Viewpoint August 12, 2009, 6:28PM EST

What American Bankers Can Learn from Canada

As the credit crisis eases and capital returns to U.S. financial institutions, a Canadian banking attorney offers advice for American lenders and borrowers

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The battered U.S. banking system is showing signs of a turnaround. That's welcome news around the globe, and certainly here in Canada, where we rely heavily on our southern neighbor and largest trading partner.

A number of institutions, including JPMorgan (JPM), Bank of New York Mellon (BK), Goldman Sachs (GS), and U.S. Bancorp (USB), have opted to return their TARP funds to the U.S. Treasury, while in recent weeks banks have raised tens of billions of dollars in fresh equity to shore up capital levels. Private equity firms are starting to take over distressed institutions, a sign that the smart money is betting on a return to profitability. And loans are flowing to small businesses and homeowners as well as to large corporations.

While we hate to rain on anyone's recovery, our northern perspective makes us see things differently. That's because in Canada, strong capital levels and increased loan activity offer only a partial picture of a bank's health. Equally important are lending standards and risk management. By those metrics, we still view the U.S. banking sector with some concern, especially in residential lending, which was at the center of the financial crisis.

Four Lessons from Canada

As U.S. lenders stabilize and reopen their credit pipelines, this is a good time to reflect on the Canadian experience, where more prudent lending and borrowing played a big part in preventing the housing bubble that proved the near-undoing of the American banking sector. Indeed, Bank of Canada Governor Mark Carney described the essence of Canada's financial strength in an Aug. 12 presentation to the Canadian Financial Forum in Beijing: Canada's sound policy framework and its balanced economy have been key to the resilience of its financial system.

Our view is that without improving the management of credit risk, all the fresh capital in the world will not prevent another cycle of misery. Here are four lessons to help U.S. financial institutions regain their vigor and avoid the next storm.

Lesson One: Homeownership Is Not a Constitutional Right

To understand how the Canadian and American systems diverged when the storm hit, start with the concept of homeownership.

For many Americans, owning a home, a long-held symbol of financial independence and personal success, has in recent years become almost a constitutional right. That entitlement was aggressively encouraged by mortgage lenders offering "innovations" such as no-documentation loans with flexible payment options, often requiring minimal down payments and even 0% introductory interest.

U.S. public policy furthered the goal of single-family homeownership, with government-sponsored entities Fannie Mae (FNM) and Freddie Mac (FRE) buying up vast pools of mortgages that could be sliced and sold to investors. The subprime boom was in some ways a byproduct of American patriotism, though it proved to be the nightmare version of the American Dream.