24 ECON FOCUS | FOURTH QUARTER | 2013
banking,” which allowed individuals to establish banks any-
where, but free banks were still prohibited from branching.
N
ational banks were created to fund the Civil War by issuing
notes backed by government bonds but were forced to
honor state branching limitations. The political infeasibility
of branching meant the Fed’s founders, despite Sprague’s
conclusions, barely even discussed it as a realistic option.
North of the border, the balance of power was different.
“In Canada those same groups existed, and they tried the
exact same things a
s in the U.S., but they didn’t succeed,”
Calomiris says.
The architects of Canada’s Constitution had precisely
the opposite objective from those of the U.S. Constitution:
After the French population in Quebec staged a revolution
in 1837-1838, “the British realized they had to build a set of
institutions to make it hard for the people who hated
their guts to create disruptions,” Calomiris says. Canadians
weren’t as fearful of the concentration of power; their inde-
pendence came in 1867 through legislation, not revolution.
The first Canadian banks were established by Scots, who
mimicked Scotland’s branched system. In addition, Canada’s
export-based economy was better served by a national sys-
tem that could help products move not from city to city, but
from country to country.
The Canadian constitution gave the regions equal weight
in the upper house of the legislature, much like the U.S.
Senate, to dilute the French influence in Quebec. Population
determines representation in the lower house, much like the
U.S. House of Representatives, creating incentives for cen-
trist parties that cater to the median voter. Laws passed by
the lower house can be overruled by the Senate, whose seats
are filled by appointment of a governor general of Her
Majesty the Queen and held until age 75.
Many times, the Canadian government defeated populist
mea
sures that w
ould have changed the banking system. One
law passed in 1850 tried to replicate U.S. free banking,
including the requirement that notes be backed by govern-
ment bonds to encourage government bond purchases. But
the legislature refused to end branching, and the free banks
simply weren’t viable in comparison. Few free bank charters
were ever issued. In response to the episode, provisions were
included in the 1867 constitution to ensure that banking
policy was made at the national level.
Domino Effects
Not only did branching restrictions persist in this country,
but new laws served to protect small banks. Many such laws
were enacted after the Depression, when a third of the
nation’s banks, most of them small, failed. Federal deposit
insurance, created in 1933, originally applied only to small
banks. It was added to the Glass-Steagall Act of 1933 at the
last minute to gain support from Henry Steagall, the power-
ful representative from agrarian Alabama. The Act was the
culmination of no fewer than 150 attempts over the previous
50 years at passing a federal deposit insurance system for
small banks, Calomiris and Haber argue. Other bank restric-
tions in Glass-Steagall — like Regulation Q’s ceilings on the
interest rates that banks could pay depositors, and rules
prohibiting banks f
rom securities dealing — were intended
to prevent excess speculation but also served to keep
banks small.
That had a side effect: The shadow banking system took
off. “Regulations limited the amount of credit that the
commercial banking system could extend to industry, so
instead it was provided through other financial markets —
the st
ock and bond markets, investment banks, and others,”
Rockoff says. With shadow banking came a disparate set of
nonbank regulators, such as the Securities and Exchange
Commission and others, helping to explain the relatively
fragmented regulatory system we have today.
Canada also suffered during the Great Depression when
its money supply plummeted. “The political situation was as
dire in Canada as it was in the United States; the government
has to do something in the depths of a depression,” Redish
says. The prime minister launched the Royal Commission on
Banking and Currency to consider a central bank. Some
scholars, including Redish and Bordo, have argued that
there was no economic necessity for a central bank. Instead,
it was seen as something that could be done in the national
interest — meeting the political demand for reform — that
wouldn’t do much harm. The Bank of Canada opened its
doors in 1935.
Though deposit insurance finally stemmed bank runs in
the United States, it wasn’t instated in Canada until 1967.
But overall, says Redish, “there was very little regulation of
the Canadian banking system until 1987. There were two
bank failures in the early 1980s that kind of woke everybody
up; they were the first bank failures in 60 years.” By compar-
ison, the United States had 79 bank failures in the 1970s
alone. The precursor to OSFI, Canada’s current regulator,
had just se
ven bank examiners in 1980
, compared with thou-
sands of examiners here. When OSFI was established in
1987, it encompassed most financial activity, including off
balance sheet activities.
When the economy changed in the decades preceding
the 2007-2008 financial crisis, the financial systems of
Canada and the United States were structured to respond
differently. This was especially true during the inflationary
1970s. With interest rates on deposits capped here, investors
sought protection from inflation elsewhere, such as money
market mutual funds that allowed check writing and other
deposit-like features. Deregulation moved additional funds
out of the banking system.
In Canada, the reverse happened; after walls between
securities brok
erage and banking were removed in 1987,
banks absorbed securities brokerages, mortgage lending,
and other activities that occur outside of the banking sector
in
America. According to a June 2013 study by Bank of
Canada economists Toni Gravelle, Timothy Grieder,
and Stéphane Lavoie, shadow banking activities are about
40 perc
ent the size of Canada’s economy, compared with
95 percent in the United States. Not only is a significant