Is the Canadian banking system as solid as it is said to be?

In Canada, the five largest banks have sufficient assets to rank among the top 10 U.S. banks (Getty Images/Yana Bukharova)

We’re often told that it takes time for interest rate hikes to be felt. The housing market is the first sector to be impacted, followed by high-growth or debt-dependent sectors such as technology or construction.

Now it's the banking system’s turn to take a hit. As interest rates rise, the value of long-term fixed income assets falls and banks are faced with liquidity issues when it comes to covering short-term liabilities (customer deposits).

This is what recently happened with regional banks Silicon Valley Bank, or SVB (US$209 billion in assets) and Signature Bank (US$110 billion in assets). Massive withdrawals led to the biggest bank failures since 2008. The fallout impacted First Republic Bank (FRB), a private wealth management bank in San Francisco with US$213 billion in assets. The Federal Reserve responded quickly with a new funding program to inject money into the banking system. It added US$400 billion to its balance sheet, wiping out nearly five months of quantitative tightening in the process.

Barely a week later, Credit Suisse saw its financial problems come to a head when its largest shareholder refused to buy more shares in the bank on regulatory grounds. This time, though, it was a big-league player that was in trouble: Credit Suisse has close to US$800 billion in assets, and it plays a significant role in the global economy. Swiss authorities immediately launched an emergency rescue plan to prevent a collapse and restore stakeholder confidence. But the crisis isn’t over yet: giants such as Deutsche Bank, which is twice the size of Credit Suisse, are showing signs of weakness.

A MODEL OF STABILITY

This begs the question: What about Canada? Could our banks fall victim to a domino effect?

In Canada, the largest market share is held by six banks, along with the Desjardins Group. The five largest have sufficient assets to rank among the top 10 U.S. banks—which means there is little real risk that they will fail as a result of being dragged down by regional or smaller banks. Moreover, in Canada, it is much easier to regulate banks and ensure compliance among a few key players. In other words, the chances of a "bad apple" are low.

It's worth noting, too, that the banks’ asset portfolios are highly diversified, unlike those of smaller U.S. regional banks such as SVB or FRB. Canadian banks are in an enviable financial position: they are better capitalized and have more liquidity than their peers.

Canadian banks are also more reliant on residential mortgages, which represent 22% of their assets—twice as much as in the U.S. These loans also present less risk in Canada, where default rates are much lower. In fact, default rates in 2022 fell to an all- time low—almost 40% lower than before the pandemic. The same downward trend can be seen in the U.S., just less pronounced.

With historically high vacancy rates and higher interest rates, commercial real estate lending is a greater concern, but again, Canadian banks are well positioned to deal with this risk, as commercial real estate represents only 2% of their assets, compared to 13% for U.S. banks. It’s the smaller banks that are at greater risk in this area, and there are very few in this country.

However, the main drawback with having monopoly banks that can maximize profits without taking too much risk is that consumers are left with higher banking fees, lower interest rates on deposits and large management fees on investment products. The same is true for businesses, which have a harder time obtaining commercial real estate financing. This also means governments and institutional investors have to do more to support them.

Just days after the SVB and Credit Suisse crises took place, the Federal Reserve and the European Central Bank chose to prioritize the fight against inflation, raising their key interest rates once again. Canada, on the other hand, has no plans to raise rates any further. Time will tell which strategy proves to be more successful.

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Learn more about what a recession really is, find out how to stay ahead of debt and bankruptcy, and check out CPA Canada's extensive financial literacy resources.