Canadian Banking Industry: Historical Evolution, Comparison, and Current State of Government Regulations (Chapters 10, and 11)

Banking Industry: Structure and Competition Chapter 11 Banking Industry: Structure and Competition Copyright  2011 Pearson Canada Inc.

1.Historical Development of the Canadian Banking System I Copyright  2011 Pearson Canada Inc.

From the Free Banking System to Government Regulated Banking System The process was “unnatual”. Initially, all banks were allowed to issue their own paper monies until the 1870 Dominion Notes Act.; BMO helped government bonds to be used for reserves, and government started monopolizing Money Issues. Bank Act: 1871, (1871), 1891……1913 Finance Act of 1914 Then, B of Canada was set up in 1934;

Historical Development of the Canadian Banking System II The Free Banking Experiment The Provincial Notes Act, 1866 The Dominion Notes Act, 1870 Seignorage Gold standard The (First) Bank Act, 1871 The Bank Act, 1881-1913 The Finance Act, 1914 Lender of last resort Copyright  2011 Pearson Canada Inc.

Bank Act over time: “Bank Act Reforms” (refer to textbook pp Bank Act over time: “Bank Act Reforms” (refer to textbook pp.238-239, Table 10-1) 1954 : Banks were allowed to go for household lending and to make mortgage loans insured by NHA 1967 * Canadian Deposit Insurance Corporation was created : the 6% ceiling on the mortgage loans was removed 1980 : banks were allowed to have mortgage loan companies and venture capital companies. 1981 : Foreign banks were allowed to set up Canadian subsidiaries banks were allowed to do leasing, factoring and data processing. Canadian Payment Association was created for nationally “open” clearing system

1987 “Financial Institutions and Deposit Insurance System Amendment Act” :banks were allowed to own securities houses(investment banks) : abolishing the Canadian equivalent of “Glass-Steagall Act” 1992 : banks were allowed to own trust companies : banks were permitted to offer a number of in-house activities, such as portfolio management, and investment counseling. : required reserves are to be phased out. 1999 :Bill C-67 2001** New ownership Rules; M & A Review Process; fexbile Bank Holding Company allowed; More Open membership of the Canadian Payment Association to non-deposit taking financial institutions

The close-up of the 2001 Bank Act Reform Bank Holding Companies Permitted Investment Ownership Rules Canadian Payments Act and Access to the Payments and Clearance System Merger Review Policy The National Financial Services Ombud Service Implications for the Canadian Banking Industry Copyright  2011 Pearson Canada Inc.

Easier Entry of New Comers Equity Capital requirement is lowered from $ 10m to $ 5 m. Some Ownership Concentration allowed for a large bank(equity>$ 5 billions) a single ownership limit is raised from 10% to 20%

Expanded Access to Canadian Payment Association membership There by access to Large Value Transactions System, and Automatic Clearing Settlement System was given to Insurance, Investment Dealers, Money Market Mutual Funds. Now these can allow their customers to use Checking Account and Debit Cards - more competition for Banks

2. Trends of Evolution of the Canadian Financial System Tradition of “Four Pillar System” : Chartered Banks( Credit Unions) Trust, Mortgage Loan companies Insurance companies Investment Intermediaries Towards Full Service/Universal Banking

Separation of Banking and Other Financial Services Industries Throughout the World Universal banking - No separation between banking and securities industries 2. British-style universal banking - May engage in security underwriting Japanese Model - Some legal separation of banking and other financial services (the post-war hybrid of U.S. and German banking systems) U.S. Model the 1930s Clear Separation; now evolving with legacy Copyright  2011 Pearson Canada Inc.

This transformation from the 4 Pillar system to the Universal Banking is the result of the Banks’ Adaptation, their Lobbying and the Legislative changes. Copyright  2011 Pearson Canada Inc.

Let’s Examine Changes in business environment of the financial market (Challenges) And Financial Innovations by the Canadian Banking Industry (Responses) Copyright  2011 Pearson Canada Inc.

