U.S. and Canadian Financial System: “Tales of Two Countries”

I. American Banking System

Summary Commercial Banking Investment Banking U.S. Fractured Regulation Highly Regulated (Federal SEC) Dominant Canada (provincial SECs) Major firms owned by Commercial Banks

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. (Commercial) Banking Industry 1) 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

2) Multiple Regulatory Agencies: “Crazy Quilt System” The Office of the Comptroller of the Currency : in primary charge of “Charter” for national banks Fed :in secondary charge of national banks, and in sole charge of bank holding companies FDIC and State Banking Authorities : in charge of state banks with FDIC insurance State Banking Authorities : in sole charge of state banks without FDIC insurance

3) Fractured Commercial Banking Industry A Large # of Banks: 12,000 until the early 1990 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

2. Historical Background 1) The Fractured C Banking Industry is the results of long-standing strugges between Federal versus State interest forces regions, parties and interest groups.

1) Parable -“The Wizard of Oz as a Monetary Allegory” by H. Rockoff Background: Depression in the 1890s Allegories: Dorothy: an Average conscientious true American Scarecrow -Western Farmer Tin Woodman- Unemployed Industrial Workers Cowardly Lion -“William Jennings Bryan” versus Wicked Witch of the East- Eastern Business and Financial Interests Munchkins -Average Americans Wicked Witch of the West - Grover Cleveland Western(Local party) Solution 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-going legacy of the long tradition of these complicated political Struggles bet

2) Anti Trust Acts of 1920s to 1930s have shaped the U. S 2) Anti Trust Acts of 1920s to 1930s have shaped the U. S. Banking System 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

However, Glass-Steagall Act deprived 1) commercial banks, now mere lenders without management participation, of Monitoring Venues against Moral Hazards while it also deprived 2) investment bank of Venues for Active Management participation, which are no longer allowed t have board representation.

3) Turn Around 1.Evolution of Bank Holding Companies 2. Reigle-Neal Act of Interstate Banking and Branching Act (1994) : Opening up M & A for “Efficiency” in banking sectors 2.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.

* How American Commercial Banks Merge? The number of banks has been decreasing; currently as of 2006, about 7,800 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.

Investment Banking in U.S. We now know more about Investment Banking in the U.S. after 911 Prime movers of M & As and Privitization around the world Well-connected with Private Equities

Cross-board M & A between Commercial and Investment Banks was allowed by G-L-B act of 1999.

Can we all copy this G-L-B in every country without having the negative effect? The negative effect could be “Lack of Competition” which may lead to “Lack of Protection of Small Lenders” beside banks as big lenders. However, in the U.S., this is not case due to

* Gramm-Leach-Bliley Act versus U.S. Legal System - G-L-B Act would not lead to Conflict of Interests due to the unique U.S. legal system. Legal protection for smaller financial investors is secured by “Lender Liability and Equitable Subordination” Read the paper by R. Kroszner (webpage form) This principle does not exist elsewhere: The U.S. case of allowing merger between banks and commerce may not be equitably applicable elsewhere.

II. Canadian Banking Systems

1. Evolution of Canadian Financial System Tradition of “Four Pillar System” : Trust, Mortgage, Fiduciary Business Chartered Banks Insurance Securities Industry (Credit Unions) Towards Full Service Banking

2. Initially Free Banking System, and changed to Government Regulated System with the Central Bank(B of Canada) The process was “unnatual”. Initially, all banks were allowed to issue their own paper monies; First, BMO helped government bonds to be used for reserves; 1840-1870,Government started monopolizing Money Issues Then, B of Canada was set up in 1934;

3. Reforms in the Canadian Bank Act 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 o pen membership to the Canadian Payment Association

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

4. Other Apparent Differences between U. S. and Canada Not Much No Big Surge U.S. Big Increases in Mortgage Backed Securities <- S & L companies’ mismatch of maturity terms of Assets and Liabilities Big Surge of Money Market Mutual Funds <- way to get around `Regulation Q’

5. Changing Characteristics of Canadian Banking Industry Chart 9 of C. Freedman

6. Quantitative Analysis of Comparison of U. S 6. Quantitative Analysis of Comparison of U.S. and Canadian Banking System Different system leads to different results 1) Canadian commercial banks may be more efficient than the U.S. counterpart in some senses. (1) monopolistic competition: contestability (Allen et al): H statistics (= elasticity of Revenue to An Increase in Input Cost) indicates the Canadian Banking system is monopolistic competition (2) monopoly protection kept by spending resources on ‘legitimacy’ (Breton and Cote) 2) Different challenges Paper on Current Financial Crisis (Han and Ibbott)

III. Japanese Banking System Post WWII Japanese banks were reorganized by the U.S. Occupying Army Yet, they have been distinct from the U.S, banks Notably, Japanese banks have been allowed to hold equities and to participate in management of non-financial corporations

Japanese Banks are allowed to own Equities: Banks are lenders as well as owners

Pros: Reduces bankruptcy costs for society (legal cost; disruption cost) Sumitomo Bank revived Mazda in the 1970s Reduces monitoring cost of Principal-Agent Problem (Sun Bae Kim, Banking and Commerce: The Japanese Case) Makes banks share ‘Upside Returns’ and ‘Calculated Entrepreneurial Risk and Venture’

Cons: Stock Market Crash leads to Loss of Bank Assets Moral Hazards: “Too Big to go bankrupt”