a small profit. Quick action by the Federal Reserve Bank of New York prevented LTCM from sparking a contagion, yet virtually all of LTCM’s investors were wiped out.

Sub-prime Lending and the Housing Bubble After the LTCM crisis, U.S. financial markets stabilized. They remained more or less stable even as stock prices fell sharply from 2000 to 2002 and the U.S. economy went into recession. During the recovery from the 2001 recession, however, the seeds for another financial crisis were planted.

The story begins with low interest rates: by 2003, U.S. interest rates were at historically low levels, partly because of Federal Reserve policy and partly because of large inflows of capital from other countries, especially China. These low interest rates helped cause a boom in housing, which in turn led the U.S. economy out of recession. As housing boomed, however, financial institutions began taking on growing risks—risks that were not well understood.

Traditionally, people could only borrow money to buy homes if they could show that they had sufficient income to meet the mortgage payments. Sub-prime lending, lending money for buying homes to people who usually wouldn’t qualify for such loans, represented only a minor part of overall lending. But in the booming housing market of 2003–2006, sub-prime lending started to seem like a safe bet. Since housing prices kept rising, borrowers who couldn’t make their mortgage payments could always pay off their mortgages, if necessary, by selling their homes. As a result, sub-prime lending exploded.

Who was making these sub-prime loans? For the most part, it wasn’t American traditional banks that were lending out depositors’ money. Instead, most of the loans were being made by “loan originators,” who quickly sold mortgages to other investors. These sales were made possible by a process known as securitization: financial institutions assembled pools of loans and sold shares in the income from these pools. These shares were considered relatively safe investments, since it was considered unlikely that large numbers of homebuyers would default on their payments all at the same time.

But that’s exactly what happened. The housing boom turned out to be a bubble, and when home prices started falling in late 2006, many sub-prime borrowers could neither make their mortgage payments nor sell their houses for enough to pay off their mortgages. As a result, investors in securities backed by sub-prime mortgages started taking heavy losses. Many of the mortgage-backed assets were held by financial institutions, including banks and other institutions playing bank-like roles. As in previous crises, these “non-bank banks” were less regulated than commercial banks, which allowed them to offer higher returns to investors but left them extremely vulnerable in a crisis. Mortgage-related losses, in turn, led to a collapse of trust in the financial system.

Figure 14-14 shows one measure of this loss of trust: the TED spread, which is the difference between the interest rate on three-month loans that banks make to each other and the interest rate the U.S. federal government pays on three-month bonds. (“TED” is an acronym formed from the “T” of treasury bills and the “ED” of euro dollars.) Since U.S. government bonds are considered extremely safe, the TED spread shows how much risk American banks think they’re taking on when lending to each other. Normally the spread is around a quarter of a percentage point, but it shot up in August 2007 and surged to an unprecedented 4.58 percentage points in October 2008, before returning to more normal levels in mid-2009.

Crisis and Response The collapse of trust in the financial system, combined with the large losses suffered by some financial firms, led to a severe cycle of deleveraging and a credit crunch for the U.S. economy as a whole. American firms found it difficult to borrow, even for short-term operations; individuals found home loans unavailable and credit card limits reduced. These symptoms were shared by individuals, firms, and governments worldwide, thanks to our interconnected global financial system.

Overall, the negative economic effect of the financial crisis bore a distinct and troubling resemblance to the effects of the banking crisis of the early 1930s, which helped cause the Great Depression. Policy-makers noticed the resemblance and tried to prevent a repeat performance. Beginning in August 2007, the Federal Reserve engaged in a series of efforts to provide cash to the financial system, lending funds to a widening range of institutions and buying private-sector debt. The Fed and the U.S. Treasury Department also stepped in to rescue individual firms that were deemed too crucial to be allowed to fail, such as the investment bank Bear Stearns and the insurance company AIG.

In September 2008, however, American policy-makers decided that one major investment bank, Lehman Brothers, could be allowed to fail. They quickly regretted the decision. Within days of Lehman’s failure, widespread panic gripped global financial markets, as illustrated by the surge in the TED spread at this time, as shown in Figure 14-14. In response to the intensified crisis, the U.S. government intervened further to support the financial system, as the U.S. Treasury began “injecting” capital into banks. Injecting capital, in practice, meant that the U.S. government would supply cash to banks in return for shares—in effect, partially nationalizing the financial system.

By the fall of 2010, the U.S. financial system appeared to be stabilized, and major institutions had repaid much of the money the U.S. federal government had injected during the crisis. It was generally expected that American taxpayers would end up losing little if any of this stimulus money. However, the recovery of the banks was not matched by a successful turnaround for the overall American economy: although the recession that began in December 2007 officially ended in June 2009, U.S. unemployment remained stubbornly high.

The Federal Reserve responded to this troubled situation with novel forms of open-market operations. Conventional open-market operations are limited to short-term government debt, but the Fed believed that this was no longer enough. It provided massive liquidity through discount window lending, as well as undertaking so-called quantitative easing, the buying of large quantities of other assets, mainly long-term government debt and the debts of Fannie Mae and Freddie Mac, government-sponsored agencies that support home lending.

Like earlier crises, the crisis of 2008 led to changes in U.S. and world banking regulation. Since much of the crisis originated in non-traditional bank institutions, the crisis of 2008 indicated that a wider safety net and broader regulation were needed in the financial sector. And such reforms were implemented. In the U.S., in July 2010, the Wall Street Reform and Consumer Protection Act, known as the Dodd-Frank bill, became law. The biggest U.S. financial reform since the 1930s, this bill resulted in a new agency, the Consumer Financial Protection Bureau, to protect borrowers. In 2012, the Basel Committee on Banking Supervision reached an agreement on detailed measures to strengthen the regulation, supervision, and risk management of the world’s banking sector. This package of measures, known as Basel III, will, in a nutshell, require a significant rise in the banking industry’s liquid capital requirements so that these institutions will become less prone to banking crises. Will these changes succeed in heading off future banking crises? Time will tell.