How is it that Canadian banks have maintained stability and outperformed international peers during economic crises, from the Great Depression to the Covid-19 pandemic?
Dr. Jie Zhang, associate professor of Finance in the Trent School of Business, recently explored that question with master's graduate Madhu Garg from the Applied Modelling and Quantitative Methods program, and Lawrence Kryzanowski, professor from Concordia University.
A question of liquidity
Their paper Canadian Bank Capital and Liquidity Creation was first published online this August at the Asia-Pacific Journal of Financial Studies. They examine how bank capital is related to on-balance-sheet liquidity creation (i.e. how readily liquid deposits can be transformed to illiquid assets such as mortgage and corporate loans).
"Our main baseline finding is that a higher bank capital ratio encourages large Canadian banks to increase on-balance-sheet liquidity creation and small banks to lessen it," said Professor Zhang. "Having higher liquidity means Canada's large Big Six' banks can take more risk and still survive major crises like the 2008 financial crisis and Covid pandemic."
The reason why Canadian banks have a higher capital ratio (known as the domestic stability buffer) is simple: it's a regulatory requirement.
"[The regulation] necessitates that the Canadian banking system maintain liquidity and helps to explain why Canada didn't see any bank failures during these major global crises," said Prof. Zhang.
One might liken it to having a personal rainy day or emergency fund. Banks with higher capital ratios are more liquid and can more easily account for financial crises. Banks with lower capital ratios (i.e. those that have less capital to absorb financial losses), conversely, are less able to maintain liquidity during turbulent times and are therefore more prone to fail.
"We saw this happen quite a bit in the U.S. where regulation of capital ratio is quite low and the banking industry has many small community banks," said Prof. Zhang.
Research implications far reaching
The research has implications both for Canada and globally.
"With Canadian banks increasingly operating in the United States, an understanding of this liquidity creation is important to ensure their ongoing solvency," said Prof. Zhang. "Our findings may also have implications for the large number of countries with concentrated banking systems, such as Asia-Pacific countries, as well as in helping policymakers in making better regulatory and monetary decisions. Since Canada's big banks can generate high liquidity, their stocks may be attractive options for both individual and institutional investors."
Interdisciplinary collaboration
Prof. Zhang's project is one example of the unique research opportunities available through Trent's Applied Modelling and Quantitative Methods program.
Through this financial analytics program, students apply the big data techniques and theory of modelling to their financial analysis and investments.
"The financial and economic knowledge our students receive through the program opens the door to a variety of career directions, such as data mining and analysis, financial analytics and programming, and wealth management," said Prof. Zhang. "Having in-depth knowledge of Canada's financial system can also be very beneficial to international students when they return to their home country, especially if they come from a country with a concentrated banking system."
Learn more about the Applied Modelling and Quantitative Methods master's program
