Banks' capital buffer, risk and performance in the Canadian banking system: Impact of business cycles and regulatory changes

•We use quarterly data of the six largest Canadian banks from 1982 to 2010.•We document positive co-movement between Canadian banks' capital buffer and business cycles.•We find that Canadian banks are well-capitalized and hold more capital buffer in expansion.•We find evidence for one possible explanation of how Canadian banks weathered the subprime financial crisis so well.

Using quarterly financial statements and stock market data from 1982 to 2010 for the six largest Canadian chartered banks, this paper documents positive co-movement between Canadian banks' capital buffer and business cycles. The adoption of Basel Accords and the balance sheet leverage cap imposed by Canadian banking regulations did not change this cyclical behavior of Canadian bank capital. We find Canadian banks to be well-capitalized and that they hold a larger capital buffer in expansion than in recession, which may explain how they weathered the recent subprime financial crisis so well. This evidence that Canadian banks ride the business and regulatory periods underscores the appropriateness of a both micro- and a macro-prudential “through-the-cycle” approach to capital adequacy as advocated in the proposed Basel III framework to strengthen the resilience of the banking sector.