Major Challenges Unstable Financial Market: Interest Rate, FX, Credit Risks have increased. More Domestic Competition(Domestic Finanical Liberalization): Banks’ advantages in funding cost and investment profits have been eroded by Other segments of the Financial System or Other Financial Institutions -> Decline of traditional banking and ‘Shadow Banking’ More International Competitions (Global Financial Liberalization) Copyright  2011 Pearson Canada Inc.

Changes in Demand Conditions: Challenges of Interest Rate Volatility and Banks’ Responses Adjustable-rate mortgages Flexible interest rates keep profits high when rates rise Lower initial interest rates make them attractive to home buyers Financial Derivatives Ability to hedge interest rate risk using futures contracts (financial derivatives) Payoffs are linked to previously issued securities Copyright  2011 Pearson Canada Inc.

Responses to Changes in Supply Conditions: Information Technology Bank credit and debit cards Improved computer technology lowers transaction costs Electronic banking ATM Home banking ABM Virtual banking Junk bonds Commercial paper market Securitization Copyright  2011 Pearson Canada Inc.

Existing Regulations, and Legislation(Bank Act) Lobbying Reserve requirements act as a tax on deposits Restrictions on interest paid on deposits led to disintermediation For example, “Regulation Q” (no interest payment on checking account balances) Money market mutual funds Sweep accounts Copyright  2011 Pearson Canada Inc.

Financial Innovation and the Decline of Traditional Banking Decline in Cost advantage of Acquiring Funds (Liabilities) Disintermediation Decline in Income Advantage on uses of funds (Assets) Bank Responses - Increase in income from off-balance sheet activities Copyright  2011 Pearson Canada Inc.

Competition and Technical Innovation Besides chartered banks, there are over 4000 financial institutions providing services, these include trust, mortgage loan companies, credit unions, caisses populaires, government saving institutions, insurance companies, pension funds, mutual funds and investment dealers New technology and the internet have led to more competition and innovative banking in Canada 2001 changes in bank ownership laws have encouraged the establishment of new banks Copyright  2011 Pearson Canada Inc.

Competition and Legislative Changes Domestic and International Competition have increased for Banks For Banks to survive, they should be allowed to be ‘Bigger’, and to cover ‘Business Across the Board’(traditional banking+ securities business + insurance, etc.) Copyright  2011 Pearson Canada Inc.

Competition Across All Four Pillars and Convergence In the past, Canada’s financial services industry was regulated by institution (banks, securities, insurance, and real estate). This approach to regulation has been known as the four-pillar approach Recent legislative changes allowed cross-ownership via subsidiaries between financial institutions As a result, Canada’s traditional four pillars have now converged into a single financial services marketplace (a kind of Universal Banking system) Copyright  2011 Pearson Canada Inc.

Implications for Financial Consolidation The way is now open to consolidation in terms not only of the number of banking institutions, but also across financial service activities Banking institutions will become not only larger, but increasingly complex organizations, engaging in the full gamut of financial service activities taking advantage of economies of scale and economies of scope Mega-mergers like that of Citicorp and Travelers in the U.S. should become increasingly common Copyright  2011 Pearson Canada Inc.

3. American Banking System for Comparison

Canadian and American banking system share a lot of similarity Canadian and American banking system share a lot of similarity. Broadly, they used to belong to the same British Specialized Banking System, which has the characteristic separation of commercial banking and securities business, or (confusingly) “ banking and commerce”.

The American Story

1) Characteristics of U. S. Banking Industry Dual Banking System Some banks are regulated by the state agency and others by the Federal agency Pre-1863 State Banking only 1863 National Banks (Act) emerging 1913 Federal Reserve System 1934 Federal Deposit Insurance Corporation

Overlapping and Complex Regulatory Agencies The Office of the Comptroller of the Currency gives out “Charter” for national banks Fed is in charge of national banks, and in sole charge of bank holding companies FDIC and State Banking Authorities are in charge of state banks with FDIC insurance State Banking Authorities are in sole charge of state banks without FDIC insurance

Fractured Banking Industry A Large # of Banks: 12,000 until the early 1990. This number has come down to 7,000 some banks. Many Lacking “Scales of Economies -> only 325 banks have assets above $1 billion (’94) -> until recently, some states had “Unit Banking System”. -> Consolidation and Simplification: Key Issue of Presidential Reforms

* How American Banks Merge? The number of banks has been decreasing; currently as of 2010, about 7,000 or so. While mergers between banking groups have slowed, there has been a move towards diversification as the barriers between commercial and investment banking have finally broken down.

