Regulation and Bank Stability: Canada and the United States, 1870 - 1980

November 1995
Three lessons for developing and transition economies from a historical comparison of U.S. and Canadian banking. First, restricting nationwide branch banking is a mistake. Second, the benefits of long-run stability and efficiency outweigh the cost of concentrated economic power. Third, efficiency can be promoted by permitting competition from foreign banking systems as well as domestic and foreign nonbank financial intermediaries.
Canada and the United States are probably as similar as any two countries in the world, but they have always had very different banking systems.
The United States has by and large had a unit banking system, although many states allow branch banking or limited branch banking. Until 1994, when Congress lifted prohibitions on interstate branch banking, the practice was not allowed nationwide and in many states. As a result, there were many small banks. Canada --- a much smaller country (except geographically) --- has always had unlimited branching and in this century a few very large nationwide banks emerged. (Both systems are different from European universal banking.)
If one system performs better than the other (in terms of stability and efficiency), Bordo contends that that is because of the regulatory system. The United States has a long history of reserve requirements, which Canada didn't mandate until the 1930s. Capital ratios have been much higher in Canada than in the United States, and Canada requires new banks to obtain a charter --- a difficult task until 1967.
The United States is moving toward eliminating the barriers to interstate branching. Bordo believes that once the forces of competition are unleashed, U.S. banking will follow a route similar to that taken earlier by Canada and earlier yet by the United Kingdom. During the merger, mistakes will be made and large institutions may become insolvent. The monetary authorities must then act to protect the payment system at large, but it would be unwise to truncate the evolutionary process with new restrictions. Big failures will inspire a movement to reregulate the system, as in the airline industry. And provisions must be available to protect small depositors from loss. Problems with the current system of deposit insurance suggest that other solutions may be required.
Canada's banking system may be both more stable and more efficient than the U.S. banking system, says Bordo, but the United States has compensated by developing more open and deep capital markets.
This paper --- a joint product of the Finance and Private Sector Development Division, Policy Research Department, and the Financial Sector Development Department --- was presented at a Bank seminar, Financial History: Lessons of the Past for Reformers of the Present, and is a chapter in a forthcoming volume, Reforming Finance: Some Lessons from History, edited by Gerard Caprio, Jr. and Dimitri Vittas.