How to save U.S. banks? Act like a Canadian.

BOSTON — Most Americans would be willing to wear flannel shirts and eat moose for the next year if it would get us out of this economic mess. Since it won’t be that easy, we might actually have to take some lessons from our very successful banking neighbor.

Not one Canadian bank has failed or received government bailout money since the credit crisis began in the summer of 2007. As 10 of the biggest U.S. banks struggle to raise $75 billion in total capital, as required by the Federal Reserve’s recent stress-testing, American bankers are trying to figure out just what True North did to make its banking system the soundest in the world.

In the past decade, as top banks in the U.S., the U.K., Switzerland and Japan destroyed wealth, Canada’s banks created it, according to economist Jan Vanous. In his study, “Global Banking Rubble: Analyzing the Decade of Western Bank Value Destruction,” Vanous and his researchers estimated that the top 20 value-destroying banks in the U.S., the U.K., Switzerland and Japan eliminated "a staggering 56 percent" of market value from May 1999 to mid-March 2009. During the same period, the market value of Canada’s major banks increased 85 percent.

As U.S. banks shrink by selling off real estate and businesses to increase liquidity, the Canadian banks are expanding. Toronto Dominion’s TD Bank now has hundreds of locations up and down the East Coast. As U.S. banks recoil from international lending, there is more pressure on Canadian banks to fill the void. Some are predicting that Toronto, already Canada’s financial center, will play an increasingly important role in global banking.

What did Canada do right? It learned powerful lessons from a couple of significant failures. In the mid 1980s, two Canadian banks tanked and the government had to pay an unprecedented amount of money to insured and uninsured depositors. The government commissioned several studies to find out why the banks had failed and to offer proposals to prevent such failures in the future.

In 1987, the Office of the Superintendent of Financial Institutions (OSFI) was created to merge two previous agencies in an effort to modernize Canada’s banking and insurance regulatory framework. As OSFI intervened in subsequent bank failures, the government kept modernizing its financial statutes. OSFI’s role has been refined over the years, but now it has a clear mandate to focus only on solvency and risk management for banks and insurance companies.

One of the ways OSFI helps banks manage risk is by requiring greater capitalization. In mid 2008, as the world credit crisis approached full meltdown, the capital adequacy ratio for Canada’s banking institutions stood at about 9.8 percent compared with just 8.5 percent for  U.S. banks. European banks had even less capital on hand, closer to 8 percent.

Not only does OSFI require greater capitalization, but it is more risk averse overall. Canadian banks operate like U.S. banks used to; they primarily originate and hold loans on their balance sheets. For the most part, they did not get involved in subprime lending.

Another reason Canada did not experience a housing bubble is because mortgage interest is not tax deductible. Homeowners are not tempted to take out the biggest possible loan to buy the biggest possible house. In this way, the Canadian government has helped protect both its citizens and the banking system from risky lending.

Canada is certainly not immune from the overall decline of the world economy. Unemployment, foreclosures and business bankruptcies have all increased. Regulators are even more involved with the banks now as they, like U.S. banks, explore raising capital by issuing stock. Still, as recently as February, figures showed that Canada was the only country of the G7, the largest seven industrial nations, to experience both a trade and budget surplus. Canada’s fiscal and economic discipline has protected and increased its wealth and security.

U.S. stock markets rose as the results for the weakest banks — Bank of America, Citigroup and Wells Fargo— were leaked to the media, indicating that investors welcomed the Fed’s first macro testing as a sign of increased toughness on the banks. The Fed subjected the banks’ data to a hypothetical spike in unemployment and increased credit and loan defaults over the next two years. But the Fed did not raise its capital adequacy standard for banks, and it is still well below Canada’s. The test it gave was not tough enough.

The pain of this banking disaster would be a horrible opportunity to waste. It offers a chance to redesign our regulatory system, to make it easier for financial institutions to measure their own individual risks as well as for the government to assess systemic risk. As Canada has learned, it could take at least 10 years of hard work to build a sounder system. First, the regulators must be willing regulate.

Susan E. Reed is an award-winning journalist who has covered business and international affairs in 34 countries for CBS News, The New York Times, The New Republic and other news organizations.

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