2) Historical Background Federal versus State Struggles for Hegemony -“The Wizard of Oz as a Monetary Allegory” by H. Rockoff Background: Depression in the 1890s Allegories: Dorothy: an Average conscientious true American Tornado Wicked Witch of the East- Eastern Business and Financial Interests Munchkins -Average Americans Scarecrow -Western Farmer Tin Woodman- Unemployed Industrial Workers Cowardly Lion -“William Jennings Bryan” Wicked Witch of the West - Grover Cleveland silver shoes: magic water that melt the witch: solution – watershed – inflation (through printing money) A Lesson: So much socio-political problems and regional interests were intertwined with Monetary policies (and banking practices): The complexity of the current banking system of the U.S. is a on-goint legacy of the long tradition of these complicated political Struggles between regions, parties and interest groups.

2) Evolution of U. S. Banking Legislation McFadden Act of 1927: limits and prohibits inter-state banking and branching Glass-Steagall Act of 1933: Anti-Trust Act separating Banks and Commerce; you can be either a commercial bank(lenders) or an investment bank(securities holders), but not both.

* Apparent Rationale Underlying the Separation of Commercial and Investment Banking: Glass-Steagall Act In favor of Specialized Banking as opposed to Universal Banking If banks are engaged in securities business, there may occur Conflicts of Interests; Unfair Competition; Risk of Safety and Soundness; Concentration of Power; Unfair Stretch of Federal safety net

*pros and cons of Glass-Steagall Act Pros: tried to control monopolistic financial mega companies; Cons: deprived commercial banks of Monitoring Venues against Moral Hazards; and investment bank of Active Management participation against Principal-Agent Problem .

Turn Around - Bank Holding Companies of the 1960s - Reigle-Neal Act of Interstate Banking and Branching Act (1994) : Opening up M & A for “Efficiency” in banking sectors -Gramm-Leach-Bliley Financial Modernization Act (1999) : Banks are allowed to form Financial Holding Companies across industries and even to carry out “merchant banking” or equity investments in non-financial firms.

* Legal Buffer against Abuse of a big financial trust: Legacy of Anti-Trust Act or G-S Act. The negative effect of the G-L-B Act is “Lack of Competition” which may lead to “Lack of Protection of Small Lenders” beside banks as big lenders. Legal protection for smaller financial investors is secured by “Lender Liability and Equitable Subordination” This principle does not exist elsewhere: The U.S. case of allowing merger between banks and commerce may not be equitably applicable elsewhere.

Frank-Dodd Act of 2008 for the Wall Street Reform -more disclosure of financial institutions and particularly Hedge Funds: As a result, some hedge funds are turning to be ‘family funds’. -Volker Rule -Funeral Plan required of a large financial Company Copyright  2011 Pearson Canada Inc.

Financial Consolidation Larger and more complex banking organizations challenge regulation Increased “too big to fail” problem Extends safety net to new activities, increasing incentives for risk taking in these areas Copyright  2011 Pearson Canada Inc.

How does the Canadian Government/OSFI Regulate the banking industry? In Canada it is the principle-based regulation as opposed to the rule-based regulation in the U.S. General emphasis is on: Copyright  2011 Pearson Canada Inc.

1) Restrictions on Asset Holding Even without government intervention banks have incentive to take more risk as risky assets provide higher returns. Full information to creditors/depositors on banks risk-taking activities might mitigate problem. Government regulation directly attempts to restrict banks from too much risk taking Restrict holdings of common stock Promote diversification Copyright  2011 Pearson Canada Inc.

2) Capital Requirements Government can impose set capital requirements Minimum leverage ratio (amount of capital divided by the bank’s total assets) Increase in off balance sheet activities a concern Basel Accord: risk-based capital requirements Regulatory arbitrage Copyright  2011 Pearson Canada Inc.

Capital Requirements (Continued) International Standards for Capital Requirements Basel (Accord) 1 by the Bank for International Settlement; requires the bank to hold as capital at least 8% of their risk-weighted asset Basel (Accord) 2 tries to eliminate Regulatory Arbitrage (to reduce off-balance risks) Copyright  2011 Pearson Canada Inc.

3)Financial Supervision: Chartering and Examination Chartering (screening of proposals to open new banks) to prevent adverse selection Examinations (scheduled and unscheduled) to monitor capital requirements and restrictions on asset holding to prevent moral hazard Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk Filing periodic ‘call reports’ Copyright  2011 Pearson Canada Inc.

4) Assessment of Risk Management Greater emphasis on evaluating soundness of management processes for controlling risk Focus is four elements of risk management Quality of oversight Adequacy of policies and limits Quality of risk measurement and monitoring systems Adequacy of internal controls Interest-rate risk limits Internal policies and procedures Internal management and monitoring Implementation of stress testing and Value-at risk (VAR) Copyright  2011 Pearson Canada Inc.

4) Disclosure Requirements Requirements to adhere to standard accounting principles and to disclose wide range of information Eurocurrency Standing Committee of the G-10 Central Banks also recommends estimates of financial risk generated by the firm’s internal monitoring system be adapted for public disclosure Copyright  2011 Pearson Canada Inc.

Disclosures (Continued) Canadian Reform: Bill 198 corresponds to the U.S. Sarbanes-Oxley Act; enhances disclosure of information with a better audit, and limits conflicts of interests International Reform International Accounting Standard Board adopts International Financial Reporting Standards (IFRS) : eg) fair-value accounting Copyright  2011 Pearson Canada Inc.

5) Consumer Protection Requires lenders to provide information to consumers on the costs of borrowing (including a standardized interest rate) Requires provision of information on the method of assessing finance charges Requires that billing complaints be handled quickly Copyright  2011 Pearson Canada Inc.

6) Restrictions on Competition Justified by moral hazard incentives to take on more risk as competition decreases profitability Disadvantages Higher consumer charges Decreased efficiency Copyright  2011 Pearson Canada Inc.

CIDC Insurable deposits include Savings and chequing accounts Term deposits with a maturity date < 5 years Money orders and drafts, certified drafts and cheques, and traveller’s cheques The CDIC does not insure Foreign currency deposits or term deposits with maturity date > 5 years T-bills, bonds and debentures issued by governments and corporations (including the chartered banks) Investments in stocks, mutual funds, and mortgages. Copyright  2011 Pearson Canada Inc.

*The Ultimate Protection of Consumers (Federal) Canadian Deposit Insurance Corporation for banks Provincial Deposit Insurance Corporation for CUCP and TMLC. Copyright  2011 Pearson Canada Inc.

Differential Premiums Differential premiums means investments with differing risk profiles are subject to different insurance premiums Premium categories range from 1 (best) for a well capitalized bank, to 4 (worst) for a significantly under capitalized bank Copyright  2011 Pearson Canada Inc.

Is No Insurance Good for the Society?: Opting-Out I Permits Schedule III banks, that accept primarily wholesale deposits (defined as $150 000 or more), to opt out of CDIC membership and therefore to operate without deposit insurance It requires, however, an opted-out bank to inform all depositors, by posting notices in its branches, that their deposits will not be protected by the CDIC, and not to charge any early withdrawal penalties for depositors who choose to withdraw Copyright  2011 Pearson Canada Inc.

Opting-Out II Implications: Minimizes CDIC exposure to uninsured deposits By compensating only the insured depositors rather than all depositors, this legislation increases the incentives of uninsured depositors to monitor the risk-taking activities of banks, thereby reducing moral hazard risk Copyright  2011 Pearson Canada Inc.

Financial Regulation after Subprime Financial Crisis -Increased Regulation of Mortgage Brokers -Fewer Subprime Mortgage Products -Regulation Compensation -Higher Capital Requirements -Additional Regulation of Privately Owned Government-Sponsored Enterprises Copyright  2011 Pearson Canada Inc.